Category: Compliance Programs

Last year, the U.S. Securities and Exchange Commission looked at how many private equity firms calculate net of fees internal rates of return for their funds. The focus was on whether the performance figures disclosed if general partner investments are included in or excluded from that calculation.

General partners in a private equity fund typically do not pay management or incentive fees. So if the general partner’s capital is included in the net of fees IRR calculation, the net IRR returns would be higher than if that capital was excluded.

I think this distortion will be largely limited to situations where general partner capital is a large percentage of fund assets. One aspect is that calculation of fees in private funds is not tightly regulated as it is for mutual funds. Different strategies will require managers to sho performance in different ways.

Private equity funds have a particularly difficult time with net IRR calculations for funds that are not fully realized. The fees keep tolling as the fund continues through its life-cycle and underlying investments are realized. A fund manager cannot show the net of fees return for a particular realized investment because the standard management fee is not tied to the investment itself, but instead to the life of the private equity fund.

The concern is always that net IRR returns for such funds should not mislead prospective investors. That means inserting adequate disclosure regarding the net IRR calculation methodology.

The SEC has stated that performance should be what a typical investor will experience. A private equity fund manager should construct and show its performance as a typical investor would have its investment perform.
Sources:

• SEC probing private equity performance figures by Greg Roumeliotis in Reuters
• SEC Probing Private Equity Firms’ Net of Fees Performance Figures by ACA Compliance

Congratulations to the Kansas City Royals on winning the World Series. It was their first World Series in thirty years and a year after their heart-breaking loss in Game 7. Mrs. Compliance Building is from Kansas City and ecstatic about the club’s turnaround.

The Mets faltered last night because of emotion. Starting pitcher Matt Harvey stymied the Royals for eight innings. Instead of replacing him with the closer, Mets coach Collins let Harvey convince Collins to keep him in for the ninth inning. As a Red Sox fan, I remember two instances of that same mistake.

Harvey walked Lorenzo Cain, who stole second, and the scored on a double by Eric Homser.  Harvey was pulled and Jeurys Familia quickly became the first man in baseball history to blow three saves in the World Series.

The 2015 Royals are a team about taking chances. After making it to third on a ground ball, Homser took the gamble and made a mad dash from third on a ground ball with one out. Not expecting this, the first baseman threw wide to home, allowing the tying run to score. Then, KC took over in extra innings.

The Royals won eleven games in the 2015 postseason. In seven of them, they trailed by at least two runs at some point, then came back to win. No team had ever done that.

It was not about big bats hitting home runs to come back. It was small-ball: stealing bases, bloops, gap-balls and line-drives.

The Royals were about taking small risks. Not “swinging for the fences.” In part, the team was designed to deal with its market. It can’t afford the big payroll of the Yankees or the Red Sox. It developed its talent in its farm system. It didn’t sign big names. It formed its own culture and groomed the players within its system.

It’s not a big risk, big reward club. It’s a small-ball club that just won the World Series.

“1989 Kansas City Royals away uniform” by Amineshaker
Licensed under CC BY-SA 3.0

You have likely heard all or some of these concerns before. Securities and Exchange Commission Chair Mary Jo White spoke at a meeting of the Managed Funds Association and pointed out areas of concern.

One thing to note is Chair White stated that the Private Funds Unit in OCIE is completing a review of private fund real estate advisers. (I assume you would call that a “sweep.”) That particular focus is related-party service providers. SEC staff is concerned that disclosure about these related-party arrangements may be non-existent or potentially misleading, particularly with regard to whether or not the related parties charge market rates.

We have heard that before from Marc Wyatt at PEI’s Private Fund Compliance Forum. It’s generally okay to use related-party service providers if the arrangement is properly disclosed. If the fund manager is going to say that it saves the fund money because the rate is at or below market rate, you need to prove that it actually is at or below market rate.

Chair White cited several other areas of interest for private fund compliance.

• Using marketing materials that included back-tested performance numbers, portable performance numbers, and benchmark comparisons without key disclosures.
• Disclosing conflicts related to advisers’ proprietary funds and the personal accounts of their portfolio managers, in particular allocation of profitable trades.
• Improperly shifting expenses away from the adviser and to the funds or portfolio companies by, for example, charging a fund for the salaries of the adviser’s employees or hiring the adviser’s former employees as “consultants” paid by the funds.
• Advisers collecting millions of dollars in accelerated monitoring fees without disclosing the practice.
• Advisers misallocating expenses to funds;[21]
• Failing to disclose loans from clients;[22]
• Using funds to pay their operating expenses without authorization and disclosure;[23] and
• Failing to disclose fees and discounts from service providers.[24]

Sources:

• Compliance issues for private fund advisers outlined by SEC Chair White in IA Watch
• Five Years On: Regulation of Private Fund Advisers after Dodd-Frank
• What To Expect From The SEC In The Year Ahead