Marc Wyatt, Acting Director, Office of Compliance Inspections and Examinations, of the SEC, recently gave his views on serious deficiencies found in examinations of private equity advisors at a conference attended by private equity officials.

Mr. Wyatt highlighted the following:

• By far the most common deficiency noted in examinations relate to expenses and expense allocation. 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.
• The SEC has detected several instances where investors in a fund were not aware that another investor negotiated priority co-investment rights. According to Mr. Wyatt, 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 has been promised to investors can be a material conflict and can result in violations of federal securities laws and regulations.
• The SEC has undertaken 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. The SEC has observed that some managers also charge back the cost of their employees who provide asset management services and their in-house attorneys. While the SEC 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, the SEC rarely saw that the vertically integrated manager was able to substantiate claims that such fees are “at market or lower.”

On the positive side, Mr. Wyatt noted that examinations disclose 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.

The SEC has also been 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.

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