I attended a seminar recently where the host law firm reviewed the SEC audit activity of private equity firms that has been spawned by Dodd-Frank. In attendance was a private equity professional whose firm had just completed one of these audits. His experience matched the law firm’s report that the audit was more of a fact finding and information gathering exercise than an actual audit by knowledgeable industry participants.
In fact, the private equity professional had enough heartburn about the government auditors’ qualifications that he asked them about their background. He was told that they could not disclose their background. So I immediately thought about a couple of guys who had just transferred from a job at IRS where they had worked on Lois Lerner’s nonprofit team to join the Dodd-Frank audit team. They can’t tell you about their background because it might raise suspicion of bias and genuine skepticism about their prime objective.
Sweating The Little Stuff
Of course, I am kidding. The private equity professional subsequently pointed out that the auditors had, in fact, demonstrated math and auditing skills by fixating on a less than $1000 discrepancy between reimbursed organizational expenses to the General Partner and actual documented organizational expenses. This was in the context of a fundraising of more than $450 million spanning a two year time frame.
Here’s What Is Going On
A recent article in the Wall Street Journal casts light on what is going on. Evidently these auditors have a hit list of supposed abuses that range from self-dealing with portfolio companies to portfolio valuation abuses. In a few cases these audits will uncover mistakes and, in even more rare circumstances, outright deception and fraud. However, the objective appears to be much more about hunting down successful people (many of whom are prominent contributors to the opposition party) than investor protection. After all the investors in private equity funds are incredibly sophisticated with access to a wide swath of managers. In many cases the investors work with their own auditors, consultants, wealth advisors and attorneys to carefully diligence the fund managers, fund formation documents and track record.
Same Group That Missed Madoff
It is lost on me how the SEC audit program is going to improve on the Darwinism of the existing system? The Agency’s track record is lower than the worst performing manager in the history of private equity. The SEC investigated Madoff’s Ponzi scheme in 2005, but failed to verify several critical pieces of information. As result, they sadly failed to discover the scheme until after the fraud was admitted in 2008.
Manager Selection Is Bedrock
The single biggest variable in private investing is the fund manager and picking a good manager who will treat your money like his own is the key to success in this asset class. If you substitute a friend’s advice for your own due diligence and follow the frenzied herd you will likely get a Madoff result. That’s capitalism!
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