Private Equity Expense Allocations
Since the “Spreading Sunshine in Private Equity Speech” delivered on May 6, 2014 by Andrew Bowden, Director, Office of Compliance Inspections and Examinations, the SEC has shined a bright spotlight on how private equity fund managers are treating direct and allocated expenses to the funds they manage. It’s no longer a matter of ensuring the appropriate language is included in the governing documents allowing the general partner to charge its respective fund expenses either directly or indirectly related to the investment activity. Financial statement disclosures of how and which expenses were charged and allocated to the fund and the internal documentation of the thought process as a fiduciary to the fund are also expected.
OVERVIEW: HOW PRIVATE EQUITY FIRMS ALLOCATE EXPENSES TO FUNDS THEY MANAGE
Private equity funds invest directly or via another entity (e.g., blocker corporation) in a portfolio company. As is typical with such investments, private equity firms will secure board seats to help guide the portfolio company to unlock value and hopefully sell at a later date for a profit to a strategic investor or via an initial public offering. The appointed board directors may receive director fees for their service and may appoint affiliated consultants to help unleash the portfolio company’s untapped value and receive consulting fees. In addition, it is customary to receive transaction fees and ongoing monitoring fees from the portfolio company.
More recent fund vintages have management fee offset provisions within the governing documents that would essentially reduce the management fees charged at the fund level. The fees that the portfolio companies pay bypass the fund and go directly to the investment adviser or its personnel. For example, if the management fee offset provision stipulates that any fees received from a portfolio company are a 100% offset to management fees charged at the fund level, the management fees would then be reduced by those received fees. If the LPs owe the investment manager $2,000,000 in management fees and transaction fees received by the investment manager amounted to $1,000,000, the LPs of the fund will only be charged a management fee of $1,000,000 at the fund level.
In addition, certain fees that the management companies incur related to running the business are often allocated to the funds the investment adviser manages. As such, the investment adviser will allocate these expenses to the respective funds. The SEC has focused on how these expenses are allocated and will review the allocation methodology and determine if this is in accordance with the LP agreement and other offering documents. In addition, the SEC will focus on the nature of the expenditure. For example, if legal fees are incurred for services rendered to a specific fund, that specific fund should be charged the legal expense and not allocated to the fund group or multiple funds.
SEC FINES INVESTMENT ADVISER POTOMAC ASSET MANAGEMENT FOR ALLEGEDLY IMPROPERLY ALLOCATING EXPENSES
On September 11, 2017, the SEC issued an order instituting administrative cease-and-desist proceedings (the “Order”) against Potomac Asset Management Company, Inc. (the “Adviser”) and Goodloe E. Byron, Jr., the Adviser’s principal.1
The Adviser served as an investment adviser to two private equity funds, hereby designated as “Fund I,” “Fund II,” and, collectively, the “Funds.” As set out in the Order, the SEC found that the Adviser violated the Investment Advisers Act of 1940, as amended (the “Advisers Act”). The violations included improperly charging $2.2 million of expenses of a portfolio company to Fund I; failing to offset fees received from a portfolio company against management fees, as required by the limited partnership agreement; and improperly using the Funds’ assets to pay the Adviser’s expenses, including compensating a member of the investment team and paying rent and other expenses.
The Order generally follows a string of similar orders issued by the SEC against private equity fund managers.2 In one case, an adviser was improperly allocating costs, either by charging costs that it did not disclose or charging expenses in a manner that was inconsistent with its disclosure that should have been borne by the adviser instead of the fund. However, this Order presents somewhat of a unique twist, in that the SEC also stated that since the Funds’ audited financials did not adequately disclose the Funds’ fees, and the Funds’ financials were not prepared in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”).3 The SEC also found that since the Funds’ audited financials were not prepared in accordance with GAAP, the Adviser violated Rule 206(4)-2 under the Advisers Act (the “Custody Rule”).
The Custody Rule regulates the custody practices of advisers registered under the Advisers Act. Generally, general partners of limited partnerships (or managing members of a limited liability companies) are deemed to have custody of client assets. The rule requires advisers that have custody of client securities or funds to implement a set of controls designed to protect those client assets from being lost, misused, misappropriated, or subject to the advisers' financial reverses. The Custody Rule provides that a private fund manager can demonstrate compliance if it distributes, at least annually, the fund’s “audited financial statements prepared in accordance with [GAAP] to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year” [emphasis added].
HOW PRIVATE EQUITY MANAGERS CAN IMPLEMENT BEST PRACTICES
Due to the recent press and SEC orders, private equity managers should revisit their existing best practices methodologies and compliance manuals. Here are some suggestions that private equity firms should consider when revisiting or enhancing their best practices methodologies and compliance manuals.
Suggested action items for an investment manager:
- Conduct a Mock Audit – Outsourced compliance service providers and consultants can emulate an SEC mock audit and provide suggested areas of improvement. A mock audit will aid in the shift of the compliance mind set of an investment advisory firm and view compliance as a value add and incorporate it into the firm’s culture.
- Pursuant to an adviser’s fiduciary duty, document the allocation methodology to provide a defensible rationale for the allocation process.
- Ensure its compliance program is consistent with and tailored to the adviser’s business–avoid boilerplate compliance manuals.
- Ensure that expense allocation methodologies are in accordance with governance documents.
- Ensure financial statement disclosures, communications with limited partners, and required regulatory disclosures are consistent with business practice and governing documents.
- For earlier vintage funds that do not specifically address management fee offsets, consider following a methodology that is expected from a fiduciary.
1. See In the Matter of Potomac Asset Management Company, Inc. and Goodloe E. Byron, Jr. (IA Release No. 4766/September 11, 2017)
2. See In the Matter of Kohlberg Kravis Roberts & Co. L.P., (IA Release No. 4131/June 29, 2015)(broken deal expenses); In the Matter of Blackstone Management Partners L.L.C., Blackstone Management Partners III L.L.C., and Blackstone Management Partners IV L.L.C., (IA Release No. 4219/October 7, 2015)(accelerated monitoring fees and discounts on legal fees); In the Matter of Fenway Partners, LLC, Peter Lamm, William Gregory Smart, Timothy Mayhew, Jr., and Walter Wiacek, CPA (Release No. 4253/ November 2015)(undisclosed payment by portfolio companies of consulting fees to an affiliate of the adviser).
3. In the Matter of Alpha Titans, LLC, Timothy P. McCormack, and Kelly D Kaeser, Esq. (IA Release 4073/April 29, 2015) the SEC also found that the fund’s audited financials were not in accordance with GAAP.
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