Don’t Get Charged with Misallocating Fees and Expenses

“Full transparency of fees and conflicts of interest is critical in the private equity industry and we will continue taking action against advisers that do not adequately disclose their fees and expenses.”

—Andrew J. Ceresney, Director of the SEC’s Division of Enforcement

Over the past several years, the Securities and Exchange Commission (“SEC”) has been increasingly focused on the fee and expense practices of private equity firms. In 2016, the SEC will continue its focus on whether fee arrangements are in the best interest of the investors and if adequate disclosures have been made to investors about the fees and expenses charged to the funds.

It is critical for Investment Advisers to remember that they have a fiduciary duty to the funds and their investors to adequately disclose fees and expenses. Breaching this fiduciary duty can result in harsh penalties, including fines and even suspensions from working in the financial services industry.

Noteworthy Enforcement Actions in 2015:

  • Fenway Partners, a New York-based middle market private equity firm, and four of its executives were charged for failing to disclose to their fund client that they rerouted portfolio company fees to an affiliate, and avoided providing the benefits of those fees to the fund client in the form of management fee offsets. Fenway settled for a total of $10,241,471.10.
  • Alpha Titans LLC, a Santa Barbara-based hedge fund, was charged for using the assets of two affiliated private funds to pay more than $450,000 in office rent, employee salaries and benefits, and similar expenses without clear authorization from fund clients and without accurate and complete disclosures that fund assets were being used for these purposes. To settle the SEC charges, Alpha Titan paid nearly $700,000; two executives were barred from the securities industry for one year; and the fund’s attorney and accountant were suspended from practicing their trade on behalf of any entity regulated by the SEC.
  • The SEC charged Kohlberg Kravis Roberts & Co. (“KKR”) with misallocating more than $17 million in “broken deal” expenses to its flagship private equity funds in breach of its fiduciary duty. KKR agreed to pay nearly $30 million to settle the charges, including a $10 million penalty.

ICSGroup has experienced first-hand what the SEC examiners are looking for with respect to disclosure and proper allocation of fees and expenses. The following issues were identified in recent SEC examinations of several of our private equity clients:

  • Definition of Offering Costs

A review of an advisor’s financial records indicated that expenses such as mailing costs and consultant fees were charged to the funds as offering costs; however, these costs did not meet the definition of “offering costs of limited partnerships” as set forth in FASB ASC 946-20-25. The examiners determined that these costs should have been accounted for as fund expenses against operations; therefore, concluding that the Funds’ audited financial statements were not in compliance with GAAP. Although the overall outcome was a wash for the LP, this issue is indicative of the SEC’s expectation of compliance with even seemingly minor generally accepted accounting principles.

  • Management Fee Discounts and Fee Caps

The examiners reviewed side letter agreements and management fee allocations for consistency. In one instance, the examiners determined that investors had been overcharged management fees because amounts over the agreed upon cap for one investor had been allocated to the other investors when they should have been borne by the LP’s GP. Be mindful that in agreeing to waive or cap fees for certain investors, the total management fee calculated based on a percentage of the assets should not be allocated among the remaining investors.

  • Fair Valuation

The examiners found that a manager’s valuation policy appeared to be inconsistent with the FASB ASC Topic 820 definition of fair market value. The SEC recommended that the advisor consider market factors influencing the value of the debt including, but not limited to: leverage; equity cushion, industry-related factors, comparable bonds, recent deals, yields on comparable securities, and recent performance of the underlying firm. The examiners went on to state that the advisor should assess and quantify the impact that any inaccurate valuations had on asset based fees that were charged to the Funds, and reimburse the Funds accordingly.

Advisers should ensure that:

  • Audited financial statements are consistent with GAAP;
  • Management fees have been allocated appropriately among the fund’s LPs;
  • Portfolio company valuations accurately determine fair market value so as not to result in inaccurate management fees (not to mention inaccurate fund performance);
  • Initial and ongoing fee and expense disclosures in Form ADV, LPAs and other disclosure documents are clear, specific and complete;
  • Fee and expense practices are consistent with prior disclosures or investor consent is obtained;
  • Overhead expenses (employee salaries; executive bonuses; health benefits; retirement benefits; and rent) are charged to the management company and not the funds; and
  • The most common misallocation pitfalls (“broken deal” fees, consultant and advisor fees and legal expenses) are avoided.

Additionally, investment advisers should always disclose:

  • Fees and expenses the client will be subject to and whether they are negotiable;
  • If the adviser is being compensated from other sources;
  • The availability of fee discounts;
  • Monitoring fees;
  • “Administrative” fees; and
  • Hidden fees in the form of undisclosed service charges, wrap fees or expenses reimbursed by other parties.

Fund managers are urged to review their financial records in conjunction with their governing documents to identify instances of fees and/or expenses charged to the funds when not expressly disclosed. Fees and expenses charged to the funds must be clearly disclosed in the PPM and governing documents.

ICSGroup can help ensure that your firm’s fee and expense practices as set forth in your Valuation and Fee and Expense policies and procedures are consistent with the disclosures contained in the governing document, comply with FASB rules and meet fiduciary standards. If your firm does not have a Fee and Expense policy we can work with your COO to develop one that meets regulatory expectations. ICSGroup also partners with fund accountants to ensure that SEC rules and requirements are fully understood and taken into consideration in preparing the audited financial statements. Contact us for assistance. We are here to help.

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