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Carlo V. di Florio, who is the Director of the  Office of Compliance Inspections and Examinations at the SEC recently gave his views as to key points the SEC will consider in the examination process of sponsors of private equity groups who are registered with the SEC and other matters.


Mr. di Florio began by outlining the data profile of new private equity registrants:

  • There are now close to 4000 IAs that manage one or more private funds registered with the Commission, of which 34 per cent have registered since the effective date of the Dodd-Frank Act.
  • 32 per cent of all advisers that register with the SEC report that they advise at least one private fund.
  • Of the roughly 4000 registered private fund advisers, 7 per cent are domiciled in a foreign country (the UK is the most significant).
  • Registered private fund advisers report that they advise nearly 31,000 private funds with total assets of $8 trillion (16% of total assets managed by all registered advisers).
  • Based on available information, of the 50 largest hedge fund advisers in the world, 48 are now registered with the Commission. Fourteen of these are new registrants.
  • Of the 50 largest private equity funds in the world, 37 are now registered with the Commission. 18 of these are new registrants.


Private equity groups will be able to engage in advertising during their fund raising cycle once the SEC deletes the prohibition on general solicitation during Rule 506 offerings as required by the JOBS Act.  Mr. di Florio noted the “advertising rule” prohibits advertisements by investment advisers that are false or misleading advertising or contain any untrue statements of material fact. Advertising, like all statements made to clients or prospective clients, is subject to the general prohibition on fraud under section 206 of the Advisers Act as well as other anti-fraud provisions under the federal securities laws. In addition to specific regulatory requirements, SEC staff has also indicated its view that, if you advertise performance data, the firm should disclose all material facts necessary to avoid any unwarranted inferences.


Mr. di Florio discussed some of the risk areas regarding private equity that might be considered during an examination:

  • What is the fund strategy? Does the fund control portfolio companies or hold only minority positions? Is the strategy to invest with other firms or alone? Does strategy make general sense? Are investments in easily understandable companies?
  • How clear are investor disclosures around ancillary fees (particularly those charged to portfolio companies), management fee offsets and allocation of expenses? How robust are the processes to ensure compliance with those disclosures?
  • Does the firm have a complicated set of diverse products? If so, how are inter-product conflicts managed? These conflicts can arise, for instance, from two products investing in different parts of a deal’s capital structure or products competing for deal allocation.
  • What risks are posed by the life cycle of the funds? For example, for funds approaching the end of their life fund raising may be necessary, in which case risks related to claims about the fund’s track record and valuation should be in focus. Conversely, a “Zombie” adviser who is unlikely to raise additional capital may be motivated to extract value from its current holdings, in which case risks related to fees, expenses and liquidity would come into focus. For a fund at the beginning of its life cycle, deal allocations between investment vehicles, or other types of favoritism might be a greater focus of concern.
  • How sophisticated and reliable are the processes used by the fund? Is the valuation process robust, fair and transparent? Are there strong processes for compliance with the fund’s agreements and formation documents? Are compliance and other key risk management and back office functions sufficiently staffed? What is the quality of investor communications? What is the quality of processes to ensure conflict resolution in disputes with or among investors?
  • What is the overall attitude of management towards the examination process, its compliance obligations, and towards risk management generally, compared to its peers?


From the examinations of private equity firms that the SEC has conducted to date, Mr. di Florio described a number of conflicts they have noted:

  • The profitability of the management company is obviously an important concern for private equity general partners and this creates an incentive to maximize fees and minimize expenses. The SEC has seen instances where expenses that should have been paid by the management company were pushed to the funds and have also seen instances where questionable fees were charged to portfolio companies. In addition, the same manager may be incentivized to be opaque with fee disclosures for fear that fund investors may not see extra fees as being in their best interest and to pursue larger deals which can absorb more fees. The adviser negotiates more favorable discounts with vendors for itself than it does for the fund;
  • The adviser favors side-by-side funds and preferred separate accounts by shifting certain expenses to its less favored funds;
  • The adviser puts one or more of the funds that it manages into both equity and debt of a company, which traditionally have conflicting interests, especially during initial pricing and restructuring situations;
  • One or more of a private equity firm’s portfolio companies may hire a related party to the adviser to perform consulting or investment banking services. This type of conflict may be remediated through strong disclosures, but the SEC has seen instances where disclosures were not very robust;
  • Conflicts between different business lines, where there may be the potential for confidential information to be improperly shared. The traditional means of remediating these types of conflicts is to maintain effective information barriers, but the SEC has seen weaknesses in private funds’ practices. For example, the SEC has have observed instances of weak or nonexistent controls where the public and private sides of the adviser’s business hold meetings or telephone conversations regarding an issuer about which the private side has confidential information, or poor physical security during business hours over the adviser’s office space such that employees of unrelated financial firms that have offices in the same building could gain access to the adviser’s offices.

Check frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

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