SEC Enforcement Division’s Asset Management Unit’s Chief Anticipates Increase in Private Equity Enforcement

Bruce Karpati, the Chief of the SEC Enforcement Division’s Asset Management Unit, held a Q&A session entitled “Private Equity Enforcement Concerns” at the Private Equity International Conference held in New York on January 23, 2013. He addressed private equity firm activities of concern, how the SEC is tracking those activities, and ways firms can avoid getting into trouble.

The New Asset Management Unit

As discussed previously, Karpati is part of the Asset Management Unit of the SEC’s Division of Enforcement, which specializes in investment advisers and investment companies, including private equity fund managers. He noted that the unit has been cultivating expertise in the following areas: industry structure, customs and practices, manager incentives, and trends and risks that enable the unit to detect and investigate fraud. The unit has garnered this expertise by hiring industry professionals with significant experience in private equity, hedge funds, mutual funds, and due diligence, having each unit staff member develop a detailed plan covering either a type of investment vehicle or an investment practice, and retaining attorneys with practical investigative experience. The increase in expertise has enabled the unit to detect fraud at an earlier stage by uncovering data anomalies, allocate resources more effectively, and tackle more complex and technical cases.

Karpati described how the unit collaborates across the SEC by, for example, training National Exam Program examiners and accompanying them to exams of private equity managers — giving the unit direct exposure to industry professionals and keeping it on the “leading edge” of industry trends and issues. The unit also collaborates with the SEC’s Division of Investment Management when an investigation involves complex legal issues and when the Division of Investment Management is crafting rules that affect the private equity industry.

Anticipating an Increase in Private Equity Enforcement Actions

When asked, Karpati revealed that “it’s not unreasonable to think that the number of cases involving private equity will increase.” This is due to the rapid growth and maturation in the private equity industry before the financial crisis, resulting in a level of assets under management similar to or greater than that of the hedge fund industry, as well as more private equity managers registering as investment advisers. He pointed out two ways in which private equity is particularly prone to fraud: portfolio companies can be controlled in a way not visible to investors, and investors often become less involved in monitoring the fund over time.

Karpati outlined a number of recent cases involving private equity funds or issues often seen in the private equity industry, yielding the following examples of misconduct:

  • Usurping an investment opportunity
  • Misallocating fund expenses
  • Misstating portfolio company performance to investors
  • Misappropriating investor funds to repay previous investors
  • Taking amounts from fund as “advance management fees”
  • Insider trading using stolen confidential information
  • Inflating values of illiquid assets
  • Overstating the value of debt securities and CLOs in an investment portfolio

Practices of Concern to the Unit

Karpati discussed some of the practices that the unit is scrutinizing in particular. First, he addressed fundraising and capital overhang. The combination of less capital available to new funds and significant amounts of uninvested capital means that many managers face failure, tempting them to engage in aggressive and potentially fraudulent behavior. Second, he addressed lack of product transparency, which matters particularly in terms of the valuation of illiquid assets and portfolio company operations and during the marketing period, when managers may be tempted to write-up assets, writing them down after that period ends. Third, he discussed conflicts of interest, which include the following:

  • Profitability vs. the best interests of investors, especially at publicly listed firms
  • Charging expenses to the management company vs. charging them to the funds
  • Charging additional fees
  • Conflicting interests of different clients, investors, and products
  • Fund business vs. manager’s other, competitive business

Risk Analytic Initiatives for the Private Equity Industry

Karpati explained that the unit’s expertise is devoted in part to developing and implementing “risk analytic initiatives,” or RAIs, that proactively detect fraud and other suspicious activities  via data and quantitative analysis. RAIs are designed to analyze data to ferret out factors that indicate high risk, such as lack of transparency and lack of monitoring by investors. Of currently active RAIs, one focuses on private equity. It attempts to detect “zombie” private equity managers, which Karpati described as “managers who have assets under management but are unable to raise follow on vehicles.” The unit’s concern is that such managers have an incentive to maximize revenue using the existing assets, rather than act in the best interest of the fund’s investors, and that this incentive can give rise to fraudulent activities. The specific factors the unit attempts to detect in this analysis include the following:

  • Misappropriation from portfolio companies
  • Fraudulent valuations
  • Lies about the portfolio to cause investors to grant extensions
  • Unusual fees
  • Principal transactions

How to Reduce the Risk of Inquiry

Karpati reminded his audience that under the Investment Advisers Act of 1940, investment advisers have a fiduciary duty to act in the client’s best interest. According to case-law cited by Karpati, this duty comprises the following obligations: “an affirmative duty of ‘utmost good faith, and full and fair disclosure of all material facts,’ as well as an affirmative obligation ‘to employ reasonable care to avoid misleading’ … clients.” He stated that investment advisers may be found at fault even when they do not intend to injure a client or even if a client does not suffer a monetary loss.

Karpati put the responsibility for ensuring that clients’ interests supersede those of the management company and its principals on the COO and CFO, as they are tasked with overseeing the investment manager’s business. He offered the following specific tips:

  • Integrate compliance risk into the overall risk management process
  • Implement a set of compliance procedures appropriate for the business model
  • Assign a deal professional with experience in compliance issues to review and implement these procedures
  • Involve COOs, CFOs, and CCOs in the firm’s significant decision-making processes and have them act as investor advocates (for example, in disclosing results to investors)
  • Utilize the Limited Partnership Advisory Committee to address conflicts of interest
  • Give COOs and CFOs authority in the organization to proactively identify and resolve issues
  • Immediately consult with the internal compliance department and counsel to resolve potential breaches of fiduciary duty to investors
  • Be ready for exam inquiries, cooperate with exam staff, and implement necessary corrective steps

Private equity firms should be aware of the enhanced scrutiny that the SEC will be bringing to bear and, in addition to avoiding activities that obviously constitute misconduct, keep their fiduciary duty to investors in mind at all times and avoid allowing economic and organizational pressures lead them into aggressive tactics or overlooking conflicts of interest.


© 2013 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

About Alexander Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

You can read more about Alex here.

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