Sep. 17, 2019

Distorting Alpha: How Fund Management Practices Affect IRR Figures (Part Two of Three)

There are numerous datapoints that, if included or omitted, can affect the internal rate of return (IRR) that a PE sponsor shows for a fund in its marketing materials. It is important not to overlook, however, how certain fundamental management practices can also skew IRR figures, even if all the inputs are faithfully and accurately calculated. Absent proper awareness and disclosure of those issues, the SEC could find that unduly misleading IRR calculations induced investors to commit capital to the sponsor under false pretenses. This three-part series describes nine scenarios in which PE sponsors can generate distorted IRR figures based on their fund management practices or calculation techniques. This overview is meant to help investors parse these issues to generate a more accurate picture of PE sponsors’ investment prowess, while also helping sponsors avoid SEC scrutiny for violating performance advertising rules. This second article details how the idiosyncrasies of secondary transactions and private credit funds can artificially inflate the IRRs of active funds, as well as issues associated with the use of subscription credit facilities. The third article will explain how sponsors can inadvertently generate IRR figures when attempting to curate the most favorable subset of investments for marketing purposes. The first article highlighted how IRR calculations can be manipulated when certain data inputs are omitted by sponsors. See “SEC Charges Fund of Private Equity Funds Portfolio Manager With Misleading Investors Concerning Fund Valuation and Performance” (Sep. 12, 2013).

PE Fund Structuring Considerations After the Final GILTI Regulations

PE sponsors and investors have been grappling with the ramifications of the final Global Intangible Low Tax Income (GILTI) Treasury Regulations that recently became effective (Final Regulations). GILTI generally provides relief for certain U.S. investors in a PE fund structured as a domestic partnership that owns foreign portfolio company investments. Although the Final Regulations have generally become more taxpayer-friendly in the treatment of domestic partnerships, PE funds should be aware of certain limitations of these new rules – especially in the context of tiered partnerships. In a guest article, Gibson, Dunn & Crutcher partner Edward S. Wei provides a selected overview of the Final Regulations, with examples of the tax ramifications of certain structural approaches under the Final Regulations compared to the previous iteration of the GILTI rules. See “How the Tax Cuts and Jobs Act Will Affect Private Fund Managers and Investors” (Feb. 22, 2018); and “New Tax Law Carries Implications for Private Funds” (Feb. 1, 2018).

The Exempt Offering Framework: Review of the Concept Release (Part One of Two)

Exceptions to a rule can sometimes become so extensive that they overpower the rule itself, as some could argue is the case with the rules regarding the registration of securities. Although the Securities Act of 1933 requires every offer and sale of securities to be registered with the SEC absent an exemption, reliance on numerous exemptions created over the years has become so common that, according to SEC estimates, new capital raised in 2018 through exempt offerings was more than double that raised through registered offerings. Further, the exempt offering framework has evolved into a complex patchwork that can be difficult for would-be participants to navigate. As a result, the SEC recently published its Concept Release on Harmonization of Securities Offering Exemptions (Concept Release) seeking public comment – due September 24, 2019 – on ways “to simplify, harmonize, and improve” the rules for exempt offerings. This two‑part series examines the exempt offerings framework and the Concept Release’s questions about that framework. This article summarizes the elements of the Concept Release of particular interest to private fund managers. The second article will discuss the key takeaways from the Concept Release for private fund managers. For analysis of other SEC initiatives, see “SEC Chair Defends Regulation Best Interest and Investment Adviser Fiduciary Duty” (Sep. 10, 2019); and “How Fund Managers Can Prepare for the Latest SEC Cyber Sweeps” (Jul. 16, 2019).

The Robare Decision: Implications for Advisers and the SEC (Part Two of Two)

The SEC continues to focus on disclosure issues, particularly in the context of conflicts of interest. A recent court decision supports the SEC’s push for adequate disclosure of potential and actual conflicts of interest, while undermining the regulator’s characterization of willful omissions in disclosures. The U.S. Court of Appeals for the D.C. Circuit (Court) ruled in Robare v. SEC that an investment adviser and two of its principals violated Section 206(2) of the Investment Advisers Act of 1940 by negligently failing to adequately disclose to investors its financial arrangement with a service provider. The Court held, however, that this negligent conduct could not also be the basis for a violation of Section 207 for willful inadequate disclosures to the SEC. This two‑part series analyzes the Robare decision. This second article provides a former senior SEC official’s perspective on the implications of Robare for investment advisers and the SEC’s Division of Enforcement. The first article reviewed the Commission’s findings and the Court’s rulings on those findings. For analysis of other significant court rulings, see “Delaware Court Enforces Contractual Provision Preserving Attorney-Client Privilege Over Seller’s Pre‑Disposition Communications” (Jul. 16, 2019); and “What the Supreme Court’s Decision in Lorenzo v. SEC Means for Fund Managers” (Jun. 18, 2019). To explore the ramifications of the Robare decision and other issues, on Thursday, October 3, 2019, at 1:00 p.m. EDT, the Private Equity Law Report’s sister product – the Hedge Fund Law Report – will host a complimentary webinar, entitled “Focus on Private Funds: A Fireside Chat with SEC Commissioner Hester M. Peirce.” During the program, Robin L. Barton, Senior Reporter for the Hedge Fund Law Report, and Commissioner Peirce will discuss topics of interest to private fund managers, and Commissioner Peirce will also answer attendees’ questions during a Q&A session at the end of the webinar. To register for the webinar, click here.

ACA Identifies 12 Most Common Compliance Failings for U.K. Firms and How to Avoid Them (Part One of Two)

ACA Compliance Group (ACA) recently shared its insights on recurring compliance issues found during its reviews of U.K. firms; the U.K. Financial Conduct Authority’s standards and expectations in these compliance areas; and recommendations for addressing those issues. The findings and suggestions were presented in a webinar featuring ACA partner Philip Naughton and ACA directors Charlotte Longman and Michael Chambers. This article, the first in a two-part series, reviews the first six compliance failings highlighted in the program: governance, compliance arrangements, general compliance, personnel, training and financial crime arrangements. The second article will explore the remaining six compliance failings: regulatory reporting, financial planning, the Internal Capital Adequacy Assessment Process, the Investment Firm Review, market abuse and transaction reporting. For additional commentary from ACA, see our two-part series on its 2019 compliance survey: “Recent SEC Exam Experience; Common Code of Ethics Issues; Use of Senior Advisers; and Fee and Expense Allocations” (Jul. 9, 2019); and “Annual Meetings, Insider Trading Controls and Common Compliance Program Issues” (Jul. 16, 2019).