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 At issue is how private equity firms report how they calculate
average net returns in past funds in their marketing materials, the
sources said.
Net returns, also known as the net internal rate of return (IRR) and
an indicator of investors' actual profits, deduct private equity
fund investors' fees and expenses from a fund's gross profits.
Private equity fees are not standard and different investors in the
same fund can pay different fees.
Fund investors such as pension funds, insurance companies and
wealthy individuals – known as limited partners - pay the fees to
the private equity firm. The private equity firm and its managers,
called general partners, also typically invest some of their own
money into the funds, but don't pay any fees.
Including the general partner's money in the average net returns can
inflate the fund's average net performance figure, and the SEC is
investigating whether private equity fund managers properly disclose
whether they are doing that or not, the sources said.
An SEC spokeswoman declined to comment.
The SEC's focus on the average net IRR disclosures, which has not
been previously reported, marks a new phase in the agency's efforts
to regulate private equity and comes at a time when the industry is
already under pressure from investors to simplify its fees and
expenses structure.
The emphasis on performance figures is likely to cause many buyout
firms to review their regulatory compliance measures and force them
to increase disclosures and make their numbers more intelligible to
investors.There is no standard practice for calculating average net
IRRs among the roughly 3,300 private equity firms headquartered in
the United States.
A Reuters review of regulatory filings and interviews with people
familiar with different firms' practices show the calculation varies
widely even among the top private equity firms.
Blackstone Group LP, Carlyle Group LP and Bain Capital LLC, for
example, do not include money that comes from general partners in
average net IRR calculations, while Apollo Global Management LLC
does, the review shows.
Fund marketing documents are not public, but the sources said all
these firms disclose to investors whether they include general
partner capital in the calculation or not.
The SEC's review comes after the agency put together a dedicated
group earlier this year to examine private equity and hedge funds
that had to register with it as part of the 2010 Dodd-Frank
financial reform law, Reuters first reported in April.
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Much of the SEC's focus so far had been on fees that private equity
funds charge. In a May 6 speech, Andrew J. Bowden, director of the
SEC's Office of Compliance Inspections and Examinations, said more
than half of the private equity funds the agency examined had
inappropriately allocated expenses and collected fees.
COMPLEX CALCULATION
The average net IRR figure is crucial to investors' understanding of
their actual profits from private equity funds. That's because not
all investors in a fund pay the same amount of fees to the private
equity firm for managing their money.
Typically, fund managers charge a management fee of about 1.5
percent of committed capital and take 20 percent of the fund's
profits assuming performance meets a returns hurdle agreed with
investors.
Investors, however, are usually offered fee breaks if, for example,
they commit money early during the fundraising process or if they
make a larger allocation to the fund.
The SEC expects private equity firms to report average net IRRs
alongside gross IRRs with equal prominence in marketing materials
when they are seeking to raise a new fund.
Industry sources said including general partner capital in the
average net IRR calculation can make a material difference if that
commitment is sizeable.
"Over the past five years, some general partners have started to
invest more of their personal capital into their vehicles on a
non-fee basis and that obviously can create some IRR distortion,"
said David Fann, chief executive officer of TorreyCove Capital
Partners LLC, a private equity advisory firm.
(Reporting by Greg Roumeliotis in New York; Editing by Paritosh
Bansal and John Pickering)
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