Addressing financial fraud in the private equity industry

Transcription

1 Addressing financial fraud in the private equity industry Prepared by: John E. Rollins, Director, Financial Advisory Services, RSM US LLP May 2014 Today s private equity advisers are more vulnerable than ever to litigation risks. Rapid industry growth, coupled with economic pressures, in recent years, has produced greater competition for deal flow, more active investors and more assertive limited partners. Moreover, U.S. regulators are now focusing on private equity with new registration and disclosure requirements. With these added pressures and regulatory risk, private equity advisers need to know how to identify and respond to potential issues of financial fraud. This paper addresses the more prevalent areas for which private equity firms, brokers and other trusted advisers may be subject to accusations of manipulation or fraud. Certain characteristics of the industry may make advisers more susceptible to allegations of fraud, such as: relatively long lockup periods, illiquid investments, complex transactions, absence of standardized partnership agreement structures (resulting in the potential for disagreements about interpretations of contract provisions), a perceived lack of transparency, inherent conflicts of interest and activist investors. More than ever, investors are scrutinizing the performance and activities of their portfolio managers and financial advisers. Limited partners are increasingly more critical of disclosure materials supplied by general partners and are demanding more detailed performance data.

2 Regulatory changes With the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, many advisers to private equity (and hedge fund) investors who formerly did not register with the U.S. Securities and Exchange Commission (SEC) are now subject to SEC oversight and disclosure requirements. Currently, nearly 1,000 new private equity registrants manage gross assets exceeding $1.5 billion. In 2012, the SEC launched a two-year Presence Exams initiative as part of its National Exam Program, involving focused, risk-based examinations of [recently registered] investment advisers to private funds. In these exams, the SEC identified five core focus areas regarding its supervision of private equity firms: 1 Table 1. SEC focus areas for private equity and related fraud risk concerns Focus Area Key Fraud Risk Concerns 1. Marketing y Dissemination of materials that contain false or misleading statements regarding historical performance 2. Portfolio management y Favoritism among clients y Misallocation of investment opportunities 3. Conflicts of interest y Failure to identify, mitigate or manage conflicts of interest y Diversion of investor funds, including shifting of fund expenses and improper transactions with affiliated parties 4. Safety of client assets y Failure to follow rules regarding safekeeping of client funds 5. Valuation of fund assets y Manipulation of valuation of illiquid or hard-to-value assets y Incorrect calculation of management and performance fees 1 US Securities and Exchange Commission, Letter to Industry Regarding Presence Exams, Office of Compliance Inspections and Examinations, October 9, The SEC reiterated these goals to senior industry executives at a national Compliance Outreach Program seminar in January The next month, SEC Chair Mary Jo White highlighted another regulatory initiative in her address at the annual SEC Speaks Conference the Financial Reporting and Audit Task Force. The Task Force identifies trends, patterns and other risk indicators of financial fraud at reporting companies, including newly registered private equity firms, in the areas of revenue recognition, asset valuations and management estimates. 3 To enhance the SEC s new programs, White has bolstered the commission with former Department of Justice prosecutors, who are using techniques such as wiretapping, witness flipping, informants and undercover agents in their pursuit of potential fraudulent activities in the private equity industry. 4 Through the end of April 2014, the SEC has conducted more than 150 exams, on pace to reach its goal of examining 25 percent of newly registered advisers by the end of Key fraud risk concerns Within the SEC s core focus areas for private equity, the related fraud risk concerns range in complexity and can occur in several ways. Stakeholders must be prepared to respond to issues that may arise at both the fund management and portfolio company-level. Stakeholders must also provide careful oversight of their outside financial advisers, brokers and agents. Dissemination of misleading statements about historical performance Fund managers must be diligent in ensuring their marketing materials contain accurate disclosures regarding the historical performance and financial condition of the fund and the companies held in their portfolio. Fund managers should critically review all information provided by company management regarding performance and financial health. Company management could be tempted to hide poor performance in order to meet targets set by fund investors or by debt covenants. Prior to being acquired, management could be tempted to misstate results in order to drive up the deal price. Additionally, results could be manipulated in advance of an initial public offering or to conceal bribery and corruption. Company results that consistently meet or exceed expectations should be examined closely to ensure that they fairly depict performance. 2 US Securities and Exchange Commission, Compliance Outreach Program, National Seminar for Investment Adviser and Investment Company Senior Officers, January 30, US Securities and Exchange Commission Chair Mary Jo White, Chairman s Address, Speech given at SEC Speaks 2014, Washington, DC, February 21, Madison Marriage, Private equity firms brace for mafia style scrutiny, Financial Times, December 1, Speech by Andrew J. Bowden, Director, Office of Compliance Inspections and Examinations, US Securities and Exchange Commission, Spreading Sunshine in Private Equity, Private Equity International (PEI), Private Fund Compliance Forum 2014, New York, NY, May 6,

3 Efforts to exaggerate company performance or financial health typically involve manipulation of the ledger accounts that consolidate up to the financial statements. For instance, a company may prematurely book revenue before products or services have been delivered or fraudulently inflate revenue by falsifying invoices, inventory counts or shipping records. Alternatively, a company may understate expenses by delaying the recording of costs of goods sold or failing to record certain accrued expenses. On the balance sheet side, a company may overstate its assets by improperly capitalizing expense items, manipulating reserves, falsely extending the depreciable life of assets or recording fictitious assets. Understating liabilities may be achieved through manipulating accounts payable or using off-balance sheet shell companies to conceal liabilities. Companies may also manipulate benchmark ratios, such as working capital or long-term debt ratios, by altering reporting assumptions relating to the timing of current and long-term liabilities. Favoritism or misallocation of investment opportunities Favoritism by a fund manager without proper disclosure of such actions to all of the fund s investors is a key concern of the SEC. In some instances, a fund manager may be accused of preferentially allocating certain investment opportunities to large, key clients without disclosing this treatment. In other instances, fund managers may be accused of inappropriately offering favorable terms or special financing to certain investors or funds they manage through the use of confidential side letters. Additionally, fund managers or sponsors could fall prey to claims regarding violations of co investment disclosure and allocation rules. Conflicts of interest or diversion of investor funds Apparent conflicts of interest can occur throughout the life cycle of an investment and may involve accusations that a fund manager has siphoned investor funds without proper authorization or investor disclosure. Diverting investor funds not only drains invested capital, but also impairs decision making, since it results in an inaccurate portrayal of fund performance. For example, investors could claim certain business expenses of the management company were inappropriately allocated to the fund level. Additionally, a fund manager could be suspected of improperly distributing legitimate fund level expenses across funds for the benefit of specific clients. Finally, accusations could involve the mischaracterization of personal expenses as fund expenses or the outright creation of fictitious expenses. Investor disclosures and information materials should be carefully crafted and reviewed with respect to affiliated entity transactions, related party loans and other significant third-party transactions. Unscrupulous fund managers may make unauthorized or misclassified personal loans to themselves or their business associates with little or no intent to replenish those investor funds. Any suspicions of vendor kickbacks or preferred pricing arrangements with related parties should be investigated quickly. Safety of client assets The SEC requires that registered investment advisers, including newly registered advisers to private equity investors, abide by certain rules under section 206(4) of the Investment Advisers Act of 1940 regarding the safekeeping of client funds (Custody Rule). The Custody Rule provides that it is a fraudulent, deceptive or manipulative act for a registered investment adviser to fail to abide by certain safekeeping rules regarding client assets held in their custody, including the use of a qualified custodian to maintain the funds and an independent public accountant(s) to provide a verification of the client assets and a report of the internal controls relating to the custody of such client assets. 6 The SEC has placed a great deal of importance on enforcing compliance with the Custody Rule 7 and identified this as a particular focus area of the Presence Exams. 8 Valuation of fund assets Since private equity investments frequently involve long holding periods, the interim valuations of portfolio holdings may be especially vulnerable to accusations of manipulation and fraud. Moreover, investors focus on valuations, as they are often important factors in the calculation of management and performance fees. Not surprisingly, the transparency and appropriateness of valuation policies and procedures is a key area of concern for the SEC. The valuation of illiquid assets poses a difficult problem for private equity advisers, since it often involves the use of subjective inputs and assumptions. Market quotes for underlying assets are not often readily available. Fund managers may be accused of fraudulently overvaluing assets for reasons that include a desire to attract new inventors by misstating marketing materials or to mask poor portfolio health. Plus, to the extent that management fees are calculated on the value of the fund, there may be an incentive to overstate asset levels to drive higher management fees. Conversely, managers could be accused of undervaluing assets in a scheme to draw investors to other co-managed funds. Calculation of management and performance fees Limited partners may dispute the calculation of management and performance fees paid to general partners and other advisers. Fund managers may be accused of artificially inflating monitoring and other additional fees by performing unnecessary services or misrepresenting the services delivered. Delaying the sale of a portfolio company to increase interim fees is another possible claim. Avoiding poorly defined fee provisions in partnership agreements can help limit disagreements between investors and fund managers. 6 Title 17 CFR Part 275, Rule 206(4)-2. 7 US Securities and Exchange Commission, Significant Deficiencies Involving Adviser Custody and Safety of Client Assets, March 4, US Securities and Exchange Commission, Examination Priorities for 2014, National Exam Program, Office of Compliance Inspections and Examinations, January 9,

4 Responding to suspicions of fraud Private equity investors and fund advisers should act swiftly and thoroughly when they suspect fraud. Consider employing outside counsel to obtain an independent and accurate picture of the situation. Contact insurance providers to verify coverage levels. Upon engaging counsel, another important consideration is whether to engage a financial consultant to assist in investigating the suspected fraud or providing other litigation support. A forensic investigation team will identify affected accounts, retrace the steps taken in recording the transactions and document the paper trail. If electronic information must be obtained and analyzed, a forensic information technology professional can help extract s and preserve or restore lost or hidden files. Further, a financial consultant may assist counsel in quantifying alleged damages suffered by injured parties. A qualified expert may be an integral part of a response to regulatory enforcement actions or investor disputes. Experts may prepare formal reports and provide expert witness testimony on matters related to their expertise if the case goes to trial or arbitration. With increasing regulatory focus and more active investors, litigation in the industry could rise in the coming years. Private equity firms and other advisers must be prepared to quickly and effectively respond to any allegations of improper conduct or fraudulent activities. * Christopher Fitzgerald, Senior Associate, assisted in the development of this white paper. Case examples: 1. In January 2014, a former portfolio manager of a $100 million fund of funds settled fraud charges with the SEC for his involvement in providing false and misleading information to investors about the value of certain underlying fund investments and about the fund s performance. The case was a rare enforcement action involving the private equity industry. In particular, the manager was accused of marking up the value of underlying investments and disseminating false internal rate of return (IRR) metrics in marketing materials whereby he had failed to deduct his fund s fees or expenses. In settling the charges, the former manager agreed to a two-year ban from the securities industry and a $100,000 penalty. Separately, the fund settled related charges for $2.8 million in Although the size of the matter is relatively small, the action very well may be a sign of things to come, given the SEC s new microscope on the private equity industry. [Focus areas 1 and 5] 2. In early 2014, the SEC filed charges against a private equity manager who paid fees to a friend s company for due diligence. The due diligence was never performed, and the friend provided kickbacks to the private equity manager. The SEC alleged that the manager diverted over $9 million from a fund worth roughly $120 million. 10 [Focus area 3] 3. In February 2014, a private equity manager and his firm were charged with using fund assets from 19 separate private equity funds to inappropriately cover the management firm s expenses. Shared expenses were split between the firm and the 19 funds based on a ratio that allegedly did not reflect the actual expenses as incurred by each fund. Furthermore, firm expenses were allocated to these funds without proper disclosures about them being made to investors and, in some cases, directly violating private placement memorandum regarding management expenses. After depleting fund reserves, the manager allegedly proceeded to loan the capital at high interest rates, pledging fund assets as collateral. Additionally, the private equity manager changed the method in which investor returns were calculated in order to reduce dividends. 11,12 [Focus areas 2-5] 9 US Securities and Exchange Commission Press Release, Former Oppenheimer Fund Manager Agrees to Settle Fraud Charges, Washington, DC, January 22, US Securities and Exchange Commission Press Release, SEC Charges Manhattan-Based Private Equity Manager With Stealing $9 Million in Investor Funds, Washington, DC, January 30, US Securities and Exchange Commission Press Release, SEC Announces Charges Against Arizona-Based Private Equity Fund Manager in Expense Misallocation Scheme, Washington, DC, February 25, US Securities and Exchange Commission Order, In the Matter of Clean Energy Capital, LLC and Scott A. Brittenham, Respondents, Administrative Proceeding File No , February 25,

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