A US regulatory body has warned that family offices and institutions who invest in private equity and hedge funds risk paying even higher charges than they expect.
The message forms part of an inspection of private fund advisers by the Office of Compliance Inspections and Examinations (OCIE) which is part of the Securities and Exchange Commission.
Special terms can be offered to some clients and not disclosed to others. Co-investment arrangements involving alternatives firms may end up favouring one party over another
The OCIE says: “Many of the deficiencies…may have caused investors in private funds to pay more in fees and expenses than they should have, or resulted in investors not being informed of conflicts of interest.”
Its report, tagged as a risk alert, has reiterated warnings that compliance standards need to improve. It also follows criticism of the industry by a range of advisers. Former consultant Richard Ennis has found they have acted as a drag on returns at large US endowments, as reported by Family Capital on 16 June.
A report on large private equity firms by Ludovic Phalippou of Saïd Business School, Oxford University has found returns merely matched the index over the long term. Harvard academics Josh Lerner and Victoria Ivashina reached a similar conclusion.
Phalippou says disappointing returns partly relate to the hefty costs and fees levied by private equity managers, which have weighed down portfolio returns. Regulatory concerns over hidden charges have led to the development of cost transparency services in the UK, such as ClearGlass, chaired by Chris Sier.
Private equity and hedge funds have lagged the indices as a result of their exposure to soaraway technology companies which have steadily expanded their earnings multiples.
It is tough for hedge funds to squeeze returns out of markets flooded with cheap money. Private equity managers have found it equally hard to squeeze profits out of value investments.
Poor performance of any kind has a habit of throwing a harsh light on accepted practice. Family offices have often complained at the way alternatives managers hide their tracks, opting for co-investment where they can.
The OCIE has warned of conflicts of interest where alternative advisers have allowed the juicy deals to flow towards new clients, or investors paying a high fee. The allocation process can lead to some investors paying more for their investments or ending up owning less.
It has also found managers opting to allocate assets in a way inconsistent with an agreed policy.
Special terms can be offered to some clients and not disclosed to others. Co-investment arrangements involving alternatives firms may end up favouring one party over another.
There can be a conflict of interest relating to recommended investments in which a private fund adviser has a stake. Deals may breach agreed limits or produce unauthorised charges. Fees can get levied on portfolios at an artificially high rate as a result of generous valuations. Techniques used to monitor charges can vary from agreed standards.
The OCIE has also found breaches in codes of ethics, such as a failure to observe restricted trading lists and the receipt of gifts, contrary to client agreements.
It says that its interrogation of private asset advisers has already led to the modification of practices.
Surveillance can only increase following the decision of the US Department of Labor to allow retail owners of personal pensions to invest in private equity.
But the OCIE report may be trivial compared to the kind of scrutiny which would result from Joe Biden winning the next election.
To quote former presidential candidate Elizabeth Warren and fellow Democrat: “Far too often, private equity firms are like vampires – bleeding the company dry and walking away enriched.”