SEC Charges Private Funds for Overcharging Fees and Failing to Disclose Fee Calculation Conflict
The Securities and Exchange Commission (“SEC”) is scrutinizing management fees for private funds, and a recent enforcement action provides more insight into SEC expectations for fund managers to consider.
The SEC announced a settled enforcement action (the “Order”) with Insight Venture Management LLC (“Insight”) and its underlying Funds (collectively, the “Funds”) on June 20, 2023.
In the Order, the SEC found that:
- Insight and its Funds charged excess management fees related to permanently impaired investments at the portfolio company level (instead of at the actual investment level) in contravention of relevant fund documents; and
- Failed to disclose certain conflicts of interest in connection with determining permanent impairments using subjective and “difficult to satisfy” criteria.
The Funds’ limited partnership agreements (“LPAs”) state that management fees charged after the commitment period or investment period as defined in the LPA shall be calculated based on an investor’s acquisition cost basis (i.e., amount of capital invested). This cost basis would be adjusted (i.e., reduced) for investments that are permanently impaired, and the management fee would apply to the adjusted cost basis. However, the LPAs did not detail the criteria that Insight used to evaluate investments for permanent impairment.
Permanent Impairment Definition and Application
The crux of the Order hinges on the LPAs’ requirement that the impairment analysis shall apply to each individual investment in the fund’s portfolio. However, the SEC found that Insight applied the impairment analysis at the portfolio company level, rather than the portfolio investment level, which resulted in Insight charging management fees it was not entitled to.
Insight had a four-factor test to determine permanent impairments, which they failed to properly apply when determining management fees. Notwithstanding this test, the LPAs granted Insight discretion to reverse permanent impairments. The Order found that Insight had failed to adequately disclose to limited partners the existence of conflicts of interest in connection with determining whether a permanent impairment had occurred. The SEC Order noted that Insight applied narrow, subjective and “difficult to satisfy” permanent impairment criteria. In connection with its findings, the SEC also concluded that Insight failed to exercise due diligence related to its procedures on permanent impairment criteria and impact on management fees and related conflicts of interest.
Examination and Impact
The Order noted that during the examination, Insight adopted and disclosed new and more “objective” impairment criteria and also waived its ability to reverse permanent impairments. Insight reimbursed limited partners $3.8 million, as calculated by applying its more objective criteria to management fees associated with four portfolio companies, plus interest penalties. Subsequently, during the investigation, Insight applied its prior (and less objective, in the eyes of the SEC) policy at the investment level across all funds and reimbursed an additional $865,000 in management fees and interest.
The SEC found Insight in violation of Sections 206(2) and 206(4) and Rules 206(4)-7 and 206(4)-8 of the Investment Advisers Act and ordered disgorgement of approximately $865,000 that was previously reimbursed and thus deemed satisfied. Insight was also ordered to pay a civil monetary penalty of $1.5 million.
- The SEC continues to be extremely focused on management fee calculations.
- Areas with greater potential for conflicts of interest and fee calculations will continue to be a focal point for examiners and enforcement staff.
- Advisers should evaluate the following:
- Review and consider if the criteria used to determine whether an impairment or other change in the value of investments, particularly where affecting fees paid by investors, could be enhanced to be more objective.
- Evaluate their existing disclosures, offering documents and other reporting to confirm that criteria are consistently and accurately applied.
- Determine how and at which level they are required to assess impairments related to investments.
- Verify that their policies, procedures and practices are designed to address these conflicts in a tailored and objective manner.
- Investors should make sure to have a proper understanding of the provisions about the calculation of the management fees per LPAs and request clarity when ambiguity exists
- Auditors should evaluate the following:
- Read the LPAs carefully to understand how fees are calculated and may be manipulated.
- Reassess the risk of revenue recognition fraud and apply appropriate procedures to the audit.
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