In the last few years, the private equity market has continued to balloon. In 2015, there was $2.4 trillion in private equity assets under management and the market as a whole saw an aggregate value of total buyout deals hit $411 billion. ((Preqin Ltd., 2016 Preqin Global Private Equity & Venture Capital Report (2016), https://www.preqin.com/docs/samples/2016-Preqin-Global-Private-Equity-and-Venture-Capital-Report-Sample_Pages.pdf.)) In comparison, there was $716 billion of total assets under management in the private equity market as of December, 2000. ((Preqin Ltd., 2015 Preqin Global Private Equity & Venture Capital Report – Table 3.1 (2015), https://www.preqin.com/docs/reports/2015-Preqin-Global-Private-Equity-and-Venture-Capital-Report-Sample-Pages.pdf.)) This strong growth has caused regulators to grow uneasy about the unknown long-term implications and risk exposure that the industry has created. ((See generally Robert Frucht, “No Direction: The Obama Administration’s Financial Reform Proposal & Pending Legislation Proposing the Registration & Further Regulation of Hedge Funds & Private Equity Pools of Equity are Overbroad & Fail to Address the Actual Risks that these Funds Pose to the Financial System,” 29 Rev. Banking & Fin. L. 157 (2009).)) To deal with this uncertainty, the SEC has aggressively imposed punishment on private equity firms who fail to perform up to the disclosure standards that Congress has enacted. But aren’t private equity funds “private” in nature and fall outside the realm of the SEC’s wrath? While intuitive, this notion is incorrect.
Since the beginning of 2015, the SEC has brought cases against some of the biggest players in the private equity business, including The Blackstone Group LP and KKR & Co. LP. ((Aruna Viswanatha, “Private-Equity Firms Move Into SEC Crosshairs” (2016), http://www.wsj.com/articles/private-equity-firms-move-into-sec-crosshairs-1471646498.)) Similarly, in August 2016, Apollo Global Management agreed to pay $52.7 million in connection with SEC allegations that Apollo misguided investors regarding the fund’s fees. ((Apollo Management V, L.P., et al. (2016), https://www.sec.gov/litigation/admin/2016/ia-4493.pdf.)) These cases alleged violations of the 1940 Investment Company Act with regard to a breach in the firm’s fiduciary duty owed to investors. ((Viswanatha, supra.))
To grasp this regulation, examining Apollo’s recent settlement can help clarify one’s understanding. The settlement resulted from two alleged fiduciary breaches. First, Apollo charged its portfolio companies a monitoring fee pursuant to the terms of their monitoring agreement. ((Apollo Management V, supra at 2.)) Future monitoring fees were later accelerated upon either a private sale or an IPO. ((Id.)) In collecting these future-based fees, this acceleration reduced the value of the portfolio companies prior to their sale or IPO. ((Id.)) Thus, the SEC declared that Apollo had a “conflict of interest” between its own desire to collect fees and its investors’ desire to maximize the price of the portfolio companies. ((Id.)) Based on this “conflict of interest,” Apollo was unable to effectively consent to the acceleration on behalf of its investors. ((Id.)) In light of such inability, the SEC declared Apollo had failed to adequately disclose to its investors that Apollo was accelerating these fees. ((Id. at 5-6.))
Second, the general partner to one of Apollo’s funds, Fund VI, took out a loan from four of the firm’s parallel funds that was equal to the amount of carried interest due to the general partner from the lending funds. ((Id. at 6-7.)) This was perceived to have been done for the purpose of deferring taxes that Apollo executives would owe on carried interest from those parallel funds. ((Suzanne Barlyn, “Apollo Private Equity Advisers to Pay $52.7 million to Settle U.S. SEC Case” (2016), http://www.reuters.com/article/us-sec-apollo-global-settlement-idUSKCN10Y205.)) This practice was announced in a footnote in the Fund VI financial statements. ((Dan Primack, “SEC Nails Private Equity Firm Apollo for Misleading Investors” (2016), http://fortune.com/2016/08/23/sec-nails-private-equity-firm-apollo-for-misleading-investors/.)) The SEC deemed this “materially misleading.”
If this alleged conduct indeed occurred, it seems natural for the regulators to step in and impose penalties that serve both compensatory and punitive purposes. While public perception tends to be that private equity firms are the “new kings of Wall Street” and go highly unregulated, the private equity market is subjected to both common law and federal statutory limitations. ((See Lee Harris, “A Critical Theory of Private Equity”, 35 Del. J. Corp. L. 259 (2010); Lorna Schnase, “An Investment Adviser’s Fiduciary Duty” (2010), http://www.thefiduciaryinstitute.org/wp-content/uploads/2013/02/lornaschnaseFiduciary-Duty-Paper.pdf.))
Under common law, agency law requires an investment adviser, the agent, to fulfill its fiduciary duties owed to the client, or principal. ((Schnase, supra at 1.))) The exact determination of how restrictive common law will be depends on the jurisdiction, with Delaware being the premier state for corporate law.
Federal statutes also impose duties on private equity firms. One of Apollo’s violations was founded under § 206(2) of the Investment Advisers Act of 1940. ((Apollo Management V, supra at 9.)) § 206(2) prohibits investment advisers from directly or indirectly engaging “in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.” ((Id.)) Another violation was based on § 206(4) of the Advisers Act which prohibits “[m]ak[ing] any untrue statement of a material fact or omit[tting] to state a material fact…” in order to mislead investors in a pooled investment vehicle. ((Id.)) Other statutory limitations that firms face include Dodd-Frank, ERISA, Blue Sky laws, and Broker-Dealer laws. ((Schnase, supra at 3-5.))
Despite the image of private equity being the Wild West of the financial universe, these common law and statutory limitations show regulators are trying to keep the industry on the straight and narrow. ((See generally Mary Jo White, Keynote Address at the Managed Fund Association: “Five Years On: Regulation of Private Fund Advisers After Dodd-Frank” (2015), https://www.sec.gov/news/speech/white-regulation-of-private-fund-advisers-after-dodd-frank.html.)) A $52.7 million settlement is no small penalty, and will undoubtedly put the industry on notice that the laws are not merely voluntary guidelines but are indeed hard-set rules. As noted earlier, 2015 saw some of the marquee private equity firms get hit with penalties. ((Viswanatha, supra.)) The Apollo settlement shows last year’s policing by the SEC was not an anomaly. The SEC recognizes the risk that private equity involves, and does not want firms to take advantage of any asymmetrical information. This trend is something to keep an eye on, especially when both the economy and political environment face uncertainty in the next calendar year.
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