(May 7, 2014) — The US Securities and Exchange Commission (SEC) announced it found overwhelming evidence of illegal fee collection in an examination of private equity firms since 2012. 

“When we examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time,” said Andrew Bowden, director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), at the Private Fund Compliance Forum. “This is a remarkable statistic.” 

The OCIE, the “eyes and ears of the commission” with over 900 examiners, said it has initiated examinations of more than 150 newly registered private equity advisers since 2012. The observations pointed to certain risks and temptations in the $3.5 trillion industry, Bowden said.

The most egregious problems were found in “an enormous grey area” of fees and expenses, according to the SEC.

“Many limited partnership agreements are broad in their characterization of the types of fees and expenses that can be charged to portfolio companies,” Bowden said. “Poor disclosure in this area is a frequent source of exam findings.”

The SEC discovered cases of accelerated monitoring fees that limited partners were often unaware of. Some private equity firms have caused their portfolio companies to sign monitoring agreements with fee obligations of 10 years or longer despite the fact that holding periods are usually around five years. 

And the termination of such agreements would also allow the private equity firms to collect a fee—one potentially exceeding eight figures. 

“There is usually no disclosure of this practice at the point when these monitoring agreements are signed, and the disclosure that does exist when the accelerations are triggered is usually too little too late,” Bowden said.

In his speech, Bowden also mentioned significant compliance shortfalls including lack of due diligence and transparency after an investor closes an investment. Limited partners are often left in the dark without sufficient information to properly monitor an investment, he said, due to opaque and imprecise language in partnership agreements.

A common flaw found in these agreements was the use of “operating partners” or consultants promoted by private equity firms, the SEC said. Often paid directly by portfolio companies, they are hired and used without the investors having full disclosure. Fees are billed to the companies owned by private equity firms in addition to management fees and carried interest, thereby reducing the overall profits and returns. 

“This effectively creates an additional ‘back door’ fee that many investors do not expect, especially since operating partners often look and act just like other [private equity] adviser employees,” Bowden said.

The OCIE recommended increased support from top management of compliance efforts to realign general partner and investor needs.

“Complexity and rapid growth have created governance and compliance issues that should be addressed as these firms mature and evolve,” Bowden said. “It all starts at the top.”

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