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Regulatory Oversight in Private Equity

Late last year, the Securities and Exchange Commission (SEC) announced an informal inquiry [1] into private equity funds. This investigation has at least three goals: (1) understanding alleged systemic risks posed by private equity funds; [2] (2) ascertaining whether valuation, due diligence, and related compliance controls are in place and adequate; [3] and (3) rooting out potential fraud. [4] However, some commentators have expressed the belief that the SEC is concerned with the valuation and compliance processes in place at smaller funds and so called “zombie”[5] funds, as opposed to the major players. [6] Indeed, neither the Blackstone Group nor KKR—both major players and publically traded—received the SEC’s first wave of informal inquiry requests in February, [7] and it is unclear if they have since received a request in a subsequent wave. Comments by the Bruce Karpati of the SEC’s enforcement division confirm this narrow view: “[the agency] is looking at zombielike funds that have potentially stale valuations.” [8]

The SEC’s espoused goals thus seem inconsistent: in contrast to large funds, small funds or zombie funds are unlikely to cause the systemic risks that would warrant investigation. Although valuations for zombie funds might raise concerns of fraud, [9] systemic fraud in private equity valuations seems unlikely due to countervailing incentives: private equity funds might want to overvalue assets to attract new investors, [10] but they want to maximize the difference between purchase and sale price [11] which could incentivize undervaluing assets. Reputation, which directly affects investor confidence, is another check on fraud. [12] Additionally, private equity investments involve sophisticated investors, [13] and as a matter of policy the SEC limits oversight of sophisticated investors. Increased regulatory oversight chips away at the notion that sophisticated investors can and should bear the economic risks of their investments themselves.

Therefore, to even investigate zombie funds is a marked policy shift for the SEC. By subjecting zombie funds to regulatory oversight, as opposed to leaving them to private resolution, the SEC has imposed not-insignificant regulatory compliance costs onto all private equity funds. [14] Simply put, the industry-wide costs imposed by the SEC’s new regulatory scheme could substantially outweigh the costs [15] associated with private resolution of zombie funds. Although investors might face significant losses through private resolution, private equity is a field for sophisticated investors that are capable of bearing investment risk. Consider a hypothetical pension fund that has invested into what has become a zombie fund. The fund must only take steps to leave the investment and absorb the associated losses. [16] In contrast, the SEC must first identify the zombie fund by reviewing valuation and compliance procedures, likely a costly and inefficient endeavor. Every private equity fund subject to SEC oversight must thus bear the cost of regulatory compliance, rather than limiting the costs to investors in zombie funds. A more efficient solution might be to work directly with aggrieved investors to investigate only particular funds. Upon receiving a complaint from an investor, the SEC can launch a targeted investigation that does not impose unnecessary costs onto the industry. The SEC already maintains a complaint reporting system, and expanding that system to include zombie funds is potentially a better use of the Commission’s finite resources.

Further, some commentators also question whether the SEC should devote any resources to valuation methods. [17] Conventional wisdom holds that valuing a private entity is an art, not a science; there is inherent uncertainty in valuation. [18] Industry groups argue that valuations are not as important to private equity funds as they are to other alternative investments. [19] Hedge funds, for example, charge fees based on changes in valuation, whereas the majority of fees due to private equity firms are based on the difference between the entrance and exit prices. [20] Although the SEC contends that smaller private equity funds might be incentivized to overvalue assets to attract greater investment and management fees, [21] they also face the countervailing incentive to minimize their asset valuation to maximize the delta between entrance and exit price. As previously noted, the private equity industry serves sophisticated investors capable of bearing investment risk, and the SEC’s resources might be better used to protect lay investors rather than to regulating an uncertain-by-nature practice.

This is not to suggest that greater regulatory oversight does not lead to benefits for the firms themselves. For example, some small and midmarket funds have retained outside firms to analyze and test their compliance practices, with the goal of understanding vulnerabilities. [22] Funds have already seen benefits from these reviews, by discovering that their internal controls with regard to data security were not up to SEC standards. [23] Nevertheless, these benefits must be weighed against the broad inefficiencies imposed by the regulatory scheme. Small and midmarket funds must already consider how to efficiently use their relatively limited resources. Rather than imposing costs across the industry, a much narrower regulatory scheme implemented through the existing complaint system is more likely to limit costs. Risk aversion will still lead to the creation of elaborate compliance schemes and mock reviews given that many compliance groups have “little or no experience with an SEC inquiry[,]” [24] or may not understand how to handle an SEC investigation. However, because fewer funds will be in the spotlight at any given time through the use of the complaint system—there at least 200 zombie funds, compared to more than 10,000 private equity funds generally— [25] it will be easier to contain industry-wide costs.

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[1] Letter from Securities and Exchange Commission to Certain Private Equity Funds (Dec. 8, 2011), available at http://online.wsj.com/public/resources/documents/SECInquiry.pdf.

[2] Shaun Gittleman, U.S. SEC Set to Monitor Private Equity Funds, Official Says, Reuters (May 8, 2012), http://blogs.reuters.com/financial-regulatory-forum/2012/05/08/u-s-sec-set-to-monitor-private-equity-funds-official-says/ (due to new regulations implemented under Dodd-Frank, private fund advisers must report potentially systemic risks through the SEC and Commodity Futures Trading Commission).

[3] Carlo V. di Florio, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, Address at the Private Equity International Private Fund Compliance Forum (May 2, 2012), available at http://www.sec.gov/news/speech/2012/spch050212cvd.htm.

[4] Id .

[5] Zombie funds are those where investors must continue to pay management fees, even though the funds are inactive or not actively managed. Often, the zombie fund’s assets are difficult to value or sell. Thus, investors are locked into these funds—which continue to accrue management fees—without the prospect of future payoff. According to one estimate, as much as $100 billion is tied up in zombie funds, and investors stand to lose substantially if they try to sell their stake: private markets value those investments at 30-40% of the stated value. See David P. Abel, Investors Beware of Zombie Funds, Motley Rice Blog (June 7, 2012),http://blog.motleyrice.com/investors-beware-of-zombie-funds/; see also Susan Pulliam and Jean Eaglesham, Investor Hazard: ‘Zombie Funds’, Wall St. J. (May 31, 2012), http://online.wsj.com/article/SB10001424052702304444604577339843949806370.html .

[6] See Dan Loeser, SEC Investigates Private Equity Valuation Methods, Colum. Bus. L. Rev. (Feb. 27, 2012), http://cblr.columbia.edu/archives/11980.

[7] Joshua Gallu and Cristina Alesci, SEC Review of Private Equity Said to Focus on Smaller Firms, Bloomberg Bus. Wk. (Feb. 14, 2012), http://www.businessweek.com/news/2012-02-14/sec-review-of-private-equity-said-to-focus-on-smaller-firms.html .

[8] Pulliam & Eaglesham, supra note 5.

[9] Abel, supra note 5 (there is “concern about the possibility of private equity firms manipulating the value of investments to prop up these zombies.”)

[10] See Gallu & Alesci, supra note 6; see also Jonathan E. Green and Lindsay S. Moilanen, SEC Scrutiny Focuses on Asset Valuation and Private Equity Funds, Inv. Funds Group Newsletter (Kaye Scholer, New York, N.Y.), Summer 2012, at 8, available at http://www.kayescholer.com/news/client_alerts/Investment-Funds-Newsletter-Summer2012/_res/id=sa_File1/Investment-Funds-Group-Newsletter-Summer2012.pdf .
[11] See Loeser, supra note 6.

[12] Id.

[13] See Gallu & Alesci, supra note 7; see also Loeser, supra note 5.

[14] See Loeser, supra note 6.

[15] Which are perhaps more accurately characterized as investment losses.

[16] Private resolution is likely to lead to losses upon exiting the investment. See Abel, supra note 5 for a description of some potential private remedies.

[17] See, e.g. , Loeser, supra note 6 (discussing the inefficiencies arising from greater SEC oversight in the context of the Commission’s already overextended resources).

[18] Id . (citing European Private Equity and Venture Capital Ass’n, Int’l Private Equity and Venture Capital Valuation Guidelines (2006)).

[19] Gregory Zuckerman, How Scared Should Private Equity Be Under SEC Microscope?, Wall St. J. (Feb. 27, 2012), http://blogs.wsj.com/deals/2012/02/27/how-scared-should-private-equity-be-under-sec-microscope/ .

[20] Id . Note, however, that private equity funds do derive some fees from fund valuation (typically 2%) but receive far greater fees from profits or “carry” (typically 20%). This fee arrangement is commonly referred to as “2 and 20.”

[21] See supra note 10.

[22] Laura Kreutzer, PE Firms Learn to Live with Dodd-Frank, Dow Jones Private Equity Analyst (Aug. 27, 2012), available at http://pevc.dowjones.com/article?an=DJFPEA0020120827e88refmxe&from=alert&pid=22

[23] Id .

[24] Id.

[25] Pulliam & Eaglesham, supra note 5.

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Kail Jethmalani

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