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Waking up to financial fraud in private equity

Rapid market growth and increased regulatory oversight could cause litigation in the private equity industry to rise in the next few years, according to research from consulting firm McGladrey.

Private equity firms and their advisors should be prepared to address issues of financial fraud in response to regulations from the US Securities and Exchange Commission, according to a white paper from assurance, tax and consulting firm McGladrey.

The paper is in response to the SEC’s two-year Presence Exams initiative, which launched in 2012. The programme involves “risk-based examinations of investment advisors to private funds that have recently registered with the Commission”, according to a letter provided by the SEC. In these exams, the SEC identifies five core focus areas regarding the supervision of private equity firms: the dissemination of marketing materials, portfolio management, conflicts of interest, safety of client’s assets, and the valuation of fund assets.

To enhance the SEC’s programme, the regulator has adopted investigative techniques that include wire-tapping, witness flipping, informants and undercover agents to catch individuals who are engaged in fraudulent behaviour.

Gary Swiman, a principal at accounting and consulting firm EisnerAmper, said these techniques have been “fairly effective” in giving the SEC the ability to catch potential violations they would not have caught before.

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Gary Swiman

“Now, the counter argument from the industry is that it’s overly invasive and it’s a lack of privacy so there are two sides to the equation,” he said.

Mathieu Drean, global head of secondaries at private equity advisor Triago, said calling the investigative techniques of “mafia-style”, is sensationalist and inaccurate.

“All of the indications are that techniques that go beyond normal auditing are being reserved for real fraud,” he said.

As a result of the risk concerns, the paper says advisors should act “swiftly and thoroughly” to combat any manipulation. It calls for both advisors and fund managers to hire external forensic investigative teams and financial consultants, to prevent fraud.

“If everyone inside a private equity firm is on the same page with respect to compliance and their awareness of the regulations, then some of these violations or fraudulent activities would be much harder to pull off,” said Swiman.

According to John Rollins, a director at McGladrey, private equity firms have generally been receptive to potential financial fraud activity.

“Of the clients we’ve worked with, we’ve seen that the management teams of private equity firms are acting very swiftly in reacting to potential problems,” he said. “This is important, not only from a regulatory compliance standpoint, but also to make sure that their investments are sound.”

Drean agreed and added that many GPs are reviewing their standards and practices and overhauling them when necessary, which is what the SEC hoped would happen.

Still, some private equity firms are not sure how significant of a role potential financial fraud cases play in their practice. Michael Granoff, chief executive officer of Pomona Capital, said he has seen few examples of actual financial fraud during his 20 years with the firm.

“We’ve bought interests in hundreds of funds and thousands of companies and I think that financial fraud has been a tiny, minuscule issue,” he said.

Read the full report on addressing financial fraud in the private equity industry here.