The Securities Litigation Expert Blog

Private Equity - Due Diligence

Posted by Jack Duval

Nov 16, 2017 8:30:16 AM

This blog post begins a series examining the risks and returns of private equity investments.

Apollo Group Structure:  Got it?

Apollo Group Structure.jpg

Source: Apollo Group S-1

On July 28, 2017, Apollo Group Management LLC announced the largest ever capital raise for a private equity fund.  While this $23.5B fund will be the largest ever, it may not hold the title for long.  The New York Times reports there are two other private equity funds in raises with higher targets.[1]

While these capital raises are impressive, they also raise questions.  As the private equity space has become increasingly crowded, returns have declined.  Industry statistics are sobering.

The most recent data from Prequin reveals that for the time period ending 2016:[2] 

  • Private equity AUM were at $2.491T, an all-time high;
  • Cash held by private equity funds was at $820M, an increase of $65B from 2015;
  • Median net IRRs have declined from 20+ percent in the early 1990’s to 12.6 percent in 2013 (the most recent vintage with meaningful numbers)
  • Likewise, median net multiples have declined from around two to around one over the same time period.

The reduction in returns has led to a number of abusive practices at private equity funds.  These abuses were highlighted by the SEC in a high-profile campaign in 2015.[3]  However, the continued bull market has helped to keep valuations high and has served to reduce litigation.  This will not always be the case.

When the market turns, successful exits will become harder to realize and this will depress IRRs.  At that point, private equity funds and the advisors who sold them may find themselves in the difficult position of having to justify total fund expenses that can amount to six percent of committed capital, annually.

While private equity remains a legitimate asset class, a tremendous amount of diligence must be conducted in order to insure that abusive practices are not being utilized by funds at the expense of their limited partners.

I will give an overview of some areas that disserve heightened diligence and then explore them in later blog posts.

Private Equity Due Diligence

Diligence into private equity funds is a time-consuming and laborious process.  Most investors are not equipped to undertake this due diligence as the private placement memorandums are written in legalese and encompass concepts from finance, economics, accounting, and law.  This is a form of complexity risk, something I have written about extensively.  Indeed, because of their complexity, many professionals are ill-equipped to properly evaluate private equity investments.

An example of private equity complexity risk can be seen at CalPERS, the massive California Pension manager.  CalPERS endured public embarrassment in 2015 when it had to admit it could not account for the fees being paid to the pension's private equity fund managers.[4]  This fact is even more remarkable in context of CalPERS’ investment staff of nearly 400.[5]

Advisors must have extensive training and experience with private equity investments before they can undertake the rigorous due diligence required to make a suitability determination.

Areas requiring heightened diligence include: 

  • General Partner/Limited Partner Conflicts, which include:
    • Non-performance based compensation;
    • Waivers of fiduciary responsibility;
    • Shifting expenses to funds (i.e. limited partners);
  • Valuation:
    • How are marks set?;
    • Assumptions used in marks?;
  • IRRs:
    • Do they reflect the economic returns to limited partners (even if “accurate” at the fund level)?;
    • Treatment of timing of flows;
    • Timing of allocation of unrealized losses;
    • Omissions of key assumptions;
  • Performance
    • Leverage-adjusted returns;
    • De-smoothed returns and volatility;

I will examine these and other factors of private equity risk and return, as well as their implications for suitability and supervision, in subsequent blog posts.



[1]       Tom Buerkle, “Apollo’s Huge Buyout Fund Provides for a Large Margin of Error”, New York Time’s; June 28,2017.  Available at:; Accessed November 16, 2017.

[2]       Prequin 2017 Global Private Equity and Venture Capital Report.  Available at:; Accessed November 16, 2017.

[3]       SEC Announces Enforcement Results for FY 2015; October 22, 2015.  Available at:; Accessed November 16, 2017.

[4]       Randy Diamond; “CalPERS CIO looking at possible drastic cuts to private equity, citing transparency”; Pensions & Investments; June 19, 2017.  Available at:; Accessed November 16, 2017.

[5]       CalPERS biography of Ted Eliopoulos, Chief Investment Officer.  Available at:; Accessed November 16, 2017.

For information about securities expert Jack Duval, click here.


Read More

Topics: suitability, supervision, Due Diligence, private equity, de-smoothed returns, IRR, leverage-adjusted returns

SEC Defining Risk as Complex Investments

Posted by Jack Duval

Jun 4, 2014 8:14:00 AM

 It has been widely reported that the SEC has put together a group dedicated to looking into how private equity and hedge funds “value their assets, disclose their fees, and communicate with investors.”[1] What has not been so widely reported is why this new group is necessary.

I believe the SEC is responding to investment complexity with specialized examination groups.  This is straight out of the SEC playbook going back to 2010, when it underwent a complete reorganization.  (See our previous coverage of this here.)


To understand why this is happening now, we have to go back to the passage of the Dodd-Frank Act in 2010, which removed registration exemptions for private equity and hedge funds.  Previously, these funds were covered under the so-called “15 client exemption” which allowed private fund advisers to count each fund as a client and thereby bypass the purview of the SEC.[2]

In testimony to the U.S. House Committee on Financial Services, SEC Chair Mary Jo White provided insight about the SEC’s private fund examination efforts.  Some of the more salient points she made include:[3]

  • Since Dodd-Frank has passed, approximately 1,800 advisers to hedge funds and private equity funds have registered with the SEC for the first time;
  • Staff is currently conducting “focused, risk-based” exams on this pool of new registrants;
  • So far, some of the problem areas that have arisen are as follows: “misallocating fees and expenses; charging improper fees to portfolio companies or the funds they manage; disclosing fee monitoring inadequately; and using bogus service providers to charge false fees in order to kick back part of the fee to the adviser.”

Focusing on Complex Businesses and Complex Investment Strategies

While the SEC has not publicly defined how it is using its “risk-based exams” it appears it is using complexity as a key determinant of risk.  The result is that the SEC is focusing on funds that have complex businesses and complex investment strategies.[4]

The Complexity of Regulating Complex Investments

How complex is this task?  One indicator is the amount of staff required to carry out the examinations.  As part of the fiscal 2015 budget request, the SEC is looking for funding to add 316 examination staff to its Office of Compliance Inspections and Examinations.[5] This would increase the current 450 examination staff by over 70 percent.[6]

To put the size and scope of their mandate in perspective, the SEC has so far only examined about nine percent of RIA firms.[7] Their goal is to have examined 25 percent of these newly registered advisers by the end of 2014.[8]

As the evolutionary speed of investments continues to increase and change the landscape, the SEC will have to match it with the speed of change in its organizational structure.  This will require great flexibility, creativity, and managerial savvy.


The Accelerant roster of securities experts with complex investment backgrounds includes:  Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

To see all of Accelerant's complex securities experts, visit our website here.

[1]                 Reuters. “Exclusive: SEC forms squad to examine private funds – sources”; Available at June 4, 2014.

[2]        “SEC Adopts Dodd-Frank Act Amendments to Investment Advisers Act”; Available at ; Accessed June 4, 2014.

[3]        “Testimony on ‘Oversight of the SEC’s Agenda, Operations and FY 2015 Budget Request’”; Available at - .U34-vlhdWht; Accessed June 4, 2014.

[4]                 PE HUB. “Some PE firms chosen for early SEC exams based on risk: Buyouts;” Available at; Accessed June 4, 2014.

[5]                 See Supra note 1.

[6]                 Id.

[7]                 Id.

[8]                 Id.

Get Updates on Complex Investments
Read More

Topics: SEC, Complex Investments, hedge funds, private equity

The Bubble in Yield Plays Continues to Grow

Posted by Jack Duval

Oct 29, 2012 3:33:29 AM

Nathaniel Popper, reporting in the New York Times, has a good piece on how individual investors are plowing into junk bonds just as they are getting more risky.  (NYT)  This continues the trend of yield chasing we have documented with our coverage of Energy plays in Master Limited Partnerships here.

The scenario is simple, the Fed has cut interest rates to near zero and intends to keep them there for the foreseeable future, while at the same time the baby boom generation is retiring at an accelerating pace.  These retirees need income but don't want the risk of equities.  Unfortunately, they are running right into the teeth of the bubble forming in risky income plays.  Like all bubbles, it will end badly.

Here are some highlights from the article:

  • Junk bond issuance has reached record levels this year

  • The average credit rating of companies issuing junk bonds has declined

  • The proceeds of many of these offerings are not going to operations, but to cash out private equity funds

  • Retail investors added $2.1 billion in the first three weeks of October, while institutional investors sold $256 million over the same time period

  • Retail investors added $22 billion to junk bond funds this year compared to $8.3 billion in all of 2011

  • LBOs are back in vogue

  • More and more junk bonds are issued that allow the borrowers to skip interest payments

For those of you who have been around for a while, this all sounds like the years leading up to the collapse of the junk bond market in the early 1990's.  (PIK bonds anyone?)

Key takeaways for investors and industry participants:

  • Investors should beware of the increasing risk in these yield plays, both from an investment cycle and individual investment perspective;

  • Compliance/supervisory officers should beware of seemingly high allocations to fixed income that are actually invested in speculative or aggressive high yield bonds or other risky income investments; and make sure the accounts are coded for such investments and that the advisor and investor are both fully aware of the risks

Read More

Topics: chasing yield, Master Limited Partnerships, junk bonds, MLP, investments, LBO, Nathaniel Popper, risk, Compliance, private equity, NYT

SEC Using Data Analysis to go After Fund Fraud

Posted by Jack Duval

Dec 27, 2011 5:20:23 AM

The WSJ reports the SEC is using data analysis of fund returns to pick out outliers for investigation.  Four fraud claims have been brought so far.  Initial reviews are of hedge funds, private equity funds, and mutual funds.

Read More

Topics: Data Analysis, litigation, returns, mutual fund, SEC, private equity, hedge fund

Subscribe to Email Updates

Recent Posts

Posts by Topic

see all