Buyout firms have been forced to erase billions of dollars from the value of their wagers in the economic downturn, and financial regulators are now scrutinizing whether managers are reducing fees for investors when those deals sour.
The Securities and Exchange Commission has been ramping up inquiries to private equity firms about whether they adjust customer fees when bets get written off to zero or below their original price tags, people with knowledge of the matter said.
While these questions have come up sporadically in recent years, regulators are now asking private equity firms about the issue regularly in routine exams and seeking a level of detail that they didn’t before, the people said. The goal is to make sure that private equity firms, which take a cut of the money they manage, aren’t overcharging state pensions, university endowments and other investors.
SEC officials are ramping up those inquiries to root out what they consider a chronic practice of firms charging more than contractually allowed, and because regulators recognize that firms face pressures to juice fees in the market downturn.
Those inquiries are coming from both examiners at the SEC’s private-funds unit as well as regional-office staff, one of the people said. The SEC has at times drilled down into whether firms have delayed write-offs to squeeze out more fees from investors, and asked for internal emails to help it make such determinations, the people said.
A spokesperson for the SEC declined to comment.
The SEC, under Chair Gary Gensler, is making a more aggressive push to police private equity firms. The industry has grown rapidly over the past decade to become a bigger part of both the finance industry and the US economy, but has so far avoided the same level of regulatory oversight that banks and mutual funds are subject to.
Complex Arrangements
Private equity firms tend to have complex fee arrangements, with most funds shifting from charging fees on money pledged by investors to taking a cut of invested funds after a few years. When that happens, fund managers typically can’t charge fees on investments written off to zero or deemed permanently impaired. In rare cases, fees are supposed to be reduced following writedowns.
“The SEC staff is very focused on the calculation of management fees and we are seeing increased scrutiny of those calculations in recent exams,” said Nabil Sabki, a partner in Kirkland & Ellis LLP’s investment-fund regulatory group. When it comes to writedowns, write-offs or permanent impairments of investments, “they are pressure-testing exactly when such events take place, and whether the manager has adjusted the management-fee base appropriately.”
SEC examiners aren’t in the regulator’s enforcement division, but can refer their findings to that unit for a formal investigation.