SEC Ramps Up Scrutiny of Private Equity Firms’ Writedowns

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(Bloomberg) — Buyout firms have been forced to write off billions of dollars in the value of their bets during the economic downturn, and financial regulators are now looking into whether managers cut investors’ fees when those deals go through. aggravate

The Securities and Exchange Commission has stepped up inquiries into private equity firms about whether they adjust customer fees when bets are canceled at zero or below their original prices, people with knowledge of the matter said.

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While such questions have come up sporadically in recent years, regulators now ask private equity firms about the issue regularly in routine examinations and seek a level of detail they didn’t have before, the people said. The goal is to make sure that private equity firms, which take a cut of the money they manage, don’t overcharge state pensions, university endowments and other investors.

SEC officials are stepping up those inquiries to eliminate what they see as a chronic practice of firms charging more than contractually allowed, and because regulators recognize that firms face pressure to collect fees in market downturns.

Those inquiries come from both examiners in the SEC’s private funds unit and regional office staff, one of the people said. The SEC has sometimes looked into whether firms have delayed cancellations to squeeze more fees from investors and has requested internal emails to help it make those determinations, the people said.

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An SEC spokesman declined to comment.

The SEC, under Chairman Gary Gensler, is making a more aggressive push to police private equity firms. The industry has grown rapidly over the past decade to become a larger part of both the financial industry and the US economy, but until now it has avoided the same level of regulatory oversight that banks are subject to and investment funds.

Complex arrangements

Private equity firms often have complex fee arrangements, and most funds switch from charging fees on money pledged by investors to taking a cut of invested funds after a few years. When this happens, fund managers typically cannot charge fees for investments that are written off to zero or that are deemed permanently impaired. In rare cases, rates are supposed to drop after cleanups.

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“The SEC staff is very focused on the calculation of management fees, and we’re seeing increased scrutiny of those calculations in recent examinations,” said Nabil Sabki, a partner in the mutual fund regulatory group at Kirkland & Ellis LLP. When it comes to write-downs, write-offs or permanent impairments of investments, “they are stress testing exactly when these events occur and whether the manager has properly adjusted the management fee base.”

SEC examiners are not in the regulator’s enforcement division, but they can refer their findings to that unit for a formal investigation.

The market slump and post-pandemic changes in the way people live and work are hurting the valuations of once-high-flying tech darlings, forcing private equity firms to reexamine their valuations for startups and unlisted companies. Stock market volatility and rising borrowing costs are slowing the once frenetic pace of trading, making it harder for buyout firms to sell businesses at big profits.

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Strong incentives

Among the companies that have cut valuations is WestCap Management, which cut the combined value of its top mutual funds by nearly a fifth in the second quarter. Blackstone Inc., the world’s largest alternative asset manager, took writedowns on some holdings that contributed to a net loss of $29.4 million in the same quarter. The Federal Reserve’s efforts to suppress inflation by raising interest rates are likely to lead to more market turmoil and more valuation cuts across the industry.

There are, however, strong incentives to delay cleanups. Red flags hurt returns and investor confidence, making it harder for companies to raise money, which is already getting harder as pensions and endowments grow wary of moving markets.

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“If private equity fundraising continues to struggle, managers will feel pressure not to write off investments because doing so would hurt management fees,” said Igor Rozenblit, a former SEC official and managing partner at Iron Road Partners, which advises private equity firms on regulatory matters. risks That dynamic is already on the radar of investors and regulators, and drove some of the increased scrutiny focused on cancellations and management fees, he added.

This month, the SEC blasted Energy Innovation Capital for ignoring stock declines and overcharging investors. The firm did not reduce management fees when some investments were canceled, even though investor documents required it to do so, according to an SEC order.

The venture firm settled with the SEC and agreed to pay penalties without admitting or denying wrongdoing. He did not respond to messages and phone calls seeking comment.