Advisors to private equity funds routinely break the law with regard to the disclosure of and procedures surrounding how fees and expenses are handled, a top compliance official with the Securities and Exchange Commission (SEC) said.
Examiners have uncovered “violations of law or material weaknesses in controls more than “50 percent of the time,” said Andrew J. Bowden, director of the SEC’s Office of Compliance Inspections and Examination (OCIE).
“This is a remarkable statistic,” he said.
Bowden said it was important for the OCIE to take a closer look at institutional advisors because small investors are more invested in private equity funds than they realize through public and private pension funds, endowments and foundations.
“To the extent that private equity advisors are engaged in improper conduct, it adversely affects the retirement savings of teacher, firemen, police officers and other workers across the U.S.,” Bowden said.
Mutual funds that take positions in alternative investments, which might include a private equity or a large hedge fund, are showing up more frequently as investment options under consideration by retail advisors and smaller investors.
In the wake of the passage of the Dodd-Frank financial reform law, the question of advisor fees have come up often in the context of retail advisors and the advice they give to retail investors invested in the market through defined contribution plans, brokerage account or insurance products.
Fee opaqueness, however, exists in the private equity model at the institutional level – critics might even say it remains so by design. Whatever the case, “we are perceiving violations despite the best efforts of investors to monitor their investments,” Bowden said.
One of the advisor deficiencies occurs around the position of the “operating partners,” who provide consulting services and advice to the companies in the private equity portfolio.
Bowden said the operating partners model is deeply flawed. Many operating partners are paid by portfolio companies or the private equity funds without enough disclosure.
“This effectively creates an additional ‘back door’ fee that many investors do not expect, especially since operating partners often look and act just like other advisor employees,” Bowden said in a speech at a meeting of the Private Fund Compliance Forum in New York.
Bowden said the operating partner model has two problems because investors don’t realize that these special partners are being paid in addition to the management fee charged by the advisor.
“The advisor is able to generate a significant marketing benefit by presenting high-profile and capable operators as part of its team, but it is the investors who are unknowingly footing the bill for these resources,” Bowden said.
He said the second problem with the operating partner model occurs because these partners are not considered employees or affiliates of the asset manager, “and the fees they receive therefore rarely offset management fees, even though in many cases the operating partners walk, talk, act and look just like employees or affiliates.”
Most limited partnership agreements, the kind of agreement under which private equity and hedge funds operate, require that a fee generated by employees or affiliates of the advisor offset the management fee.
Advisors find value in the operating partner model because they impose operational efficiency to private equity agreements.
Bowden also said his examiners had noted another trend in which institutional advisors gradually shift expenses to clients as a fund ages, but never reveal the shift to the fund’s limited partners.
In some cases employees are purported to work for the advisor, which they are during the fundraising stage, but then are “terminated and hired back as so-called ‘consultants’ by the funds or portfolio companies,” Bowden said. Because the funds are never told, fund partners assume the consultant is still an official employee of the advisor.
“The only client of one of these ‘consultants’ is the fund or portfolio company that he or she covered while employed by the advisor,” Bowden said. Back-office functions such as legal, compliance and accounting are wrapped up into one management fee, but advisors sometimes bill the funds separately for functions, but never reveal that to investors, Bowden also said.
Accelerated monitoring fees charged by advisors to provide services during the portfolio company’s holding period, which is typically five years, often go on for a decade or more, and sometimes far beyond the term of the fund.
Other “administrative” fees, transaction fees in relation to a recapitalization, and the hiring of outside consultants and accountants are often not properly disclosed, Bowden also said.
Cyril Tuohy is a writer based in Pennsylvania. He has covered the financial services industry for more than 15 years. Cyril may be reached at [email protected].