PE Branding: Zombies or Fiduciaries? The Choice is Theirs

PE shops, it seems, are about to get a bit more heat, and may need to think about ways to cool down.

Private equity firms were part of a force of registrants last year who enrolled for the first time with the Securities and Exchange Commission as required by the Dodd-Frank Act, putting them under a new regulatory microscope. It wasn’t long before the SEC dispatched examiners to target higher-risk areas of the new population, including valuation, marketing and conflicts of interest.

Now, it seems the SEC’s Division of Enforcement might be ramping up their focus on PE shops, creating potential fodder for a fresh slew of negative headlines. Bruce Karpati, the tenacious chief of the Division’s Asset Management Unit, stated, “… it’s not unreasonable to think that the number of cases involving private equity will increase,” according to recent written remarks offered to the Private Equity International Conference.

If past headlines are any indication of potential fallout to come, it could be a bumpy road for PE firms trying not only to comply with SEC mandates, but also navigate an increasingly electrified PR terrain.

Karpati said his unit has been busy: It has plucked specialists right from the industry to help investigate complex transactions. It’s joining SEC examiners in the field inspecting private equity managers. It’s collecting intelligence from the SEC’s Division of Investment Management on complex legal and contractual issues. And, it is taking advantage of risk analytic initiatives to use data and quantitative analysis to detect fraud.

He sees private equity as a rapidly maturing industry, one that is perhaps even larger than the hedge fund industry in terms of assets under management, and his unit’s concerns about its practices are “always evolving.” He pointed to “unique characteristics that may make the industry more susceptible to fraud,” such as the ability to control portfolio companies in a way that’s not totally transparent to investors.

So what is Karpati paying special attention to? Areas where the industry is changing, and spots that are lacking in transparency where fraud might go undetected. He singles out fundraising and capital overhang as two industry stressors, and the potential for aggressive marketing that may lead some managers to behave inappropriately. He talks about conflicts of interest and the valuation of illiquid assets.

To get a sense of what damage control might be in order, we don’t have to look any further than the recent attention on so-called “Zombie funds,” which, not surprisingly, seemed to get special attention around Halloween.

As Karpati describes, Zombie funds result when private equity holdings are not designed for quick liquidity. Managers of these funds, struggling to raise new capital, may have incentives that shift from maintaining good investor relations to maximizing their revenue with remaining assets. His unit is bracing for problematic conduct here.

The media coverage of this issue in the past has produced such headlines as, “Investor Hazard: ‘Zombie Funds,’” (WSJ); “Private Equity Trapped in ‘Zombie Funds,’” (FT); and “Oh, the Horror: Zombie Funds Stalk LPs” (Dow Jones).

If there are issues, a “detect and correct” plan is in order, he says, but he also points to a potential image problem where PE practices may be “viewed as putting the manager’s interest ahead of those of investors.” PE managers, as fiduciaries, must take steps to guard against incentives that might result in disinterested advice, he says.

He singles out COOs, CFOs and CCOs as those who should play a role in this process by becoming investor advocates. He suggests, for one, they consider assigning an experienced deal professional who has the knowledge to help review and implement appropriate compliance procedures, given the transactional focus of the firms.

CCOs often remain behind the scenes, but aspects of a strong compliance program, and proactive steps taken by CFOs and COOs, can be highlighted in safe and effective ways in the face of a scrutinizing SEC, cautious investors and a suspicious public.

If PE firms are viewed as lacking in transparency, maybe there is room for them to embrace transparency before regulators descend on their lack of it. Maybe there’s an opportunity here to market the news that their executive suite heeded at least some of the regulatory advice, and brand themselves as the fiduciaries Karpati values and not the “zombies” the headlines imply.