The Securities and Exchange Commission charged Kohlberg Kravis Roberts & Co. (KKR) with misallocating more than $17 million in “broken deal” expenses to its private equity funds as a breach of KKR’s fiduciary duty. The SEC felt that KKR should not have charged all of those broken deal expenses to the Fund.
But how should you allocate those broken deal expenses?
KKR incurred $338 million in broken deal or diligence expenses. Even though KKR’s co-investors, including KKR executives, participated in the firm’s successful transactions efforts, KKR largely did not allocate any portion of these broken deal expenses to them. KKR put a policy in place in 2012 to address the allocation of expenses.
Perhaps KKR had something programatic in place, with regular co-investments. The problem for most co-investment deals is that they are put together ad-hoc. The fund is generally the primary participant and would be pursing the transaction regardless of co-investors.
The fund would be incurring the deal expenses. The fund documents provide that the fund will pay for deal expenses.
Generally, for co-investments there is no document providing for the payment of deal expenses until the transaction closes. So there is no mechanism for the payment of broken deal expenses by potential co-investors. Fairly or unfairly, that leaves the fund paying the broken deal expenses. It seems that the SEC thinks that is unfair.
According to the SEC’s order against KKR, the firm had come up with a policy for dealing with broken deal expenses. In my reading of the order, it looks like the SEC made KKR apply the policy retroactively from 2012 to the beginning of the fund and return a portion of the broken deal expenses to the fund. I would guess that KKR is not able to get those expenses from the potential co-investors, leaving the management company holding the bag for the costs.
It does not seem fair that the management company should bear the burden of the broken deal expenses when the fund documents and investor expectations would be that the fund carry the burden of broken deal expenses.
The question is “at what point does the co-investment opportunity become such a part of the transaction that the broken deal expenses should be shared?” Of course, the second question, and perhaps the answer to the first is “at what point is the co-investor so committed that it is willing to pay a portion of the broken deal expenses?” I think the answer to the second question is often “never.” That puts the answer at odds with the expectations of the SEC.
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