Private Equity Management of Fees and Expenses: A Cautionary Tale

In recent weeks, the Securities and Exchange Commission (SEC) has revealed that it is closely reviewing how private equity fund advisers disclose the allocation of fees and expenses to their investors. The SEC is primarily implementing this review through thePresence Exam Initiative (the Initiative), which has been initiated through the SEC's Office of Compliance Inspections and Examinations (OCIE). Under the Initiative, the SEC has examined more than 150 newly-registered private equity advisers. According to the OCIE, the goal is to examine 25% of the new private fund registrants by the end of the year. The SEC has indicated that over 50% of the newly-registered private equity fund advisers that it has examined to date have either violated the law or have demonstrated material weaknesses in their controls related to the allocation of fees and expenses. The SEC has identified inadequate policies and procedures and inadequate disclosure as related issues, with deficiencies in these arenas running between 40% and 60% of all adviser examinations conducted, depending on the year. This sheer number of perceived deficiencies likely will result in increased regulatory investigations, enforcement activity and possible sanctions, as well as increased exposure to investor-initiated lawsuits. As a result, (i) sophisticated fund investors will likely start asking questions to determine whether their fund managers engage in these practices and (ii) private equity firms should consider compliance and disclosure practices that can help limit this exposure.