Our August blog provided an overview of key areas under review by the SEC. This month our focus is on:

• IRR
• Co-Investment Allocation
• Conflict of Interest

IRR

The private equity firm and its managers are called General Partner (GP) and the investors who commit capital into the fund are known as Limited Partners (LPs). LPs often pay various fees to the PE firm throughout the life of the fund but on the other hand GP do not pay fees. So including GP’s returns in the IRR calculation will tend to inflate the fund performance.

Since the net IRR is crucial to investors, the SEC is reviewing how PE firms calculate and report the net returns (IRR) for the historical funds in their marketing materials. The expectation of the SEC is that Private Equity firms should report average net IRRs and along with gross IRRs in their marketing materials.

Co-Investment Allocation

Investors in a private equity fund should be aware of all co-investment opportunities and have equal opportunities to invest. Any undisclosed co-investment may lead to a material conflict and could result in violations of federal securities laws and regulations.

Implementing a best practice of disclosing co-investment opportunities is necessary in all PE firms because the SEC requires all investors know where they stand in the co-investment priority stack.

Conflicts of Interest

Regulators are focusing on the conflicts of interest in fees and expense allocations. Conflicts of interest are material facts and have economic impact, which makes it necessary for advisers to disclose all conflicts to their clients. The SEC requires advisers to identify all the conflicts and address them by disclosing or eliminating the conflict completely.

Within the private equity real estate segment, an advisor who is also an Owner-Operator often provides additional services such as property management, leasing services or maintenance services for additional fees. The SEC expects all fees to be reasonable and fully disclosed. Other instances have been noted where advisers also charge additional undisclosed fees for the asset management services provided by their employees and in-house attorney on top of the management fee.

Transparency in the private equity fund administration is what regulators are seeking. By regulating the PE industry, the SEC believes there will be an increase in confidence by the investor and lead to growth in the industry.