Conflicts of Interest in the News: Private Equity

This week we’ve been looking at COI issues in different types of business organizations – first non-profits, then joint ventures and now private equity.

While the fight for the Republican nomination for President has occasioned unprecedented (and largely un-illuminating) public scrutiny of the private equity field (i.e., on a net basis, whether it destroys or creates jobs), of greater significance for that industry  are provisions in the Dodd-Frank Act that treat many private equity firms as investment advisors, and thereby impose  various compliance requirements.  And, according to this helpful client alert published by Latham & Watkins,   that new mandate has occasioned scrutiny by the Securities and Exchange Commission  of the following types of possible COIs in the life cycle of private equity funds: “Fund-Raising Stage. Does a firm use consistent and comparable valuation methods and disclose pricing methodologies? Is the valuation methodology documented? Is the firm a party to side letters with certain limited partners, giving them preferential treatment regarding expenses, services provided by related parties or access to co-investments? Are the terms of these side letters fully and fairly disclosed to other limited partners?  Is the firm seeking to raise more funds than it can effectively deploy in an effort to maximize management fees? Investment Stage.  How does the firm allocate investment opportunities between funds? Is co-investing allowed on a deal-by-deal basis, creating a risk that private equity professionals will cherry pick deals with the best prospects for the co-investment vehicle at the expense of the fund? Management Stage . Do investors receive accurate reports regarding fund performance? Does the firm selectively highlight only the most successful portfolio companies while ignoring or underweighting portfolio companies that underperform?  Are fees charged to portfolio companies (transactional, monitoring, consulting, directors) fairly determined, adequately disclosed and consistent with what investors agreed to at the outset of the partnership?  Exit Stage. Has there been an effort on behalf of fund managers not to divest portfolio companies to extend mature funds beyond their normal lives?  How are conflicts handled when portfolio companies are sold by a fund to an affiliated fund?”

This is quite a list – and creating appropriate standards and controls around all of these areas of possible conflict could be quite a task for some firms, although obviously many are not starting from scratch.  (Note:  for beginners, as well as others, an dispensable resource for learning more about private equity compliance programs is Doug Cornelius’ Compliance Building web site. )  Indeed, at least for financial services compliance officers, private equity should be a source of job creation for some time to come.