SEC Warns Private Equity Funds Not To Put Their Own Interests Ahead of Those Of Clients

It’s now 10 years since the Dodd-Frank Act forced private funds, hedge funds and private
equity funds, to register as investment advisers. That placed them under the oversight of
the SEC, the USA’s financial regulator and the equivalent to the FCA in the UK. Oversight of
the banking system is what most associate with the Dodd-Frank Act, but SEC oversight of
private equity and hedge funds is also proving significant.

Investors in private equity funds and hedge funds are not the inexperienced retail investors
that the SEC’s main mandate is to protect. They are usually wealthy individuals, family
offices and pension and other funds run by professional investors.

Despite that, the SEC’s Office of Compliance Inspections and Examinations (OCIE), recently
published a “risk alert”, warning the industry to clean up across three problem areas. The
private equity industry has been largely untroubled by the Covid-19 pandemic. In fact, it is
proving an opportunity for funds to acquire otherwise healthy companies struggling with
cash flow at prices they wouldn’t have been able to a few months ago. But the feeding
frenzy is, believes the SEC, seeing some private equity funds put their own interests ahead
of those of their client investors.

The danger the SEC sees in the private equity industry is that these funds typically buy out
or into privately held companies. Sometimes private equity funds even take previously
public funds private. Public companies have to offer a lot of insight into their finances. But
privately held companies do not. That opaqueness, the SEC has previously intimated, means
private equity advisers can be tempted by conflicts of interest that don’t exist for advisers
who deal with public companies.

It means that investors into private equity funds often have very little information about
what their fund managers are actually doing. It also means it is easier for private equity
funds to cloak fees and charges that eat into investor returns.

In June the SEC, based on hundreds of annual examinations of firms, said there were still
several areas of deficiency in how private equity funds operate in terms of their openness
with clients and transparency around costs. It cited conflicts of interest, fees and expenses,
and the treatment of material non-public information.

Lack of transparency and disclosure on fees and charges is one issue but the SEC believes it’s
not the only problem that needs to be addressed. The regulator has cited cases of different
private equity funds within the same firm all investing in the same company. They usually
invest through different securities but the SEC still view this as a conflict of interests.

The SEC has also highlighted cases of potentially dubious co-investments, where other large
investors, such as pension funds, put money into transactions alongside private equity
funds, without being directly invested in these funds. The suspicion is these are cosy
arrangements that mean both the private equity fund and co-investors gain an advantage, potentially by jointly negotiating concessions. Without the co-investor paying the same kind
of fees as other investors actually inside of the fund.

For now, there has been no major scandal, but numerous fines have been issued by the SEC,
penalising private equity funds for perceived conflicts of interest with their investors. But
this has raised awareness.

Chris Hayes, policy council at the Institutional Limited Partners Association, a trade group
representing investors in private equity funds, recently warned members to be vigilant of
potential conflicts of interest and to place pressure on fund management. He comments on
the SEC’s risk warnings:

“The risk alert highlighted the need for continued, improved transparency in fees and
expenses, as well as an enhanced focus on strong fiduciary duties in fund agreements.”