A few days ago, Bloomberg published a story that the Securities and Exchange Commission has examined about 400 private equity firms and found that more than half charged “unjustified fees and expenses without notifying investors”. The SEC followed through with that story and recently charged Total Wealth Management with improperly disclosing fee revenue.
Total Wealth sponsored a series of private funds that invested in other funds. Total Wealth had revenue sharing arrangements in place with several of the funds in which it invested, paying Total Wealth a fee when it placed client investments in those funds. Total Wealth would split the revenue sharing income among the firm’s principals.
Revenue sharing is not illegal and not necessarily misleading, deceptive, or fraudulent. The key is disclosure. If properly disclosed, the SEC would have little basis for bringing charges.
According to the SEC order, the funds’ offering memoranda failed to adequately disclose the revenue sharing arrangement. One of document stated”
“Some Private Funds may pay the General Partner or its affiliates a referral fee or a portion of the management fee paid by the Private fund to its general partner or investment adviser, including a portion of any incentive allocation” (emphasis added).
The revenue sharing arrangement was not disclosed in the “other fees and expenses” summary portion of the offering document.
The SEC argues that Total Wealth should have disclosed that it was already receiving the fee income and not merely that it “may” receive the income.
Stopping at this point, the SEC charges leave me unsettled. The argument over the definitive nature of the fees seems to be over-reaching to me. I think many fund disclosures use “may” when describing other revenue sources.
The other aspect of fee arrangements is the distortion in behavior. Disclosure of the fees alone may be enough, but not if the fee distorts behavior so the fund manager might not be acting in the best interest of its investors.
Here is where the SEC’s case is stronger. About 92% of Total Wealth’s fund assets were invested in entities that had revenue sharing arrangements. Total Wealth’s behavior was apparently distorted because it was more likely to invest in funds with a revenue sharing arrangement. Some of these arrangements also had lock-ups that prevented investors from withdrawing money.
The SEC also accused Total Wealth of deliberately burying the revenue sharing arrangement. The revenue was shared through two entities and labeled the fees as consulting fees, even though the entities did not do any consulting work. Total Wealth fired an experienced compliance consultant who drafted a Form ADV Part 2 that very clearly disclosed the revenue sharing arrangement. The next consultant was much less experienced and used the “may” language instead. The SEC also accused Total Wealth of hiring an inexperienced accountant who inadequately investigated the revenue sharing.
Total Wealth has not agreed to the charges, so we only have the government’s side of the story. The SEC also threw in charges of failing to comply with the Custody Rule and Total Wealth’s failure to meet its own diligence standard.
I’m troubled by the SEC’s position in this case over the use of “may.” (Of course, there are other issues in the case.) If this truly is the SEC’s position, then I understand why the SEC thinks 50% of private fund managers have problematic fees. And if it this truly is the SEC’s position then there will be lots of fund managers going back through and revising their documents.
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