Buyout firms have been forced to erase billions of dollars from the value of their wagers in the economic downturn, and financial regulators are now scrutinizing whether managers are reducing fees for investors when those deals sour.

The Securities and Exchange Commission has been ramping up inquiries to private equity firms about whether they adjust customer fees when bets get written off to zero or below their original price tags, people with knowledge of the matter said.

While these questions have come up sporadically in recent years, regulators are now asking private equity firms about the issue regularly in routine exams and seeking a level of detail that they didn’t before, the people said. The goal is to make sure that private equity firms, which take a cut of the money they manage, aren’t overcharging state pensions, university endowments and other investors.

SEC officials are ramping up those inquiries to root out what they consider a chronic practice of firms charging more than contractually allowed, and because regulators recognize that firms face pressures to juice fees in the market downturn.

Those inquiries are coming from both examiners at the SEC’s private funds unit as well as regional-office staff, one of the people said. The SEC has at times drilled down into whether firms have delayed write-offs to squeeze out more fees from investors, and asked for internal emails to help it make such determinations, the people said.

The SEC, under Chair Gary Gensler, is making a more aggressive push to police private equity firms. The industry has grown rapidly over the past decade to become a bigger part of both the finance industry and the U.S. economy, but has so far avoided the same level of regulatory oversight that banks and mutual funds are subject to.

A spokesperson for the SEC declined to comment. It couldn’t be determined which firms have received such inquiries. The SEC conducts exams to check practices and questions don’t necessarily suggest suspicion of wrongdoing. SEC examiners aren’t in the regulator’s enforcement division, but can refer their findings to that unit for a formal investigation.

Complex Arrangements

Private equity firms tend to have complex fee arrangements, with most funds shifting from charging fees on money pledged by investors to taking a cut of invested funds after a few years. When that happens, fund managers typically can’t charge fees on investments written off to zero or deemed permanently impaired. Write-offs suggest that lost value can’t be recovered and would trigger fee reductions. In contrast, writedowns can be temporary. Only in rare cases do funds promise to reduce fees following writedowns.

“The SEC staff is very focused on the calculation of management fees and we are seeing increased scrutiny of those calculations in recent exams,” said Nabil Sabki, a partner in Kirkland & Ellis LLP’s investment-fund regulatory group. When it comes to writedowns, write-offs or permanent impairments of investments, “they are pressure-testing exactly when such events take place, and whether the manager has adjusted the management-fee base appropriately.”

Market declines and post-pandemic shifts in how people live and work are hurting valuations of once-high-flying technology darlings, forcing private equity firms to re-examine their valuations for startups and unlisted companies. Stock-market volatility and rising borrowing costs are slowing the once-frenetic pace of dealmaking, making it harder for buyout firms to sell companies at big profits.

Strong Incentives

Among the firms that have cut valuations is WestCap Management, which wrote down the combined value of its main investment funds by almost a fifth in the second quarter. Blackstone Inc., the world’s largest alternative-asset manager, took writedowns on some holdings that contributed to a net loss of $29.4 million in the same quarter.

The Federal Reserve’s efforts to tamp down inflation by raising interest rates are likely to cause more market turmoil — and more valuation cuts — across the industry.

There are strong incentives, however, to delay writedowns. Red marks hurt returns and dent investor trust, making it harder for firms to raise money — something already becoming more difficult as pensions and endowments grow cautious with markets in flux.

“If private equity fundraising continues to struggle, managers will feel pressure to not write off investments because doing so would impair management fees,” said Igor Rozenblit, a former SEC official and managing partner at Iron Road Partners, which advises private equity firms on regulatory risks. That dynamic is already on the radar of investors and regulators, and driving some of the uptick in examinations focused on write-offs and management fees, he added.

This month, the SEC rebuked Energy Innovation Capital for failing to account for writedowns and overcharging investors. The firm didn’t reduce management fees when some investments were written down, even though investor documents required it to, according to an SEC order.

The venture firm settled with the SEC and agreed to pay penalties without admitting or denying any wrongdoing. It didn’t respond to messages and phone calls seeking comment.