A majority of private-equity firms inflate fees and expenses charged to companies in which they hold stakes, according to an internal review by the U.S. Securities and Exchange Commission, raising the prospect of a wave of sanctions by the agency.
More than half of about 400 private-equity firms that SEC staff have examined have charged unjustified fees and expenses without notifying investors, according to a person with knowledge of the SEC’s findings who asked not to be named because the results aren’t public. While some of the problems appear to have resulted from error, some may have been deliberate, the person said.
The SEC’s review of the $3.5 trillion private-equity industry began after the 2010 Dodd-Frank Act authorized greater oversight of money managers, putting many firms under the agency’s scrutiny for the first time. By December 2012, examiners had found that some advisers were miscalculating fees, improperly collecting money from companies in their portfolio and using the fund’s assets to cover their own expenses.
“A lot of the practices, in the eyes of the SEC, raise conflicts,” said Barry Barbash, co-head of the asset-management group at Willkie Farr & Gallagher LLP in Washington. “The SEC wants those conflicts aired out and wants certain practices ultimately changed, and I’m sure we’re going to see it.”
John Nester, an SEC spokesman, declined to comment on the exams.
Private-equity firms buy companies using a combination of investor capital and debt, with the goal of selling them or taking them public for a profit. They typically 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. Most buyout firms also charge fees to the companies they acquire to help cover costs related to the deals or restructuring, often sharing some of the proceeds with their investors.
“These organizations, though, are opaque, and that’s the problem. We’re basically taking them at their word,” said William Atwood, executive director of the Illinois State Board of Investment, which oversees three state retirement systems. “The role of the regulator in this situation can’t be overstated.”
The private-equity model lends itself to potential abuse because it’s so opaque, according to Daniel Greenwood, a law professor at Hofstra University in New York and author of a 2008 paper entitled “Looting: The Puzzle of Private Equity.” The attraction of the funds is that the managers have broad discretion, which also means that investors have a hard time knowing what the managers are doing, he said.
“The SEC and SEC enforcement can now see problems that probably existed all along and probably were actionable all along, but there was nobody to bring the action,” Greenwood said. “The big change has got to be the disclosure.”
Last month, the agency filed a civil case against Clean Energy Capital LLC and its founder Scott Brittenham, accusing them of misusing more than $3 million in funds to pay for office rent, tuition costs, bottled water and group photo sessions. The money should have gone to investors, the SEC said.
“We believe that all of the expenses the SEC was complaining of were permitted by the limited partnership agreements and Delaware law,” said Aegis Frumento, a partner at Stern Tannenbaum & Bell LLP in New York, who represents Brittenham and the firm. “We have every confidence at the end of the day that these charges will not be found to have been fraudulent under the Investors Advisers Act.”
The SEC’s action against Clean Energy Capital is probably just the first of several enforcement cases that will draw the boundaries of what’s allowed, according to Barbash, a former director of the SEC’s investment-management division.
“The industry is going to be forced into change because, frankly, when your big investors are public plans and other money that’s run by fiduciaries, you can’t afford as a business matter to be deemed to be engaging in fraud,” Barbash said. “Fraud doesn’t sell very well.”