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Private Equity: A Look Back and a Glimpse Ahead

Marc Wyatt, Acting Director, Office of Compliance Inspections and Examinations

New York

May 13, 2015

I. Introduction

Good morning and thank you very much for the kind introduction.

Before I begin, I’ll remind you that the Securities and Exchange Commission (“SEC or Commission”) disclaims responsibility for any statement or private publication by any of its employees, including me. The views expressed here are my own and do not necessarily reflect the views of the Commission, the Commissioners, or of other members of the staff.

I want to thank Private Equity International for inviting me to speak at this conference and follow up on the speech given to this group last year by Drew Bowden, then the Director of the SEC’s Office of Compliance, Inspections and Examinations, which we call “OCIE.”

Today, I would like to take a look back since the enactment of Dodd Frank, particularly the last year, and give a glimpse ahead on how we at OCIE anticipate operating going forward in the private equity space.

II. Recap of Our Activities

To recap, OCIE commenced the Presence Exam Initiative in October 2012 in response to the Dodd Frank provisions requiring the registration of many advisers to private equity funds. We designed the Initiative to quickly establish a presence in the private fund industry and to better assess the issues and risks presented by these unique business models. OCIE’s approach was to be as transparent as possible about what we were doing, about where we see risks and therefore where we intended to place particular focus. We also wanted to share our observations with you so that as compliance professionals you have the opportunity to bolster your compliance programs to meet your firms’ unique challenges and risks.

Our observations, which we have communicated to you in various statements and public appearances, came from the more than 150 exams of private equity advisers. As you recall, these exams focused on select areas, including the advisers’ collection of fees, allocation of expenses, marketing and valuation. Among other things we discussed expense shifting and hidden fees where disclosure was limited or inadequate. Advisers have an affirmative duty to fully and fairly describe “the deal” to investors, including discussing in a meaningful way how expenses will be assessed and fees will be collected.

Industry Statistics

Part of the SEC’s mission is to promote capital formation, so I would like to review the underlying data for the private equity industry.

From year end 2011 through Q2 2014, the private equity industry grew by 25% as measured by capital under management or money invested plus dry powder.[1] On a trailing 12 month basis, capital raised by private equity firms increased by over 40% (from $354 billion in Q1 2012 to $503 billion in Q3 2014).[2] Dry powder has increased by approximately 19% (from $1 trillion in December 2011 to $1.2 trillion in September 2014).[3] Deal volume by number of deals increased by approximately 7.5% between the end of 2011 and the end of 2014. Deal value increased by about 36% during that same time.[4]

  • There are other statistics worth noting. For instance:
    • The size of funds that are currently being marketed has decreased by about 14% (from $410 million in January 2012 to $355 million in September 2014). This suggests that smaller managers are forming, contrary to industry concerns that the cost of SEC registration and regulation could stifle the formation of smaller managers.[5]
    • Interestingly, the average size of the actual funds raised has increased by about 57% (from $316 million in the 12 months ending March 2012 to $497 million in the 12 months ending Q4 2014). To me, this is a reflection of the natural maturing and consolidation of the industry and the preference of some investors, especially large non-US investors, for the brand and the services that larger managers can provide.[6]

Just last year, exits from buyouts surpassed $450 billion, an industry record by a wide margin and the fourth consecutive year where Limited Partners (“LPs”) received more distributions than capital calls.[7] While the growth of the industry is a function of the free market, the business cycle, and the robust exit environment, it is not unreasonable to infer that greater transparency is fostering greater trust from investors and helping the industry to evolve and grow in healthy ways.

B. Enhanced OCIE Expertise in Private Equity

While some skeptics worried that registration would impede capital formation, others worried that the SEC and its examinations program was not prepared for the challenge of regulating a complex asset class.

I am pleased to say that I hear this concern less and less these days because OCIE has been able to very quickly come up to speed on this industry and have proven that we are up to the task.

We did this by adding expertise from outside our agency, investing heavily in staff training and creating groups and structures which promote information sharing and provide continuing education.

Over the past several years, the SEC added individuals with industry experience in particular areas including in private equity, trading, cybersecurity, options, high frequency trading, pricing and valuation. These experts complement OCIE’s excellent exam teams by helping to identify industry structures, business challenges, outside pressures and incentives all of which are important inputs in understanding key risk areas. I myself joined the Commission as one of OCIE’s senior specialized examiners focused on examinations of advisers to hedge funds and private equity funds.

With private funds, OCIE has taken another step towards knowledge building and deeper specialization by creating the Private Funds Unit (“PFU”) which is dedicated to examining advisers to private funds, including private equity advisers. The Private Funds Unit is based in four of our regional offices where there is a particularly high concentration of private fund registrants. It is composed of experienced examiners who have now developed the pattern recognition necessary to quickly and efficiently execute on OCIE’s four pillars, which are to promote compliance, monitor risk, detect fraud, and inform policy.

Led by Igor Rozenblit, a veteran of the private equity industry, the PFU’s mission is to apply industry and product knowledge to conduct focused, risk-based examinations using OCIE’s limited resources. The Private Funds Unit plays a critical role in targeting and selecting exam candidates, scoping risk areas, executing examinations, and analyzing data gleaned from those examinations. It also works closely with the policy-makers in the Division of Investment Management’s Private Funds Group, relaying information learned from exams to help shape policy and identify areas in need of more guidance.

While our Private Funds Unit itself is small, it has an outsized impact on the National Examination Program because exam teams are able to incorporate both PFU members and other experienced exam staff from our regional offices. In this way, the insights and expertise generated by the PFU is dispersed throughout our organization.

The Unit also conducts formal classroom training. PFU members are among the faculty for our new examiner training, and they also conduct formalized, case study intensive training for experienced examiners.

The Private Funds Unit has also taken the lead in reaching out to, and engaging with, the private equity industry. We have now connected with most of the major industry associations and are able to maintain on-going conversations with both General Partners (“GPs”) and LPs. We also seek out dialogue with industry and investors at conferences such as this and often receive direct feedback during exams. We are meeting with investors, individually and in smaller groups, to share our observations and to better understand their perspective on potential risk areas. This dialogue enables these investors to better protect the interests of the teachers, firemen, and policemen they often serve.

C. Influence beyond Exams

Our efforts in OCIE to build expertise not only help us better execute our examinations but also help us build credibility with all of you. That is important when we try to focus you on what we believe are some of private equity’s more important compliance problem areas.

When Drew originally announced the observations from our Presence Exams at last year’s forum in the “Spreading Sunshine in Private Equity Speech” (the “Sunshine Speech”),[8] there was industry speculation that our findings would be limited to small, unsophisticated advisers. Others hypothesized that our findings would be generally immaterial or that private equity’s sophisticated investor base would already be aware of the practices we were bringing to light.

Since that time, there have been many press articles detailing the breadth and depth of some of the practices contained in the Sunshine Speech. Investors are more focused on fee and expense topics, and the industry is reviewing and often changing the practices highlighted a year ago. This is a positive change.

We have also seen changes in GP disclosure practices. As widely reported in the media, additional disclosures of many private equity advisers included significant modifications in their responses to Part 2A of Form ADV, adding more discussion of fee, expense, and other practices. While this too is a positive change, I want to highlight that disclosure of material changes in terms of post-fund closing on Part 2A of Form ADV alone is usually not a sufficient remedy for absence of disclosure prior to fund closing. Here, I would encourage GPs to engage with their investors to obtain whatever consents are necessary under their existing Limited Partnership Agreements (“LPAs”) to reflect current practices.

Through our exams, we have learned that disclosure has also been enhanced on certain private equity websites, such as by more clearly defining the role of Operating Partners. In addition, we observed that more robust disclosures are being made to Limited Partnership Advisory Committees.

In our exams we see that some advisers are changing fee and expense practices. For example, the practice of accelerating monitoring fees when a portfolio company is sold or taken public appears to be falling out of favor and the use of evergreen provisions in monitoring agreements, which often enable advisers to take large monitoring agreement termination payments, appears to be declining. Additionally, the collection of revenues from portfolio companies’ use of group purchasing organizations is being better disclosed and contained.

We are encouraged to learn that many advisers are increasingly retaining consultants to evaluate their fee practices and have been revising their practices where issues have been found. We are seeing changes both in current practices and in plans for future funds.[9]

We have also observed increased attention to compliance programs, which is critical because an adviser’s compliance program is paramount in the defense against fraud, abuse, negligence, and errors. Among other changes, we are seeing greater resources being devoted to compliance, including the splitting of the CCO function into its own separate role from a combined role with the CFO or General Counsel. Also, private equity CCOs are becoming more integrated into the businesses and have greater visibility into their firm’s business model. We believe this often leads to more effective policies and procedures.

D. Impact on Institutional Investors

We have also seen changes in the limited partner community. Institutional investors have long taken due diligence seriously. Nonetheless many were surprised by some of the practices we discovered. The private equity business is complex with many moving pieces with the adviser frequently controlling operating companies and other entities. At the same time, private equity operations are not always transparent to investors. This, combined with the fact that many LPs do not have the staff or access to delve as deeply into manager operations as our examiners, may create an environment where bad conduct can occur.

While some of these dynamics are structural and therefore not likely to change significantly, OCIE believes that our examinations have enabled limited partners to better focus their resources and priorities. Some of this focus takes the form of new due diligence procedures. For instance, from OCIE’s discussions with institutional limited partners we have observed that operational due diligence, once thought to be unnecessary in private equity, is now taking a greater role at many organizations. And, while access to the top managers and economic terms are still critical factors in private equity manager selection, according to those institutional limited partners, transparency, governance, and access to information have all grown in importance.

III. There Is Still Room for Improvement

Over the past several years, we in OCIE have worked diligently to identify problem areas and as I just discussed, some progress has been made toward addressing some very important issues. However, there is still room for improvement. Many of the areas that could still be improved are ones that you are very familiar with — fees, expenses, valuation, and co-investment allocation — but some are new.

A. Expenses and Expense Allocation

By far the most common deficiencies noted by our examiners in private equity relate to expenses and expense allocation. Many managers still seem to take the position that if investors have not yet discovered and objected to their expense allocation methodology, then it must be legitimate and consistent with their fiduciary duty.

One of the most common and often cited practices in this area involves shifting expenses away from parallel funds created for insiders, friends, family, and preferred investors to the main co-mingled, flagship vehicles. Frequently, operational expenses, broken deal expenses, and even the formation expenses of the side-by-side vehicle are borne by investors in the main fund. Some of these expense items are small, but some, such as the broken deal expenses of an active fund, can be quite large. This practice can be a difficult for investors to detect but easy for our examiners to test.

B. Co-Investment Allocation

Another area where we have been dedicating resources is co-investment allocation. We’ve spoken before about our observation that co-investment allocation was becoming a key part of an investor’s thesis in allocating to a particular private equity fund, and over the past year, co-investments have become even more important to the industry.

While most of our co-investment observations have been around policies and procedures, we have detected several instances where investors in a fund were not aware that another investor negotiated priority co-investment rights. Disclosing this information is important because co-investment opportunities have a very real and tangible economic value but also can be a source of various conflicts of interest. Therefore, allocating co-investment opportunities in a manner that is contrary to what you have promised your investors can be a material conflict and can result in violations of federal securities laws and regulations.

Ironically, many in the industry have responded to our focus by disclosing less about co-investment allocation rather than more under the theory that if an adviser does not promise their investors anything, that adviser cannot be held to account. However, the risk in that approach is that such promises are often made anyway, either orally or through email. I believe that the best way to avoid this risk is to have a robust and detailed co-investment allocation policy which is shared with all investors. To be clear, I am not saying that an adviser must allocate its co-investments pro-rata or in any other particular manner, but I am suggesting that all investors deserve to know where they stand in the co-investment priority stack.

C. Real Estate Advisers

In addition to our focus on traditional private equity, the National Examination Program began utilizing our Private Funds Unit to systematically look at adjacent asset classes. Specifically, last year, the PFU undertook a thematic review of private equity real estate advisers based on the observation that real estate managers, especially those executing opportunistic and value-add strategies, tended to be much more vertically integrated than traditional private equity managers. After buying a property, it is not unusual for a vertically integrated owner-operator investment adviser to provide property management, construction management, and leasing services for additional fees. We have observed that some managers also charge back the cost of their employees who provide asset management services and their in-house attorneys. The PFU decided to examine the disclosure of such fees and expenses.

While we found that sometimes these ancillary services are indeed not disclosed, a more frequent observation was that investors have allowed the manager to charge these additional fees based on the understanding that the fees would be at or below a market rate. Unfortunately, we rarely saw that the vertically integrated manager was able to substantiate claims that such fees are “at market or lower.” We observed a range of behaviors. During some of our exams, we have seen that the manager collects no data to justify their fees at all. Other times, the data is collected informally through calls to other industry participants and is not documented. Or, when the information is collected, what is presented to investors can be misleading. I hope that private equity real estate managers who have promised to provide their investors with “rates at or below market rate” review their benchmarking practices to ensure they can support their claims.

IV. Glimpse Ahead

As we have gotten to know one another during the past few years, many of you have wondered what the ongoing steady state environment would look like. OCIE has now completed our Presence Exams, which examined 25% of the newly registered private fund advisers (including both private equity and hedge funds). The Presence Exams were different then our normal, risk-based, examinations. For example, the Presence Exams typically focused on only two or three key risk areas, while our normal examinations can focus on a larger number of risk areas. Outside of the buyout industry, the PFU is or will be undertaking exams of real estate private equity advisers, credit advisers, and infrastructure and timber advisers, among others.

We will continue to apply our risk methodology to private equity exam selection. Let me elaborate a bit on what “risk-based” means and how our process may be misperceived by industry. Through our risk-based exam selection process, we identify situations or behaviors which pose significant risk to investors or which, we believe, may violate federal securities laws and regulations. These risk factors and other inputs help determine our exam candidates. A firm may be operating in a key risk area but may have developed policies and procedures which address the related risks. An examination of an adviser, in and of itself, does not imply that we believe that the adviser has committed any securities law violations.

It is reasonable to assume that the next year may bring additional private equity actions by the SEC’s Division of Enforcement, and so we anticipate heightened awareness of reputational and headline risk by the investor community. No investor wants to see their manager portrayed negatively in the media. As everyone knows, the Commission has already brought some private equity Enforcement cases.[10] Based on a recent speech titled “Conflicts, Conflicts Everywhere” by Julie Riewe, Co-Chief of the SEC Enforcement Division’s Asset Management Unit, we can expect additional Enforcement recommendations involving undisclosed and misallocated fees and expenses as well as conflicts of interest.[11] It’s important to understand that we work closely with our colleagues in Enforcement and that there is a natural lag between examination and enforcement activity. The Enforcement staff must take the time that is necessary to make an informed and thoughtful decision as to whether to recommend that the Commission take enforcement action based on the facts and the law. It may take two years or longer between the time an examination uncovers problematic conduct and the public announcement of an enforcement action or settlement.

I have now shared with you some of my thoughts and our current focus areas, but it’s worth noting that they are not static. The private equity industry has experienced strong growth in the past few years, but we all know that private equity markets are cyclical. Current levels of dry powder and transaction multiples make me worry that, at some point, the markets will start to recede and that the outgoing tide may reveal disturbing practices which will need to be addressed. Issues such as zombie advisers and fund restructurings may again come to the fore as we move through the business cycle.

Additionally, recent media reports and our own examinations suggest that the private equity industry is developing vehicles to make its funds available to retail and mass affluent investors. While most groups are focusing their efforts on smaller accredited investors, some groups are pushing into the retail market. Certainly as private equity eyes the coveted and untapped retail space, full transparency is essential. It will be particularly important that retail investors understand the fees they are paying, the conflicts that the advisers might face, and other risks inherent in the private equity model. Only through complete and timely disclosure can advisers, as fiduciaries, discharge their obligation to put their clients’ and investors’ interests ahead of their own.

We will therefore continue to vigilantly study and track the private capital markets and adjust our resources as necessary.

V. Conclusion

While this has been an interesting year, it is my hope that we can continue to keep a constructive dialogue in order to advance our mutual goal of keeping investors safe and well informed as your industry continues to evolve. Thank you.


[1] 2015 Preqin Global Private Equity & Venture Capital Report — Sample Pages, available at

[2] The Q3 2014 Preqin Quarterly Update: Private Equity, available at

[3] Id.

[4] Q1 2015 Private Equity-Backed Buyout Deals and Exists (April 1, 2015), available at

[5] Preqin Press Release, “Strong Private Equity Fundraising Continues in 2014, But Capital Concentrated Among Fewer Funds, January 5, 2015, available at

[6] Id.

[7] Bain & Company, Global Private Equity Report 2015, available at

[8] Andrew J. Bowden, Director, OCIE, “Spreading Sunshine in Private Equity,” May 6, 2014, available at

[9] See Private Equity Manager, “GPs push back on LP data requests,” November 12, 2014. See also Mark Maremont and Mike Spector, “Blackstone to Curb Controversial Fee Practice,” Wall Street Journal, October 7, 2014, available at

[10] See, e.g., In re Lincolnshire Management, Inc. (Sept. 22, 2014), available at; In re Clean Energy Capital, LLC et al. (Oct. 17, 2014) (settled), available at; In re Brian Williamson (Aug. 20, 2013) (settled), available at; and In re Oppenheimer Asset Management Inc. (Mar. 11, 2013) (settled), available at

[11] Julie M. Riewe, Co-Chief, Asset Management Unit, Division of Enforcement, “Conflicts, Conflicts Everywhere — Remarks to the IA Watch 17th Annual IA Compliance Conference: The Full 360 View, available at

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