As a catalyst for job creation among small and medium-sized enterprises, private equity is vital to the middle-market companies that make up the backbone of our nation’s economy. Since the economic downturn, the amount of capital invested by U.S. private equity investors has steadily increased, growing at a compound annual growth rate of over
25 percent since 2009 and reaching $424 billion so far in 2014.
1 Healthy growth — thanks to low-interest rates, strong stock prices and successful fundraising — will likely continue for the foreseeable future.
Meanwhile, private equity firms are sitting on a record level of dry powder, which as of Q3 2014 stood at
$1.19 trillion.
2 Pre-money valuations also reached a record high of $46.7 million so far in 2014, 3 and the median valuation-to-EBITDA multiple came in at 9.7x through Q3.
4 These factors indicate that high-potential companies are still in short supply, with many firms sitting on the sidelines until more attractive targets come into play.
However, the coming year will not be without its challenges. According to DealBook , heavy-weight institutional investors, such as pension funds, are flush with cash, giving them greater leverage than ever to negotiate terms and fees — or jump to new general partners entirely.
5 This is putting even more pressure on all but the largest funds. What’s more, 2015 brings with it a torrent of new regulations that will only increase the cost of doing business. Although private equity advisers were first pulled into the harsh glare of regulatory scrutiny by the passage of the Dodd-
Frank Wall Street Reform and Consumer Protection
Act, now SEC staff are officially up to speed — and that scrutiny is switching gears into enforcement. The agency is suddenly asking all the right questions, and many private equity firms don’t have the right internal structure or expertise in place to answer.
1 PitchBook, accessed Dec. 19, 2014.
2 Prequin Quarterly Private Equity Update, Q3 2014. See https://www.preqin.com/docs/quarterly/pe/Preqin-Quarterly-Private-Equity-Update-Q3-2014.pdf for more details.
3 PitchBook, accessed Dec. 19, 2014.
4 “4Q 2014: U.S. PE Breakdown,” PitchBook, Oct. 8, 2014.
5 Alden, William. “Private Equity Change Favors Strongest Firms,” The New York Times , Dec. 10, 2014.

2015 private equity update: Strong performance, increased risk
With regulators making it clear that fines and enforcement actions are just around the corner, many large and small private equity firms have worked to improve compliance systems. However, while firm leaders may have hired experts to draft policies, the new policies and procedures have not yet taken root in the firmwide company culture, resulting in a lack of follow-through and ground-level compliance actions.
To attain the level of sophistication that’s expected of them in the coming year, private equity firms — large and small — must initiate a top-down cultural shift that is more conducive to effective risk management.
If they don’t and investors perceive they’re not following the right guidance and rules, raising another fund could prove impossible.
Heightened regulations take shape
Over the past four years, SEC staff hired a team of private equity experts to conduct hundreds of evaluations, with the goal of gaining more visibility into private equity administration. In 2012, the
Office of Compliance Inspections and Examinations
(OCIE) launched its National Exam Program, which consisted of “risk-based examinations of investment advisers to private funds that recently registered with the commission.
6 ”
This past May, after completing 250 presence exams of newly registered investment advisers, OCIE leadership announced the creation of a special unit composed of industry experts, who will focus on actively examining private equity fund advisers.
7
Presenting to a Private Equity International conference in New York, OCIE Director Andrew
Bowden stunned the crowd when he said that roughly half of all examined private equity advisers were guilty of one or more serious infractions. Bowden identified three key areas where private equity advisers are consistently falling short:
• Inappropriate fees and expenses. Common issues involve lack of disclosure, such as misallocation of transaction-related fees and expenses to the funds or between funds, or paying outside consultants through a portfolio company or fund.
• Hidden adviser fees. For example, companies may be charging undisclosed administrative fees or extending the term of monitoring fees beyond when the fund is likely to divest the company, all unbeknownst to investors.
• Improper marketing and valuation.
Some companies use a different valuation methodology than what was disclosed to investors or use projections in performance data where actual valuations should be used instead.
8
6 See http://www.sec.gov/about/offices/ocie/letter-presence-exams.pdf for more details.
7 See http://www.natlawreview.com/article/sec-securities-and-exchange-commission-establishes-dedicated-group-to-focus-private- for more details.
8 For more detail on the types of problems the OCIE identified in private equity funds, see http://www.sec.gov/News/Speech/Detail/Speech/1370541735361#.
VJSVu_8WA to read a transcript of Andrew Bowden’s speech.
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2015 private equity update: Strong performance, increased risk
The winners in 2014
Despite the challenges posed by the industry’s changing compliance protocol requirements, current returns appear to have been unaffected thus far. Indeed, 2014 was another banner year for the industry, defined by an active seller market driven by high valuations. The year’s performance was led by 26 companies valued at $1 billion or more, including the
IPOs of Uber ($39.8 billion), Airbnb ($10.3 billion) and Dropbox ($10.0 billion).
9
Overall, the industry segments experiencing strong growth also achieved particularly high valuations, including energy (median of $60.4 million), IT
(median of $52.8 million) and health care (median of $51.3 million).
10 This year’s notable overachiever was the financial services industry, which notched a median valuation of $215.6 million on 107 deals, blowing away the annual average of $28.9 million achieved on an average of 97 deals over the previous
10 years. This outlier performance is partly due to
Lending Club and Pershing Square Foundation, both of which were valued at more than $3.5 billion each.
Several factors contributed to the high median of valuations, including the strength of the stock market and continued relative scarcity of attractive targets.
Investors were pleased to observe an overall increase in the quality of available companies, a high level of equity, and a desire by banks to grow their lending portfolios, particularly at the mezzanine level. Indeed, this high valuation trend suggests that funds are placing at least 40 percent equity in these deals.
In terms of returns, venture capital led the pack with an average internal rate of return of 16.5 percent, followed by co-investment (15.8 percent) and secondaries (15.5 percent).
11
Looking forward — are you ready?
Though private equity advisers have proven less effective in providing capital to the larger or mega markets in recent years, private equity funds are and will remain an important source of capital in the middle market. Because of this, some larger funds are reinventing themselves in smaller forms, so that they can better focus on segments where more private equity is required and exit opportunities are more diverse.
Contact
Michael Patanella
Audit Partner
National Asset Management
Sector Leader
T +1 212 624 5258
E michael.patanella@us.gt.com
Jack Katz
National Managing Partner
Global Leader,
Financial Services
T +1 212 542 9660
E jack.katz@us.gt.com
To continue their pace of growth and profitability, private equity firms of all sizes must address compliance challenges. The SEC staff has indicated that, “given the high rate of deficiencies observed” in regard to fees and expenses, private equity firms shoul d continue to expect examinations in this area in 2015.
12 Firms should take action immediately, beginning with forming an evolved mindset. In particular, advisers who have not already integrated compliance into the fabric of their operations must move quickly, especially if they intend to compete for cash-rich heavy-weight investors facing more choice than ever in private equity firms. A good first step would be to perform a risk audit — which might include a mock compliance audit — to identify compliance gaps in the context of the firm’s culture.
The authors would like to acknowledge the contributions of Grant Rapaport to the research conducted for this report.
Because subjectivity and resource constraints can be major obstacles to handling this review internally, many private equity firms will require outside assistance. In addition to an objective, independent voice, outside advisers can offer extensive industry experience, including a thorough understanding of technical requirements, interpretations of the law and examiner’s key focus areas, to help private equity advisers make sense of regulatory filings. They can also help with structuring, legal and tax issues associated with co-investment opportunities. On both the sell and buy sides, an independent adviser involved in advance can prepare due diligence packages that verify records and performance data are collated, clean and substantiated, providing peace of mind throughout the process.
9 PitchBook, accessed Dec. 19, 2014.
10 PitchBook, accessed Dec. 19, 2014.
11 PitchBook, accessed Nov. 24, 2014.
12 Office of Compliance Inspections and Examinations, National Exam Program Examination Priorities for 2015. More information is available at www.sec.gov/about/offices/ocie/national-examination-program-priorities-2015.pdf
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Content in this publication is not intended to answer specific questions or suggest suitability of action in a particular case. For additional information about the issues discussed, consult a Grant Thornton LLP client service partner or another qualified professional.
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