PE Firms Face Steep Regulatory Hurdles in the Post-Dodd-Frank Era, Says a Panel of Legal and Compliance Experts

Shannon Beeman
October 23, 2014

Private equity firms are now operating in a highly regulated world that has transformed the way business is conducted, said a panel of legal and compliance experts at the Michigan Private Equity Conference on Friday, Oct. 17.

The heightened regulatory and record-keeping requirements stem from the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama in July 2010, and subsequent regulations issued by the Securities and Exchange Commission that impose significant new registration and compliance burdens on managers of private equity funds, hedge funds, fund of funds and, to a lesser extent, venture capital funds. Two separate SEC enforcement actions involving two different investment advisory firms, Ranieri Partners and Clean Energy Capital LLC, have sent a chill through the industry.

“Traditionally, private equity has been a handshake deal,” said Josh Westerholm, a partner at Kirkland & Ellis LLP. “Post-Dodd-Frank, there has been a sea change of culture. Now firms are looking at investor relationships differently.”

Audrey DiMarzo, principal and general counsel at Rizvi Traverse Management, reports seeing a “learning curve on both sides” of the regulatory equation. “It’s been a matter of educating the SEC about the PE industry, and educating firms about the need to follow policies, produce documentation, formalize relationships and pay more attention to details at every level.”

Prior to the Dodd-Frank Act, many PE fund managers avoided registering with the SEC by relying on the “private investment adviser” exemption, which exempted firms that had fewer than 15 clients over the course of the preceding 12 months and that did not act as an investment adviser to the public or to any company registered under the Investment Company Act of 1940. Title IV of the Dodd-Frank Act ─ known as the “Private Fund Investment Advisers Registration Act of 2010 ─ replaced the private investment adviser exemption with new and much narrower exemptions. Now, only private fund managers with less than $150 million of assets under management are exempt from registration with the SEC. All other PE firms are required to register, effective July 2011, and are subject to periodic, on-site SEC inspections.

Registered firms must comply with a number of requirements. The panelists discussed several of these key provisions and their implications:

Registration of Brokers

“If you’re paying a placement agent 1% for every dollar they bring in, the SEC views it as a transaction-based fee and that agent needs to be registered,” Westerholm advised. Added DiMarzo: “If we use an agent for fundraising, we make sure that person is registered.”

The panelists cited a 2013 enforcement proceeding in which the SEC brought charges against New York-based PE firm Ranieri Partners, a former senior executive and an unregistered broker who violated securities laws when soliciting more than $500 million in capital commitments for private firms managed by the firm. The broker acted as a hired consultant for Ranieri and was paid fees by the firm, but never registered as a broker with the SEC. The SEC imposed stiff penalties on both the firm and the executive for “aiding and abetting” the broker’s violations and the broker was barred from the securities industry.

Recordkeeping Obligations

The SEC is “digging in its heels and taking an expansive view” on the documentation of transaction fees and expenses, the proper allocation of expenses between PE sponsors and LPs and the disclosure of those expenses to LPs, said Ian Rivera, a principal consultant at ACA Compliance Group. “There is no dollar threshold for expenses that are misallocated.”

A recent enforcement proceeding illustrates the hard line the SEC is taking on violators. In 2014, the SEC brought charges against an Arizona-based PE fund manager and his investment advisory firm for orchestrating a scheme to misallocate their expenses to the funds they manage. The SEC Enforcement Division alleged that the fund manager and Clean Energy Capital LLC improperly paid more than $3 million of the firm’s expenses for rent, salaries and employee benefits by using assets from 19 private equity funds that invest in private ethanol production plants. No disclosure of the payment arrangement was made in fund offering documents. When the private equity funds ran out of cash to pay the firm’s expenses, CEC and the fund manager loaned money to the funds at unfavorable interest rates and unilaterally changed how they calculated investor returns to benefit themselves. The SEC alleged that the firm and fund manager violated the antifraud provisions of the federal securities laws, and made violations in disclosure, compliance, custody and reporting.

Compliance Programs and Policies

Registered advisers must adopt written policies and procedures designed to prevent violation of the Private Fund Act and its rules. “The SEC is looking at your firm’s policies and whether you are following them in the way you told your investors,” DiMarzo said. “Make sure your financial staff knows what the rules and procedures are.”

Disclosures to Adviser’s Clients

PE firms also are required to make disclosures annually to their advisory clients on matters such as products, management, material adverse financial or disciplinary matters, conflicts of interest and privacy policies. “The SEC is deep-diving into disclosures and asking for documents,” Rivera reported.

“Savvy limited partners also are beginning to ask the same questions as the SEC: Did you get any deficiencies at the last SEC exam?” Westerholm said. “LPs are going down a checklist and asking for copies of compliance policies. The LP community has moved to become another set of regulatory eyes.” Added DiMarzo: “If you don’t get nice closure from the SEC, LPs get skiddish.”