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March 16, 2012 1:54 pm

SEC stalking bigger fish than thought in PE probe

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This article is provided to readers by dealReporter—a news service focused on providing insightful intelligence on event driven situations to investors.


The Securities and Exchange Commission (SEC) has sent letters to private equity (PE) firms of “all sizes” as part of its informal inquiry into the industry, a well-placed SEC sourcetold dealReporter.

The SEC probe was reportedly focusing on smaller PE organizations, but the source revealed around 12 firms of varying size received the letter. It is understood the ‘sweep’ letter, requesting information from certain funds, focused on issues of valuation in PE.

The source added that the inquiry is a nationwide initiative centered on no specific geography. Some of the letters are understood to have come from California-located SEC offices.

The inquiry has so far kept a narrow focus, but sources believe there are other suspect practices on the agency’s radar. These include: the use of leverage; insider trading; investment opportunity allocation; the allocation of expenses and zombie funds.

One area of concern is the possibility that leverage in large private equity firms could have some kind of impact on systemic stability, according to a second senior SEC source.

A third SEC source pointed to the issue of ‘mission drift’ whereby a PE firm moves away from its originally stated objective. He also pointed to insider trading based on PE firms taking companies both public and private.

A source with knowledge of the inner workings of the SEC also highlighted insider trading as a concern. Insider trading within PE could also relate to mergers and acquisitions, he said.

A legal source close to a number of large private equity funds explained that the allocation of investment opportunities involves some worrying issues.

“Sometimes a firm may have several types of funds with overlapping investment strategies, either geographic or industry,” he said. “For example, a fund that invests in power projects and a buyout fund that has the ability to invest in power products. For a power project, how much of the possible USD 300m investment comes from the power fund and how much from the generalist buyout funds?”

He also highlighted possible conflict of interest when the owners of a firm would like to invest in an opportunity, but it also falls within the investment mandate one of the firm’s funds.

“These issues are almost always negotiated with fund investors in the fund partnership agreement, but some judgment may be called for,” he said. “The SEC wants to be sure that the fund manager is acting in the best interest of the fund or funds, and fairly and consistently.”

He added that the division of expenses in fund agreements could also be on the SEC’s radar.

Legal sources also warned that there could be concerns about zombie funds, a practice in which unsuccessful managers keep investments to benefit from the management fee.

The source familiar with the inner workings of the SEC said the agency is coordinating heavily on PE, with resources being pooled from departments across the organization.

“They are bringing together lots of areas of the SEC to work together,” said the source “What’s interesting these days is the involvement of enforcement in private equity. This is a new thing.”

The legal source said the new SEC Asset Management Unit and the Compliance Inspections and Examinations division are working together more closely than before – a move understood to be spearheaded by Asset Management Unit Co-Chief Robert Kaplan.

“Kaplan is the guy, and he is thinking about this pretty strategically,” said the source. “They brought in some experts to gain industry knowledge.”

The Dodd-Frank Act required that advisers to private funds, both hedge funds and private equity funds, register with the SEC. There are exemptions for advisers that exclusively counsel venture capital funds and advisers solely to private funds with less than USD 150m in assets under management in the US, according to the SEC.

The act also allows the SEC to obtain data from registered investment advisers about their funds so the Financial Stability Oversight Council (FSOC) can assess systemic risk.

The second SEC source said some PE groups are concerned that the information they submit to the agency could be obtained by competitors.

“I know groups are coming in and asking us to fine tune the reporting requirements,” said the source. “Some groups don’t mind giving info, but want it kept within the SEC.”

A second legal source suggested it would be harder for the SEC to pursue an enforcement action against a larger firm because of the strong compliance function they are likely to have in place.

“The smaller firms don’t have the infrastructure to deal with it,” said the source. “[They would] need to work harder to get one of the big guys on the hook.”

It is unclear when or if enforcement actions will be brought in the private equity space, but the SEC appears keenly aware that hard evidence must be uncovered.

“The timing of action depends on how quickly you find a smoking gun,” the second SEC source concluded.


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