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GP-led restructurings in SEC’s sights

The US regulator is taking a closer look at ‘creative approaches’ managers are taking to deal with end-of-life and zombie funds. But investors cannot rely on the SEC alone to defend their interests.

General partner-led restructurings and zombie funds are coming under increased scrutiny from the US Securities and Exchange Commission (SEC).

Speaking at the PEI CFO and COOs Forum in New York last week, Igor Rozenblit, co-head of the SEC’s private funds unit, warned the audience the regulator was watching so-called zombie funds that may be “tempted to resort to creative approaches in markets that are less favourable … to make sure that those creative approaches don’t cross the line and violate federal securities laws”.

There were more than 1000 zombie funds – past-term vehicles managed by GPs unlikely to raise a successor vehicle – as of July last year, almost half of which were in the US, according to PEI Research & Analytics. One area the SEC is looking into is the practice of GPs creating third-party providers to charge fees and expenses to funds.

It’s also keeping a close eye on the trend towards GP-led restructurings or fund recaps.

“The past three years have seen enormous growth in the number of GP-led restructurings,” Jeff Hammer, managing director at investment bank Houlihan Lokey‘s illiquid financial assets practice told sister title Secondaries Investor. “What started out as a trickle of one-off, highly-negotiated deals has become a regular flow of transactions using increasingly standardised techniques.”

Potential conflicts of interests between manager and investor arising from related secondaries transactions, including stapled deals, and fees charged by advisory firms on GP-led transactions are among the issues that have caught the regulator’s eye.

Both zombie funds and good managers grappling with end-of-life fund situations need to make sure they abide by the rules when they dispose of those vehicles and/or assets. The SEC investigation of New York firm Fenway Partners demonstrates the SEC’s resolve. The firm had been trying to recapitalise its second fund, a 1998-vintage vehicle, and its third fund launched in 2006, with no plans to raise further vehicles.

The regulator found in November last year that four executives at the firm “weren’t fully forthcoming to the client and investors about several transactions involving more than $20 million in payments out of fund assets or portfolio companies to an affiliated entity for consulting services” relating to its third fund. Fenway settled with the SEC for $10.2 million to be held in a fund for “harmed investors”.

“I think the general take-away from that case is that these kinds of things are actually not that uncommon when funds enter zombie mode, and this is what makes zombies particularly of interest to us,” Rozenblit said at the forum. An SEC statement on the Fenway settlement noted advisors needed to be “particularly vigilant about conflicts of interest and disclosure when entering into arrangements with affiliates that benefit them at the expense of their fund clients or when receiving payments from portfolio companies”.

Equally, investors cannot rely on the regulator to defend their interests. They too must remain vigilant. As Rozenblit told the conference: “Investors shouldn’t be afraid to band together and fire their manager if their assets aren’t being managed appropriately and they shouldn’t be afraid to report fraud to the SEC if it occurs.”

Investor action should provide managers with the strongest incentive to do the right thing for LPs.