The Securities and Exchange Commission has made it clear that one of its primary points of interest with private funds is fees and expenses. Some of that is well-deserved. Some private funds had a history of being opaque about fees and expenses.
A recent enforcement case by the Securities and Exchange Commission highlights mistakes that could easily be made by a fund manager if not paying attention to what the fund documents say. The case against Energy Innovation Capital Management, LLC is illustrative of items to pay attention to when checking management fee calculations.
The first thing to note is that Energy Innovation is a venture capital firm and is an exempt reporting adviser. Those types of firms are not subject to routine examination. I’m intrigued how the SEC came across the fee calculation problems at the firm.
As with most non-hedge private funds, the fund management fee calculation changes after the equity commitment period ends. During the commitment period, the fee is a percentage of committed capital while the fund deploys the capital. Once the commitment period ends, the fund is limited in its ability to make investments and the fee basis is reduced to an amount that generally equates to the amount of capital deployed.
In the Energy Innovation fund the commitment period ended in the first quarter of 2020. The firm changed the calculation as of the end of the quarter. That was inaccurate. The fee should have been pro-rated as of the actual date. Of course, by waiting until the end of the quarter the firm had a higher fee basis for a longer time.
The second problem was that the firm included accrued, but unpaid, interest attributed to certain individual portfolio company securities in the fee basis. Without the language of the fund agreement its hard to tell what went wrong. It may be that the fund documents did not specifically allow it to be included so the SEC took the position that it can’t be included.
The biggest problem is that the firm wrote down individual portfolio company securities and wrote off certain others for valuations, but did not incorporate any of these write-downs into its post-commitment period fee basis.
The final corollary issue was that the firm aggregated invested capital at the portfolio company level in fee basis, instead of at the individual portfolio company security level. The fund documents did not permit aggregation of invested capital at the portfolio company level. I assume this is tied to the treatment of write-downs.
The net result of these problems was that the firm earned $678,861 in excess management fees. Interestingly, the the order did not require repayment of those excess fees. The order notes that “the Commission considered remedial acts promptly undertaken.” I assume the firm had already repaid the excess fees during the examination.
This enforcement action is a warning to other firms that the SEC is laser focused on management fees.
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