Since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, private funds have become the subject of heightened scrutiny by both the SEC’s Division of Enforcement and the Office of Compliance Inspections and Examinations (“OCIE”). Based on recent announcements by SEC senior management, this trend is likely to continue. The SEC has announced a new group within OCIE that will focus on newly registered advisers to private equity and hedge funds. In addition, the head of OCIE has identified publicly significant control weaknesses in at least 50% of its examinations of advisers to private equity firms.
By way of background, in 2012, OCIE announced an initiative to conduct “Presence Exams” or focused, risk-based examinations of investment advisers to private funds who recently registered with the SEC. See here. The SEC reiterated at its 2014 CCO Outreach Program that focus areas of the Presence Exams included: (1) investment conflicts of interest including personal and affiliates’ transactions and fees paid to advisers and expenses charged to funds; (2) marketing, including the use of placement agents and using past performance; (3) valuation; and (4) custody. See here.
Signaling the importance that the SEC places on private equity funds and its concern that investors may be at risk, the SEC also formed a new “group” within OCIE to focus on the newly registered advisers to private equity and hedge funds. In addition to forming the new group, the SEC has also asked Congress for additional funds to support its examination program. If the SEC receives the additional funds, it could almost double the size of its examination staff, allowing it to conduct significantly more exams and assist with more enforcement investigations.
Even more recently, in remarks to a group of compliance officers from investment advisers to private equity funds in New York City, Andrew J. Bowden, the director of the OCIE, announced that the Exam staff has identified violations and material control weaknesses at more than half of all private equity advisers examined pursuant to the SEC’s recent initiative to examine recently registered advisers (commonly referred to as “Presence Exams”). See here.
According to Bowden, OCIE has conducted Presence Exams of more than 150 newly registered private equity advisers since October 2012 and is on track to complete its goal of examining 25% of the new private fund registrants by the end of this year. Bowden noted that private equity funds have historically involved limited transparency and limited investor rights. Bowden expressed concern that the environment creates risks and temptations that may result in the adviser putting its interest ahead of its clients’ interests. On the basis of the Presence Exams conducted thus far, Bowden declared that OCIE has seen that the temptations are real and significant.
Bowden addressed the most common exam findings. The first involves advisers’ use of “Operating Partners.” Private equity advisers commonly retain “Operating Partners” to provide portfolio companies with consulting services or other assistance that the portfolio companies normally could not afford on their own. Typically, Operating Partners are paid with fund assets. According to Bowden, the exam staff found that the disclosures regarding those payments are not sufficient because, in its view, these Operating Partners usually appear, at least to investors, as employees of the adviser. Accordingly, there is no reason investors should suspect that their compensation is an “extra” expense charged to the fund in addition to the management fee. Moreover, if these Operating Partners were employees or affiliates of the adviser, any compensation received by the employee or affiliate would ordinarily be used to offset the management fee. According to Bowden, despite the fact that Operating Partners look like employees, the fees associated with their services rarely offset management fees.
Bowden also raised the issue of advisers shifting expenses from themselves to their clients during the middle of a fund’s life without disclosing the new fees to clients. For example, he claimed that the exam staff found instances in which advisers started charging funds for “back-office” functions, such as compliance, legal and accounting, that have traditionally been included as services provided in exchange for the management fee.
As another example, Bowden said the staff also found instances of hidden “fees” that were not adequately disclosed. Bowden specifically referenced accelerated monitoring fees. Monitoring fees are typically charged to portfolio companies in exchange for the adviser providing board and other advisory services to portfolio companies. Bowden believes most private equity investors are aware of the fee received by the adviser, but investors may not be aware that advisers usually require portfolio companies to pay such fees for 10 years or longer, even though the typical holding period is around five years. Moreover, mergers, acquisitions, and IPOs typically trigger acceleration agreements that result in the adviser collecting the remaining monitoring fees. Bowden claimed those fees are often “significant” and not disclosed to clients. Other examples that Bowden gave of hidden fees included “administrative” fees or fees paid to related-party service providers who deliver services of “questionable” value.
Finally, Bowden discussed the observed marketing and valuation weaknesses. The most common valuation issue identified by the exam staff involved advisers using a valuation methodology that differed from the methodology disclosed to investors. Bowden assured the audience that OCIE’s job was not to “second-guess” the adviser’s assessment of the value of portfolio companies, but rather to identify situations in which the adviser’s valuation is clearly erroneous. With respect to marketing materials, the exam staff has also noted instances in which internal rates of return did not include fees and expenses, and where projections were used as opposed to actual valuations, and misstatements were made about the investment team.
Given the SEC’s willingness to share the result of the Presence Exams, advisers to private equity funds should take care to review their policies and procedures as well as the fees they charge funds and the expenses that are paid with fund assets. Meaningful disclosure and robust compliance policies and procedures will be key to avoiding a deficiency letter, or worse yet, an enforcement investigation and action.
A private equity fund (PE) made a major investment in a foreign manufacturer in 2005, and its majority investment gave it various supervisory and governance rights (such as the right to elect or remove the portfolio company’s governing body). In 2007, the PE reduced its stake, and it exited the investment entirely in 2009. According to the European Commission (and quite probably without the knowledge of the PE fund), from 1998 to 2008 the portfolio company and nearly a dozen other manufacturers were engaged in a cartel to undermine the competitive pricing of underground and submarine high voltage power cables. Collectively, the cartel participants were fined nearly 302 million euros earlier this year. The portfolio company and its former investor are jointly and severally liable for more than 104 million euros as their part of the cartel fine.
The European Courts have declined, in this and other cases, to give financial investors a pass when it comes to policing the behavior of their portfolio companies. As long as a parent company has the power to exercise decisive control over its subsidiary and exercises that power (by, for example, electing the subsidiary board, directing the subsidiary’s economic activities, and conforming the portfolio company’s policies to its own strategic goals), then the conduct of the subsidiary likely will be imputed to the parent, whether or not the parent directed or even knew of any suspicious conduct. One could imagine a purely passive minority investment where the issue of control could be refuted, but where a private equity owns (directly or indirectly) most or all of the equity of its portfolio company, that fund will be presumed to exercise decisive influence over its subsidiary. That presumption will be very difficult, and perhaps impossible, to overcome.
So, what’s an investor to do?
This tale is a reminder that rigorous pre-acquisition due diligence, focusing on antitrust risks, is a must for private equity funds investing in Europe. Upon acquisition and periodically throughout the life of the investment a majority financial investor should revisit and reinforce its antitrust compliance programs, at both the portfolio company and fund levels. And an investor in multiple industry segments might not want to rely on a “one size fits all” compliance program. Instead, a private equity fund should tailor its compliance checks to the specific industry and competitive risks of each investment.
Under the Patient Protection and Affordable Care Act (the “Affordable Care Act”), employers with 50 or more full-time or full-time equivalent (“FTE”) employees may be subject to a penalty if the employer fails to offer a certain percentage of its full-time employees and their dependent children health coverage that meets the minimum essential coverage requirements of the Act (the “No Coverage Penalty”) or the employer offers coverage that is unaffordable or that does not provide minimum value (the “Insufficient Coverage Penalty”). The penalties will apply to employers with 100 or more FTE employees starting in 2015, and to employers with 50 or more FTE employees starting in 2016.
To determine whether an employer has 50 or more FTEs, the number of employees is determined on a “controlled group” basis as defined under Section 414 of the Internal Revenue Code. Under the controlled group rules, all employees of commonly-controlled corporations, trades or businesses are treated as employees of a single corporation, trade or business. There are three basic types of controlled groups under the Code: (i) a parent-subsidiary controlled group, which generally exists where one entity owns at least 80% of a second entity (e.g., a holding company that is the principal owner of a portfolio company constitutes a parent-subsidiary controlled group); (ii) a brother-sister controlled group, which exists where the same five or fewer individuals, estates or trusts own at least 80% of two or more entities and own more than 50% of those entities when considering each individual’s, estate’s or trust’s ownership to the extent that it is identical with respect to each entity; and (iii) a “combined” controlled group, which exists where the group includes both parent-subsidiary and brother-sister members.
Private equity funds have historically relied on Whipple v. Commissioner, 373 U.S. 193 (1963) and Higgins v. Commissioner, 312 U.S. 212 (1941) for the proposition that private equity funds, as passive investors in portfolio companies, are not engaged in a trade or business (and therefore the funds are not part of a controlled group with their portfolio companies). Thus, in the case of a private equity fund with fewer than 50 FTEs that owns multiple, unrelated portfolio companies each employing fewer than 50 FTEs:
The fund and its portfolio companies would not constitute a controlled group and would not be subject to the employer mandates of the Affordable Care Act based solely on the fund’s ownership of the companies.
None of the portfolio companies would be in a “portfolio company” controlled group with each other, and would not be subject to the employer mandates of the Affordable Care Act based solely on the fund’s ownership of the companies.
However, traps for the unwary exist and a careful analysis of the proposed ownership structure of a portfolio company should be undertaken to determine if a controlled group would be created. For example, where private equity funds engage in “add on acquisitions” under a holding company that is itself wholly-owned by the private equity funds, the acquired companies would likely be considered part of a controlled group with the holding company, thereby subjecting the holding company and its portfolio companies to the employer mandates of the Affordable Care Act.
Moreover, in a July 2013 decision of the First Circuit involving private equity fund Sun Capital Partners IV, the Court concluded that the fund was engaged in a “trade or business” under the controlled group rules of ERISA for purposes of a portfolio company’s unfunded pension liabilities. For a detailed discussion of the Sun Capital Partners IV case, please see our Client Alert dated September 13, 2013, which can be found here.
While the Sun Capital Partners IV case is not a tax case under the Internal Revenue Code, it raises the possibility that a private equity fund could be considered a trade or business and part of a controlled group with its portfolio companies for tax purposes, depending on the facts of the particular situation. The potential implications for private equity funds under the Affordable Care Act include the following:
Portfolio companies with less than 50 FTEs who believe that they are not subject to the Affordable Care Act may actually be subject to the requirements of the Affordable Care Act, which could result in the imposition of substantial penalties for noncompliance.
Private equity funds that have employees (as opposed to private equity funds without employees that are managed by the fund’s sponsor or by an investment manager that does not have an ownership interest in the portfolio company) may be subject to the requirements of the Affordable Care Act.
It is worth noting that Craig Gerson, an attorney-advisor in the tax policy section of Treasury, stated at a September 2013 meeting of the American Bar Association tax section that Treasury recognizes the Sun Capital Partners IV decision could provide it with an opportunity to reassess what a “trade or business” means, but the administration would not be in a rush to issue guidance relating to the decision.
 In order for a partnership or limited liability company, such as a fund, to be part of a controlled group with another entity, the partnership or limited liability company must be a trade or business and under common control with the other entity.
A no-action letter recently issued by the SEC’s Division of Trading and Markets is a welcome development in the private equity world as it permits “M&A Brokers,” subject to conditions, to provide advice regarding certain types of mergers and acquisition transactions (“M&A Transactions”), participate in the negotiation of the transaction, and receive transaction-based compensation, without registering as broker-dealers pursuant to Section 15(b) of the Securities Exchange Act. The letter goes far beyond the SEC’s previous guidance on permitted activities for unregistered intermediaries.
In the letter, an M&A Broker is defined as a “person engaged in the business of effecting securities transactions solely in connection with the transfer of ownership and control of a privately held company… through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company to a buyer who will actively operate the company or the business conducted with the assets of the company.” The letter permits, subject to conditions, M&A Brokers to facilitate the sale of privately held businesses by way of mergers, acquisitions, business sales, and combinations, without regard to the size of the transaction. Significantly, the relief does not restrict the type of compensation the M&A Broker can receive.
The relief is subject to a number of conditions, including the following:
The M&A Broker does not have the ability to bind a party to an M&A Transaction.
An M&A Broker may not directly, or indirectly through any of its affiliates, provide financing for an M&A Transaction. However, subject to certain conditions, the M&A Broker may arrange financing with unaffiliated third parties.
An M&A Transaction may not involve a public offering.
Under no circumstances will an M&A Broker have custody, control, or possession of or otherwise handle funds or securities issued or exchanged in connection with an M&A Transaction or other securities transaction for the account of others.
An M&A Broker may facilitate an M&A Transaction with a group of buyers only if the group is formed without the assistance of the M&A Broker.
The M&A Broker, its officers, directors, and employees may not have been barred from association with a broker-dealer by the SEC, any state or other U.S. jurisdiction or any self-regulatory organization and is not suspended from association with a broker dealer.
The letter does not provide any relief for the transfer of interests to a passive buyer or a group of passive buyers. An M&A Transaction must result in a buyer or a group of buyers who control and actively operate the company or the business conducted with the assets of the business. A buyer, or group of buyers will satisfy the control requirement if they have the power, directly or indirectly, to direct the management or policies of a company, whether through ownership of securities, by contract, or otherwise. Control will be presumed to exist if, upon completion of the transaction, the buyer or group of buyers has the right to vote 25% or more of a class of voting securities, has the power to sell or direct the sale of 25% or more of a class of voting securities, or, in the case of a partnership or limited liability company, has the right to receive upon dissolution or has contributed 25% or more of the capital.
While the no-action letter does not address important issues related to the sale of interests in private equity funds by persons or firms that are not registered as broker-dealers, it does provided needed clarity for private funds as to when they can pay M&A Brokers for participating in M&A Transactions without incurring regulatory and other risks that may be created when engaging in securities transactions with parties that are not registered as broker-dealers. Hopefully, the letter is the foundation for other initiatives to improve the broker-dealer regulatory scheme and also to assist in the creation of capital for privately held companies.
 M&A Brokers (SEC No-Action Letter, January 31, 2014, Revised February 4, 2014).
 The SEC Staff previously issued two letters providing limited relief in this area. Country Business, Inc. (SEC No-Action Letter, November 8, 2006), and International Business Exchange Corporation (SEC No-Action Letter, December 12, 1986). A person seeking to rely on those letters could not engage in negotiations on behalf of a client, advise the client whether to issue securities, or assess the value of any securities sold. Transactions were limited to the sale of 100% of the equity of the company to be acquired. The letters also left unclear whether alternative fee arrangements were permissible in connection with the sale of larger businesses.
 These risks include potential rescission rights that arise when a securities transaction is effected in violation of the Exchange Act. The laws of various states may still provide purchasers in M&A Transactions rescission rights.