The SEC's Private Equity "Initiative" Leaves No Stone Unturned: Time to Look at Your Compliance Programs

In March, the SEC settled two enforcement actions involving private equity. The two actions are just the latest indicators of the SEC’s wide ranging and close scrutiny of the private equity industry, which has been ongoing for some time. We are hearing multiple speeches by SEC Staff focused on perceived compliance problems in the private equity industry. Focusing on both registered and unregistered investment advisers, the SEC has expressed concern with virtually every type of violation, large and small, of which a private equity investment adviser is capable. From the manner in which the offering is conducted to violations of fiduciary duties — improper valuations of portfolio assets, conflicts of interest, favoring some clients over others, improper use of unregistered broker-dealers and finders, general solicitation in private placements, inaccurate disclosures – nothing is being overlooked.

The SEC’s “Private Equity Initiative”

For well over a year, the SEC Enforcement Division’s new Asset Management Unit (AMU) has been heavily targeting private equity. The AMU has recruited industry professionals with asset management experience to serve as specialists on the unit, including private equity specialists. The unit is leveraging this expertise to ferret out wrongdoing in the industry. In January of this year, AMU Chief Bruce Karpati explained why the SEC thinks it is important to focus on private equity:

Private equity went through a significant growth spurt in the run-up to the financial crisis and is a rapidly maturing industry. In terms of assets under management, it’s roughly equivalent to, and perhaps larger than, the hedge fund industry. Also, many private equity managers have only recently become registered investment advisers. As a result of these developments, it’s not unreasonable to think that the number of cases involving private equity will increase. Many in the private equity industry have pointed to the greater perceived alignment of interests in private equity products — for instance, in the way carried interest is paid on realizations and not on net asset values but private equity has other unique characteristics that may make the industry more susceptible to fraud, for example, the ability to control portfolio companies in a way not completely transparent to investors.


Mr. Karpati expressed concern that in the private equity industry currently, “there is more capital chasing the same number of deals, which puts extra pressure on returns,” in turn creating a heightened incentive for “inappropriate” behaviors.

Enforcement Casting a Wide Net

The Enforcement Division appears to be taking a shotgun approach in its targeting of private equity. Staff has expressed concern over a wide array of issues in speeches and other informal communications. Actual enforcement actions also involve a wide array of offenses. In 2012, the private equity specialist on the AMU stated that nearly every private equity firm examined had a variety of different “issues” of varying size and scope.

In 2010, the head of the Enforcement Division described an intention to apply the “broken window” theory to SEC enforcement, under which the agency deliberately seeks to ferret out and pursue violations that may seem minor in nature. The notion behind this criminological theory is that better policing of minor infractions will lead to less serious crime as well by creating an overall heightened culture of compliance. Along a somewhat similar theme, last year the AMU instituted “Operation ADV,” in which the unit scrutinizes Forms ADV (filed by registered investment advisers). Among other things, the unit is paying close attention to the disclosures made about the educational background of, and other biographical information disclosed by, advisers. These are items that an investment adviser may not intuitively expect to receive such close scrutiny by enforcement staff.

Unregistered Advisers Are Not Beneath the Radar

It might be tempting to think that unregistered advisers are beneath the AMU’s radar. As a practical matter, it probably is, to a certain extent, more difficult for the AMU to subject unregistered advisers to the same level of scrutiny. Certainly, the AMU’s investigatory powers are far less sweeping with regard to unregulated entities, as to which they need a subpoena. This does not mean, however, that unregistered advisers are outside the scope of the current enforcement initiative.

In December of 2012, AMU Chief Bruce Karpati expressed concern about unregistered advisers. Apparently thinking ahead to the Congressionally mandated (but not yet enacted) lifting of the ban on general solicitation in 506 offerings, he particularly noted a risk that unregistered advisers may engage in general solicitation without proper policies to ensure that only accredited investors invest.

It is worth noting as well that an investment adviser with valid registration exemptions is nonetheless subject to the anti-fraud provisions of the Investment Advisers Act, as well as a “duty to supervise.” The SEC has used these provisions to bring enforcement actions against unregistered advisers in the past. Thus, lack of federal registration does not render an investment adviser immune to federal enforcement activity.

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