[by Larry Goldfarb]

The traditionally relaxed approach to private equity investing is starting to get scrutiny.  The U.S. Securities and Exchange Commission is seeking to determine whether some private-equity firms are taking more profits from investments than they should under agreements with fund clients, according to two people with knowledge of the matter. Regulators are looking for deviations from the distribution process, or waterfall, which usually calls for clients to receive some gains on investments before the fund manager.

"More SEC scrutiny will force firms to add controls, increasing their costs in an already difficult operating environment of decreased profit margins,"said Tom Bell, a partner at Simpson Thacher & Bartlett in New York who oversees the firm’s private-funds practice. “We may see a few enforcement actions as a result, which would probably put the subject firms effectively out of business.”

The SEC is focused on 4 areas:

Expense Allocations:

 “As a fiduciary, it is important that private-equity advisers allocate their fees and expenses fairly,” Carlo V. di Florio, director of the SEC’s office of compliance inspections and examinations, said at a conference in New York in May. “ Private-equity firms charge annual management fees of 1.5 percent to 2 percent of committed funds and keep 15 percent to 20 percent of profit from investments, known as carried interest.

Fee Conversion:

When a buyout fund exits a holding, investors often get their investment back first, plus a certain percentage of the profits, known as the hurdle. Once the hurdle has been paid, the fund manager can begin collecting carried interest.  The SEC is concerned that firms lack internal controls to track payments and ensure that the agreed waterfall plan is followed, the people said.  While buyout companies have traditionally managed funds that pool capital from multiple investors such as pensions, endowments and wealthy individuals, large investors have increasingly sought their own separately managed accounts with better terms than the others.

‘Broken Deals’:

The SEC has asked some firms for information about how so- called broken-deal expenses are allocated, one of the people said. If a manager evaluates the same investment opportunity for a pooled fund and a separately managed account, regulators are concerned that the manager may protect the favored large investor from due diligence costs if the deal falls through, shifting the burden to the smaller investors in the co-mingled fund.

‘Inherent Conflicts’

“Some people at the agency believe that there are more inherent conflicts with private-equity funds than there are with hedge funds,” said Barry Barbash, a partner and head of the asset-management group at Willkie Farr & Gallagher LLP in Washington and a former director of the SEC’s investment- management division. “The agency’s focus on the private-equity industry is leading to a greater degree of wariness, pushing firms to think twice about their practices.”

For more information, [Bloomberg, 9/21/12].