SEC makes strides to strengthen oversight

Hedge fund and private equity managers can expect increased attention from the Securities and Exchange Commission, as the agency builds staff expertise in both asset classes and the regulator takes sharper aim at others that present opportunities for abuse.

The SEC's approach to alternative investment managers has changed in the past year. It hired former hedge fund managers, private equity analysts, due diligence professionals and other practitioners in all of its divisions; the specialized enforcement unit for asset management — created in 2010 — matured; and divisions within the regulator coordinated more closely with each other. The changes come after the Dodd-Frank Wall Street Reform and Consumer Protection Act required some 1,500 hedge fund and private equity managers to register with the SEC in 2012.

“In the SEC's view, there are a lot of assets under management at these firms, and they are quite varied in their nature such that it warrants extra scrutiny. They present on their face control risks that are different, so it makes sense,” said attorney John Sturc, who co-chairs the securities enforcement practice at Washington-based Gibson Dunn & Crutcher LLP, which has seen a recent uptick in cases against hedge funds and private equity firms.

Thanks to the added expertise, “we are now able to identify promising cases earlier (and) we are much better able to take on cases that have a variety of complex and technical issues,” Bruce Karpati, chief of the SEC's enforcement division's asset management unit, said at a recent private equity conference in New York. “You won't see (us) shy away from cases that involve illiquid asset valuations or that require us to dig into the operations of a portfolio company.” The increased attention is driven partly by higher allocations from public-sector pension funds, particularly by those with $1 billion or more in assets, Mr. Karpati said.

Since 2010, the SEC has brought more than 100 cases against hedge fund managers for conflicts of interest, questionable performance or inadequate compliance controls, and is beginning to do more with private equity.

One practice drawing particular attention now is how alternative fund managers handle valuation. On March 11, Oppenheimer Asset Management and Oppenheimer Alternative Investment Management settled charges that inflated valuation of one private equity holding caused two Massachusetts pension funds and other investors to lose more than $2 million. While the $333 million Brockton Contributory Retirement System and the $290 million Quincy Contributory Retirement System lost a legal claim against Oppenheimer, the SEC prevailed in a settlement with the firm that, without admitting or denying the charges, agreed to give back the pension funds $2.23 million in management fees and interest, and to enhance its valuation procedures.

The Oppenheimer action was a signal to alternative investment managers that their valuation practices need to be more transparent, particularly with pension funds and endowments increasing their exposure to those asset classes, said Julie Riewe, the SEC's asset management enforcement deputy chief. Those investors must be able “to understand private funds' valuation methodologies,” Ms. Riewe said in an e-mail.

Along with enforcement, the SEC's investment management division is also paying attention to how private funds handle valuation, developing guidance for fund managers and directors and hiring more examiners and risk experts from the industry to visit firms and compare notes with their enforcement colleagues.

That shouldn't be a problem for reputable firms, said David Fann, CEO of TorreyCove Capital Partners LLC, San Diego, a private equity consultant to pension funds and other investors representing $20 billion in assets. Most firms use multiple valuation techniques and have controls in place, including outside advisory boards to protect against overvaluation, and most mark down values for underperforming investments, he said.

“For most of the firms we know, valuation is not a big issue,” said Mr. Fann, but the SEC learning more about it “is smart and helpful. My belief is that the industry has behaved relatively well. I don't think the private equity industry has anything to hide.” Still, he notes, “valuation is an art, not a science.”

For that reason, said Mr. Sturc of Gibson Dunn, the SEC “should be careful about second-guessing them, particularly when dealing with illiquid assets.” The former SEC enforcement attorney said the key is for managers to have good valuation procedures in place and be sure to follow them.

Another recent SEC tactic is the aberrational performance inquiry initiative, which uses proprietary risk analytics to identify hedge funds with suspicious returns inconsistent with a fund's investment strategy or other benchmarks. That has led to seven enforcement actions so far. The most recent one involved New York-based Yorkville Advisors, which SEC officials accused of reaping at least $10 million in excess fees after overvaluing assets and exaggerating returns to hide losses, charges that the firm disputes. “The analytics put Yorkville front and center on our radar screen,” Mr. Karpati said when the case was filed in October. “When we looked further we found lies to investors and the firm's auditors as well as a scheme to inflate fees by grossly overvaluing fund assets. We will continue to pursue hedge fund managers whose success is based on fiction rather than fact.”

Yorkville Advisors is seeking to have the case dismissed. Calls to the firm and its attorneys at DLA Piper LLP in New York were not returned at press time.

The investment management division's new risk and examinations group also is deploying examiners, quantitative and financial analysts, and accountants to look more closely at risk-taking activities of alternative money managers.

A national exam program launched in October to learn more about managers newly registered thanks to Dodd-Frank “is real,” said Brynn Peltz, a partner in the financial institutions group at law firm Goodwin Procter LLP, New York. “They are getting out there, and you are getting people who know the process.” Particularly beyond New York and Washington, in areas where SEC interactions are less common, “it's a huge change. This is a whole new world for them.”

Ms. Peltz, who represents hedge fund managers, private equity firms and other money managers, tells her clients to be prepared to explain to SEC examiners how their business works, and to understand that for the SEC, fiduciary responsibility comes first.

She expects SEC examiners to be looking for questionable valuations and insider trading, and scrutinizing fees other than direct advisory fees, such as for strategic acquisitions or structuring deals, but to be open-minded. “I think the SEC is looking for the really egregious cases. They want to get the real fraud.”

SEC officials are also expecting results from a new private equity initiative to identify private equity managers at higher risk for certain types of misbehavior, including misrepresenting the value of holdings to investors, failing to liquidate assets properly, or running “zombie” funds that delay liquidation to stretch out revenue as long as possible. While that sounds pretty aggressive, Mr. Fann of TorreyCove sees it as another way to understand the industry better. “We believe it's more of a fact-finding mission,” he said.

Using multiple metrics and looking for outliers “is a good idea,” said Thomas Gorman, a former SEC enforcement official and partner at international law firm Dorsey & Whitney in Washington. “They have revamped the way they look at the markets and the way they prospect for fraud. The industry expertise should give them better boots on the ground.”