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January 24, 2013

SEC Official Says Private Equity Enforcement Actions Could Increase

By John Filar Atwood

The private equity industry is susceptible to fraud in ways that hedge funds are not, which is one reason that the number of enforcement cases involving private equity could rise, according to Bruce Karpati, chief of the SEC Enforcement Division's Asset Management Unit. He delivered remarks at the recent Private Equity International conference in New York.

One characteristic that may make the private equity industry more susceptible to fraud is the ability to control portfolio companies in a way that is not completely transparent to investors, Karpati said. Diminished investor oversight of older funds is another factor that affects private equity, he noted. He said that the staff has observed that as a fund ages, investors become less engaged and may devote fewer and fewer resources to monitoring the fund. In his view, this makes private equity funds prone to fraud in a way that hedge fund investors, who generally make more frequent decisions about their positions in a fund, are not.

Asked what some of the staff's main concerns are about practices in the private equity industry, Karpati said that the primary industry stressors are fundraising and capital overhang. The recent rapid growth in assets under management has left many funds with a significant amount of uninvested capital, which means that there is more capital chasing the same number of deals. This puts extra pressure on returns, he noted, and may incentivize managers to engage in aggressive marketing and possibly to cross the line into inappropriate behavior.

The staff is also concerned that many private equity products lack transparency, especially into the valuation of illiquid assets and the operations of portfolio companies. This has led to fund managers inappropriately writing up assets during a fundraising period and then writing them down soon after the fundraising period closes, Karpati said.

He went on to discuss how conflicts of interest lead to much of the improper conduct in the private equity industry. He outlined some of the conflicts the staff has observed and provided suggestions on how a private equity chief operating officer or chief financial officer can reduce the risk of an Enforcement Division inquiry.

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