Alert February 04, 2013

SEC Enforcement Division Signals Likely Increase in Private Equity Enforcement Actions

On January 23, 2013, Bruce Karpati, Chief of the Securities and Exchange Commission ("SEC") Enforcement Division's Asset Management Unit ("AMU"), offered remarks at the Private Equity International Conference in New York.i During his address, Mr. Karpati touched on (i) the focus of the AMU on the private equity space; (ii) the likely increase in private equity enforcement actions; (iii) the AMU’s areas of focus in the private equity industry; and (iv) steps private equity firms can take to reduce the risk of an SEC inquiry.

AMU's Coverage of Private Equity and Its Current Resources

The AMU was created in 2010 in connection with a reorganization of the Enforcement Division. According to Mr. Karpati, the AMU is the Division's largest unit and focuses on investment advisors and investment companies, including managers of private equity funds. The SEC is focused on developing expertise in each area that it covers and is hiring private equity specialists with deep industry knowledge.

Mr. Karpati noted that the SEC is using its industry knowledge to develop risk analytic initiatives ("RAIs") to identify fraudulent activity and other industry problems using data and quantitative analytics. For instance, the SEC is using RAIs to identify so-called "zombie managers" who manage funds which are not designed for quick liquidity and are having difficulty raising new capital. Mr. Karpati warned that zombie managers might find themselves in a position where their incentives shift from keeping investors happy to maximizing their own revenue using the remaining assets. Therefore, the SEC tries to identify funds which may be engaging in misappropriation from portfolio companies, fraudulent valuations, misrepresentations about portfolio companies, unusual fees, principal transactions and other concerning conduct.

Potential Increase in Private Equity Enforcement Actions

Mr. Karpati noted that it is "not unreasonable to think that the number of cases involving private equity will increase." He attributed the possible increase to the fact that (i) the assets under management in private equity have grown significantly and are now roughly equal to the assets in hedge funds and (ii) many managers have just recently become registered investment advisors as required under the Dodd-Frank Act.

Mr. Karpati noted that there has already been an increase in private equity enforcement actions and specifically identified the following examples among others:

  • Partner allegedly usurped an investment opportunity from one private equity fund managed by redirecting an investment opportunity to another fund that he co-managed.
  • Principal of private equity manager, allegedly misappropriated funds from a private equity fund by using money to pay expenses that he incurred defending himself in an SEC action related to a different fund.
  • Broker-dealer allegedly made misrepresentations to investors about the performance of a portfolio company.
  • Private equity principal allegedly misrepresented fund as a viable entity and misappropriated investor funds to repay loans from other investors.
  • Principal allegedly took more than $2 million from a fund purportedly as advance management fees.
  • Hedge fund manager allegedly inflated the values of certain illiquid assets. Mr. Karpati noted that such valuation issues are very similar to ones seen in private equity.

SEC's Concerns in Private Equity Industry

While Mr. Karpati noted that the SEC's list of focus areas is always evolving, he did identify a few key issues to watch. First, the industry dynamic whereby there are several managers competing for the same deals and potentially facing the expiration of capital raised in prior years. The SEC sees this as a potential driver for inappropriate marketing activity by managers. Second, the SEC views many private equity products as lacking transparency, which it believes can lead to misleading valuation of illiquid assets and the operation of portfolio companies. The SEC watches for manager misconduct in the form of improper writing up of assets during the fund raising process. Finally, the SEC is always monitoring potential conflicts of interests, including the following:

  • Conflict between the profitability of the management company and the best interests of investors.
  • Shifting expenses from the management company to the funds, including utilizing the funds' buying power to get better deals from vendors - such as law and accounting firms - for the management company at the expense of the fund.
  • Charging additional fees to portfolio companies where the allowable fees may be poorly defined by the partnership agreement.
  • Conflicts arising from managing different clients, investors and products under the same umbrella.
  • Conflicts with a manager's other business which may be run in parallel with the adviser and may incentivize managers to usurp investment opportunities or enter into related party transactions at the expense of investors.

While the SEC recognizes that these conflicts may be a natural part of the industry, Mr. Karpati warned that managers need to be careful to identify, control, and disclose material conflicts to ensure that investors are not harmed.


Mr. Karpati highlighted the key role played by private equity COOs and CFOs in ensuring that investor interests are placed ahead of those of the management company and its principals. He suggested that these executives focus on the following:

  • Integrating compliance risk into the overarching risk management processes and procedures. Consider appointing an experienced deal professional as a compliance monitor;
  • Utilizing limited partnership advisory committees;
  • Acting swiftly to address potential compliance issues; and
  • Staying alert and prepared for SEC exam inquiries.

While Mr. Karpati's comments do not represent a departure from the SEC Enforcement Division's previously stated positions related to the private equity industry, his words do signal an increased focus on the industry.


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For more information on the issues discussed above, contact R. Todd Cronan, Stephen D. PossMichael Jones or the Goodwin Procter attorney to whom you typically direct your inquiries.

i Mr. Karpati's full remarks can be viewed here.