SEC Provides Insights on Areas of Improvement for Private Fund Managers


Recently, Andrew J. Bowden, director of the U.S. Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations (OCIE), shared the SEC staff’s observations from recent examinations of registered investments advisers to private equity funds(1). These examinations are part of the SEC’s Presence Exam Initiative (“Presence Exams”) that began in October 2012 for advisers to private funds—e.g., hedge funds and private equity funds—that registered with the SEC after July 21, 2011, the effective date of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010(2). The Presence Exams are expected to continue through the end of this year.

Call for More Transparent Disclosures in the Partnership Agreements

The SEC staff noted that limited partnership agreements (LPAs) do not provide investors with sufficient information rights to enable them to adequately monitor their investments and the operations of the manager. In fact, the SEC staff noted that “[p]oor disclosure…is a frequent source of exam findings”

Concerns expressed by the SEC staff are that the LPAs are often broad and laced with imprecise language. Some of the poor disclosures encompass:

  • Broad characterization of the fees and expenses
  • Lack of clearly defined valuation procedures
  • Lack of clearly defined investment strategy
  • Protocols for mitigating conflicts of interests

Below is a summary of the SEC staff observations from examinations of over 150 private equity fund advisers.

Fund Fees and Expenses
Fees and expenses charged by these advisers’ were the most commonly cited area of deficiency. In fact, the SEC staff noted violations of law or material weaknesses in controls over 50 percent of the time when looking at how fees and expenses are handled by these advisers. Some of the areas of violation or deficiency include:

  • Use of Consultants: Advisers sometimes use consultants to enhance the value of the portfolio companies. Fees paid to these consultants are not always adequately disclosed to fund investors. The SEC staff noted that, frequently, such fees are not paid by the advisers but, instead, are charged to the fund. In cases where the consultants appear to be an extension of (or part of) the adviser’s management team, the fees often do not offset the fund’s management fees when paid by the portfolio company.
  • Expense Shifting: Advisers bill the fund for the cost of its back office operations and for improving its processes—e.g., cost of software and its implementation. Such costs are billed in addition to the management fees charged to the fund, rather than borne by the adviser, from which the management fees traditionally are, and reasonably expected by investors, meant to cover.
  • Hidden Fees: In some cases, advisers charge the fund fees or costs that are not otherwise reflected in the LPA, such as administrative fees, transactions fees or exorbitant costs of services provided by related party services providers.

Earlier this year, the SEC brought charges against Arizona-based private equity fund manager Clean Energy Capital LLC (CEC) for orchestrating a scheme to misallocate expenses to the funds it managed. The SEC alleges that CEC paid more than $3 million of the fund’s expenses, including rent, salaries and other employee benefits, using assets from 19 private equity funds without disclosing any such payment arrangement. The money taken was in addition to the millions of dollars in management fees already being paid to CEC out of the funds.

Because the SEC staff has cited expense allocation as a key issue for private fund advisers, and is taking action against those who do not properly allocate fees and expenses among client accounts and related funds, it’s imperative that fund advisers:

  • Provide greater transparency in the fund’s LPAs and offering memorandum about the types of expenses that will be borne by the adviser, investors and the portfolio companies as well as the use of related parties that provide services to the fund and the portfolio companies;
  • Where changes occur, provide disclosures to the investors about new expense arrangements and the reason for such changes; and
  • Ensure that expenses charged to the funds and client accounts are:
    • Consistent with the fees and expenses disclosed as the fund’s responsibilities/obligations in the LPAs or offering/private placement memorandums
    • Appropriate fund expenses, rather than expenses that should otherwise be borne by the manager
    • Allocated among multiple funds/accounts appropriately and on a reasonable and consistent basis

Valuation and Marketing
Valuation methodology is of the utmost importance when it comes to marketing, as valuation is an indicator and driver of performance that can make or break an investor’s ultimate decision. According to the SEC staff, the following were cited as areas of concerns for valuation:

  • Cherry-picking comparables or adding back inappropriate items to key valuation metrics—e.g., EBITDA
  • Using a valuation methodology that is different from the one disclosed to investors
  • Changing methodology from quarter to quarter—e.g., using trailing EBITDA, then switching to forward EBITDA

While making changes in the valuation methodology is not wrong in and of itself, the change should be reasonable, adequately supportable, consistent with the adviser’s valuation policy and sufficiently disclosed to investors.

Marketing is key to fundraising in this industry. However, misrepresentations and inconsistencies within marketing materials may lead the OCIE to believe that an adviser knowingly made untrue or misleading statements in order to secure funding. According to Director Bowden, particular marketing areas of focus include the use of valuation projections, rather than actual valuations, and misstatements about the investment team.

In sharing its observations from the Presence Exams, the SEC staff hopes to encourage firms to review compliance in these areas, self-correct where necessary and promote improvements in their compliance programs. Many of the legal and regulatory issues seen among hedge funds and private equity funds are related to compliance programs, or the lack thereof. “The most effective defense your firms have against such risks is a strong culture of compliance that is supported by the owners and principals of a firm,” Director Bowden noted during his speech.


(1)See the speech by Andrew J. Bowden, Director, OCIE, at:

(2)See the Letter to Industry Regarding Presence Exams at:

Dale Thompson is an Assurance Partner at BDO USA serving alternative funds, registered funds and broker dealers in the Boston and New York markets. Dale has more than 16 years experience managing multiple audit engagements covering a wide range of asset management companies including hedge funds, private equity funds, mutual funds, business development companies, registered investment partnerships, and investment advisors.

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