Sept. 21 (Bloomberg) -- The U.S. Securities and Exchange Commission is seeking to determine whether some private-equity firms are taking more profits from investments than they should under agreements with fund clients, according to two people with knowledge of the matter.
The SEC, pursuing a review of the industry begun after passage of the Dodd-Frank Act in 2010, is examining how buyout funds ensure that payouts follow the sequence set out in partnership documents, said the people, who asked not to be identified because the matter isn’t public. Regulators are looking for deviations from the distribution process, or waterfall, which usually calls for clients to receive some gains on investments before the fund manager.
The SEC stepped up its scrutiny of the private-equity business following the 2008 collapse of Lehman Brothers Holdings Inc., which accelerated a financial crisis that froze deal-making and forced firms to write down the value of their holdings. After Dodd-Frank authorized greater oversight of money managers, the agency initiated its broad review of practices at private-equity and hedge funds.
“More SEC scrutiny will force firms to add controls, increasing their costs in an already difficult operating environment of decreased profit margins,” said Tom Bell, a partner at Simpson Thacher & Bartlett in New York who oversees the firm’s private-funds practice. “We may see a few enforcement actions as a result, which would probably put the subject firms effectively out of business.”
The SEC has implemented examinations to police the industry. In connection with regular inspections, the SEC is also looking into how buyout firms allocate expenses among investors, including those incurred for deals that are pursued but not completed.
John Nester, a spokesman for the SEC in Washington, declined to comment. Ken Spain, a spokesman for the Private Equity Growth Capital Counsel, said the SEC hadn't contacted the Washington-based trade group about it inquiries.
“As a fiduciary, it is important that private-equity advisers allocate their fees and expenses fairly,” Carlo V. di Florio, director of the SEC’s office of compliance inspections and examinations, said at a conference in New York in May. “A firm should clearly disclose to clients the fees that it is earning in connection with managing investments as well as expense allocations between a firm and its client fund.”
Private-equity firms buy companies using a combination of investor capital and debt, with the goal of selling them or taking them public later for a profit. They charge annual management fees of 1.5 percent to 2 percent of committed funds and keep 15 percent to 20 percent of profit from investments, known as carried interest.
When a buyout fund exits a holding, investors often get their investment back first, plus a certain percentage of the profits, known as the hurdle. Once the hurdle has been paid, the fund manager can begin collecting carried interest.
Investment agreements aren’t uniform among funds. In some cases a firm may waive upfront management fees and instead take an equivalent payout from investment profits. Under such arrangements, the manager may pay itself before returning the investors’ original contribution.
The SEC is concerned that firms lack internal controls to track payments and ensure that the agreed waterfall plan is followed, the people said. One issue is whether the firms are taking more of the deal profits than they are entitled to, said another person with knowledge of the matter.
While buyout companies have traditionally managed funds that pool capital from multiple investors such as pensions, endowments and wealthy individuals, large investors have increasingly sought their own separately managed accounts with better terms than the others.
The SEC has asked some firms for information about how so-called broken-deal expenses are allocated, one of the people said. If a manager evaluates the same investment opportunity for a pooled fund and a separately managed account, regulators are concerned that the manager may protect the favored large investor from due diligence costs if the deal falls through, shifting the burden to the smaller investors in the co-mingled fund.
Regulators are also examining whether some managers are giving lawyers and bankers business related to their funds in exchange for fee discounts for the management company, according to the people.
“Some people at the agency believe that there are more inherent conflicts with private-equity funds than there are with hedge funds,” said Barry Barbash, a partner and head of the asset-management group at Willkie Farr & Gallagher LLP in Washington and a former director of the SEC’s investment-management division. “The agency’s focus on the private-equity industry is leading to a greater degree of wariness, pushing firms to think twice about their practices.”
The private-equity industry has been under the spotlight as a result of Mitt Romney’s campaign for U.S. President. Romney co-founded Bain Capital LLC in 1984, and even after retiring from the Boston-based buyout firm in 1999, he still receives payouts from Bain funds as part of an exit package. Carried interest is taxed at the 15 percent rate for capital gains, rather than the 35 percent top rate that applies to regular income.
While the debate over Romney’s ties to private equity has centered mainly on taxes, it has also highlighted the general lack of transparency in an industry based on private deals involving wealthy investors.
The SEC adopted a rule last year that required private-equity companies and hedge funds with more than $150 million in assets under management to register with the agency. Of the 50 largest private-equity funds in the world, 37 are now registered with the SEC, 18 of which had not been registered before.
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