Why the SEC is investigating private equity

FORTUNE — Reuters reported yesterday that the Securities and Exchange Commission has formed a “dedicated group to examine private equity and hedge funds.” Also yesterday, Bloomberg reported that the SEC completed a review that found “a majority of private equity firms inflate fees and expenses charged to companies in which they hold stakes.”

The two revelations are being closely watched by private equity firms, which always opposed the registration requirements in Dodd-Frank that opened the door for possible oversight (although, at the time, they simply balked at the extra costs). Particularly by private equity firms that may be secretly skimming money from their portfolio companies.

Here’s what I mean:

When private equity firms raise a fund, they sign “limited partnership agreements” (LPA) with each of their investors. In general, the LPA is designed to specify each side’s obligations. For example, Private Equity Fund A will receive a $50 million commitment from Limited Partner B, and in exchange will provide Limited Partner B with 80% of the fund’s investment profits (a.k.a. carried interest). There also will be clauses about how long the fund is allowed to invest, what types of investments it can make, who will make the investments and how much the LP is required to pay in regular management fees. LPAs differ from firm to firm, and almost always are highly-negotiated.

One big change to LPAs in recent years, however, has had to do with who is entitled to various fees charged to portfolio companies. Historically, a private equity fund could charge its portfolio company all sorts of fees — including “transaction fees” related to the original acquisition and “monitoring fees” related to active ownership — and effectively pocket the proceeds. Or, if not all of the proceeds, at least more than the 20% of so that firms are entitled to receive in carried interest. Today, however, most private equity LPAs include a 100% offset for such fees — a move that actually has resulted in fewer such fees being charged to portfolio companies in the first place.

What is important to realize, however, is that limited partners only are entitled to these offsets on fees that are specifically enumerated. But what if there are a dozen such enumerated fees in an LPA, and then the private equity firm conjures up a 13th type of fee to charge its portfolio company?

From my understanding, this may be what the SEC is referring to when it talks about inflated fees and expenses. After all, the SEC shouldn’t really care if a private equity firm is pillaging its portfolio company, so long as it is transparently and equitably sharing the booty with its investors. But if it’s pocketing monies in a manner that reduces the value of fund assets, then it’s a question of investor protection. And that very much is in the SEC’s jurisdiction.

Key here is that limited partners really have no idea if they are being ripped off or not. Today I spoke with several large ones who “trust” that their general partners are not charging that 13th fee (or 14th or 15th), but acknowledge that they have no real means of verification. Private equity firms typically do not provide portfolio company cash flow statements to their investors and, even if they did, such reports likely would include any such fees in a generic expense line. A limited partner theoretically could sue for more granular information, but to do so would be to effectively forgo the ability to invest in future funds. After all, what successful private equity firm wants to take on a litigious limited partner?

In a Bloomberg Television appearance earlier today, Private Equity Growth Capital Council president Steve Judge suggested that private equity firms would never skim fees from portfolio companies, because to do so would be to “alienate investors.” Well, not if the private equity firms don’t believe that investors have any way to find out. And, remember, most of these firms are receiving much less traditional fee income than they have in years past, due not only to revised sharing provisions but also smaller fund sizes. In other words, they have motive.

To be clear, the SEC has not provided any details on what it’s found, or even how it has obtained the information (the best bet is so-called “presence exams” for recently-registered investment advisors, which are said to be very broad in scope). And it’s possible that the Bloomberg report relates, at least in part, to more traditional fees from the pre-sharing era. But I’ve got reason to think that regulators have found some incidents of hidden fees and, if so, it could destroy all of that trust that private equity firms appear to have built with their limited partners.

Sign up for Dan’s daily email newsletter on deals and deal-makers: GetTermSheet.com

Subscribe to Well Adjusted, our newsletter full of simple strategies to work smarter and live better, from the Fortune Well team. Sign up today.