A friend of mine at the CFA institute sent me a link to a speech given at PEI’s compliance forum by Andrew Bowden, who is the Director of the Office of Compliance and Examinations at the SEC.
Here is the link to his speech
http://goo.gl/1oIfBS
There has been significant hand wringing, consternation and opinion writing on the new spotlight (some would say floodlight) that the SEC has shown on private equity. For those of us who have been in the industry for years who have had cogent arguments why this oversight isn’t warranted, this spotlight was been unwelcome but a predictable consequence of the overall reaction to the recent financial crisis.
Regulation inevitable?
\Years ago one regulatory insider disclosed to me that “private equity and venture capital have escaped scrutiny by a fingernail primarily because nothing bad has ever happened.”
I guess it goes hand in hand with a slide in my slide deck of presentations that i often use that says:
“We tend not to measure things ’til things go wrong”
Interestingly, the compliance officer at one of my former employers made me remove that slide from a presentation I did at a company conference. We can only guess as to why.
A prediction
In 2003, i predicted in several presentations I made at the time that :
- LPs are shifting to absolute returns vehicles (can you say hedge funds)
- Derivative instruments like hedge funds will have an “event”
- Private equity will receive shrapnel from that event.
- as a result SEC oversight is a real threat.
This is not hubris to suggest that I’m prescient, but simply note that the lack of transparency or disclosure would bring lots of flashlights into the dark caves we operate in when things go wrong.
BTW, I have found over the years that the call for more transparency over the last 15 years has led to less disclosure and vice versa.
The SEC exposition
He give extremely cogent arguments for (among others):
- Why the SEC is now focused on private equity.
- The results of the exams they have made of 150 firms.
- The particular focus on expense shifting and hidden fees.
My libertarian tendencies favor less government involvement than more and i do feel the current advisor registration regime for private equity changes the industry permanently and may have unintended consequences for a business model that have had relatively fewer sins than other asset classes.
So put me in the category of “I don’t like it, but it is what it is.”
But i found his observations to show a level of understanding (and dare I say empathy) for the industry by the SEC that i didn’t expect or have observed in years past.
The one “Gotcha” that Mr. Bowden cleverly uses is in using the Private Equity and Growth Capital Council’s (“PEGCC”) words against the industry in positing that the SEC’s scrutiny of the well established PE industry rather than smaller “mom and pop” investment firms that might fly under the radar is warranted because of the PEGCC’s own contention that there are a lot of small investors who have a vested interest in private equity because of the significant holdings that pension funds have in the industry.
I have to say “well played”.
Piling on Private Equity
What does irk me is the lay press and financial media feeding frenzy on speeches like this.
Google “private equity fees bowden SEC” and you get headlines like
“Majority of buyout firm fees found to be illegal”
or
“SEC Sees Illegal or Bad Fees in 50% of Buyout Firms, Bowden Says”
While statistically accurate, Mr. Bowden recognizes that the vast majority of firms are not “bad actors” but simply have a lack of understanding of the compliance regime or are tempted by an environment which can lead to conflicts.
His sample is the 150 firms they examined to date. I am going to suggest it’s probably not a representative sample nor random but he is alarmed by the level of non-compliance for this small sample as compared with other examination samples the SEC has.
I imagine the SEC must see it as the tip of an iceberg rather than a statistical aberration,
Nevertheless the media feeding frenzy will probably grab the most provocative sound bites
Disclosure and Absolution
I have often remarked that “disclosure absolves or prevents a lot of sins”.
Mr. Bowden takes that observation to task as he note that GPs often point to the voluminous Limited Partner Agreement (“LPA”) as the magna carta which discloses and codifies the rules by which the GP will play. Thus all they do is “by the book” that LPs have agreed to. He feels that some of the suspect practices he sees are not often disclosed and thus run counter to or skirt the spirit if not the actual tenets of the LPA. Thats the observation some LPs make. Hard to tell from outside whether those are sins of commission or sins of ommision but the SEC definitely has these practices in their sights.
The Fee problem
He is extremely strident in his criticism of expense shifting and hidden fees. The reason is simply that returns are supposed to disclosed as net of fees and it’s not always clear which fees affect the return and which don’t.
I don’t take the use of the word “hidden” as necessarily having a nefarious or misleading purpose but the rapid adoption of new practices an technology may make the recognition of some costs to be more difficult to put into traditional buckets and thus are hidden from the investor.
One of his interesting examples is in the use of technology. In the “olden days” when all investor reporting might be done by a CFO and his team of financial analysts. It would be easy to recognize that reporting as a joint internal cost of management of the fund thus offset by the management fee. Now with the abundance of technology solutions that consolidate those reporting function and isn’t necessarily a human cost but a technology cost, that expense might be shifted as a service fee either to the firm or to the portfolio company. This might be intentional or not, but in any event might have a material impact on the returns the investor would ultimately realize.
Other areas he remarks on include valuation and fundraising — i guess the focus is on the real or potential gaming that can go on during fundraising has the the potential for misleading or nefarious use when reporting returns an performance.
Investors get less diligent post-commitment
One interesting argument he makes is that investors are quite diligent when they make the investment but are much more lax after they make the investment and thus aren’t as diligent post-commitment whether because they are trusting, or don’t have resources or have shifted their gaze to other ares of interest. Or that they depend too much on GP auditors to find any bad acts.
Putting on my GIPS hat, i have to say all of these arguments fall into the multitude of reasons that the GIPS performance guidelines exist and why there is such focus on recognition of fees that might impact returns and performance reporting. The purpose of the guidelines is to provide a compliant framework for presenting performance results for prospective investors.
Growth as a problem
He astutely notes that many firms have diversified their offerings to include separate accounts or are diversifying into other asset classes as they grow. Thus they may not understand that this growth may bring on new compliance with regulatory requirements that might not have been necessary for a typically pooled investment vehicle.
Proposed Solution
His solution. Separate independent compliance unit that is involved in the fundraising and investment process to be the grown-up in the room with the proverbial green eyeshade and wagging finger. Not that image is a pejorative. They do serve as an important over-the-shoulder observer. I recall that in one presentation we made for a client in my prior life at Bear Stearns that our compliance officer made us turn the clients presentation to landscape from portrait in order to attenuate the slope of the investment line in the presentation. Also we were told by another compliance advisor that we should avoid the colors green and red as they had a subconscious connotation of profit and loss which might be misleading.
I don’t intend these observations to be tongue-in-cheek. Just a note that the private equity world has a lot to learn in order to comply with the large body of practice and knowledge and rigorous regulatory environment that other financial investment managers have operated in.
I teach a class on investing in Private Equity and Venture Capital at Cornell’s Johnson Graduate School of Business Management . I have told my students for the last three years to give up their aspirations of investment banking, business startups and private equity associates. They should drop what they are doing and become compliance lawyers and compliance officers-they will be gainfully employed for years to come.
I will let you read the article — is the SEC more PE savvy than we give them credit for. Does the PE industry have to learn to play by new rules for a reason or is this just oversight theater? Let me know what you think.