According to a story in Bloomberg, the Securities and Exchange Commission has examined about 400 private equity firms and found that more than half have charged “unjustified fees and expenses without notifying investors”. The editor decided to change the headline from “unjustified” to “bogus”.
Fees and expenses charged by a fund manager to investors in the fund is always a conflict. The manager is taking cash from the limited partners.
The first question is whether the fees and expenses are adequately disclosed in the private placement memorandum or the partnership agreement. Most funds give the manager broad discretion to charge expenses for managing the investments to the investors in the fund. I have a hard time believing that over 50% of fund managers are charging expenses that are not permitted by the fund documents.
The story used “unjustified” when disclosing what the “person with knowledge of the SEC’s findings” stated about the fees. That may be more about the SEC not being happy with the fees charged, not necessarily that the fund manager is not legally entitled to the fees.
The second issue to think about with fees is whether the fees distort behavior. Certainly, a fund manager could be tempted to operate its private equity investments in a way that maximizes its fee revenue. That may cause the manager to make decisions that are in its best interest and not necessarily in the best interest of the fund investors. If a fund manager earns a fee for raising additional debt for a portfolio company, but not for raising additional equity. You might think the fund manager would be inclined to more often raise debt instead of equity.
To counter that inclination, private fund mangers earn the best returns by deliver great returns to their investors. Most managers earn a carry, taking an extra piece of the profit for good returns to investors. Taking a fee in the short term would hurt the long term, bigger return.
Compliance has a role to monitor fees to make sure they comply with the disclosures and legal agreements. It also has a role to monitor whether the nature of the additional fees distorts behavior in a way that could be perceived as adverse to investors.
The story mentions three types of bogus fees:
- miscalculating fees,
- improperly collecting money from companies in their portfolio and
- using the fund’s assets to cover their own expenses
One is failing to comply with the documents. Two is a potential disclosure failure. Although, the SEC may be expecting more specific disclosure than exists in the fund documents. Three may be a difference of opinion by the SEC over what should be a fund expense and what should be a management company expense.
As for expenses, the story mentions the Clean Energy Capital case where the SEC has accused the fund manager of grossly over-allocating expenses to the fund instead of the management company.
References:
Doug –
I am a corporate and securities lawyer and have interests similar to yours – I’m always coming across something in the press or from the SEC or other regulatory agencies that affects what I do for a living. I want to share those bits of information and also organize them for myself. Rather than compliance or real estate, my focus would be on business and legal solutions for operating companies with between $2 mm and $50mm in annual revenues. I don’t think they are well served by service providers right now. But, I also have a couple of private funds and their registered advisers as clients and I am interested that in several of your blog posts you say that “theoretically, a problem can be solved through disclosure.” How do you think about this issue of “unjustified fees”? Is there a fiduciary duty to charge reasonable fees? Or is there no fiduciary duty, but a duty not to mislead in offering documents. If there were a fiduciary duty to charge reasonable fees, could it be waived through consent? Thanks and glad to know there is someone else out there with similar interests and inclinations. Carol Mattick
I think you are mixing up a few terms. Fund managers and registered advisers do have a fiduciary duty to their clients. “Reasonable” is merely an arguable position. “Unjustified” is a bit different than reasonable, implying that it is not earned or warranted. A fee could be reasonable, but not justified and vice versa.
At some point a fee becomes unreasonable and a violation of the fiduciary duty. I’m not sure what that level is. I don;t recall many claims that a fund manager or investment adviser was charging unreasonable fee.
A fee needs to be disclosed and agreed to if paid by the client. If the fee is so high that it’s unreasonable, I don’t think that could be waived by consent. A fee is justified if it is agreed to by the client/investor.
Some of the fees earned by fund managers and investment advisers are not paid by the client by a third party or portfolio company. That gets a bit trickier about the level of disclosure needed. Those fees may be both reasonable and justified.
Certainly if the fees are disclosed, there is much less of an argument that the fee is “unjustified.”