Tag: Broken deal expenses

Improperly Allocating Broken Deal Expenses

The Securities and Exchange Commission has been looking at fees and expenses at private equity funds for several years. Two years ago it brought a case against Kohlberg Kravis Roberts & Co. for misallocating more than $17 million in “broken deal” expenses to its private equity funds. An SEC investigation found that from 2006 to 2011, 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.

The SEC just brought a similar case against Platinum Equity. According to the SEC’s order, from 2004 to 2015, Platinum’s funds invested in 85 companies, in which co-investors connected with Platinum also invested. Platinum incurred broken deal expenses that were paid by the funds. While the co-investors participated in Platinum’s successful transactions and benefited from Platinum’s sourcing of the transactions, Platinum did not allocate any of the broken deal expenses to the co-investors.

Platinum did not have a standing co-investment vehicle. Platinum used a separate investment vehicle to co-invest in each transaction. While there was some overlap in the co-investors from deal to deal (officers, directors, executives, and employees of Platinum), the co-Investors varied from transaction to transaction. The co-investment vehicles required payments of a pro-rata share of expenses related to the investment. There was no arrangement for Platinum to charge co-investors for broken deal expenses.

It’s tough to address the broken deal expenses for co-investments. There is no vehicle to create the contractual obligation for reimbursement. Of course, it is not right for the fund investors to bear all of the costs if the fund manager is having so many co-investments.

At least it’s not right if it’s not disclosed in the fund documents. That is what the SEC pointed out in the order. The allocation of the broken deal expenses to the fund was not disclosed in the fund documents. That could be fixed by stating that the fund pays for the broken deal expenses even when there are co-investors. Assuming you can get investors to agree to that.

This is also the first case I have noticed that the SEC has self-imposed the Kokesh limitation on disgorgement. The Kokesh case said the the SEC’s power of disgorgement was limited to going back five years. Even though Platinum was improperly allocating expenses back to 2004, the disgorgement only goes back five years to 2012.

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How to Allocate Broken Deal Expenses After the KKR Case?

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 sec

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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Allocation of Broken Deal Expenses

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. The SEC found this to be a breach of KKR’s fiduciary duty.

kkr sec

An SEC investigation found that from 2006 to 2011, 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. According to the SEC Order, there was a partial allocation to certain co-investors in 2011.

The main KKR fund invested $30.2 billion in successful transaction, while co-investors put in $3.9 billion and KKR executives put in $750 million.

In June 2011, KKR began examining its allocation strategy and recognized a problem. That resulted in that first allocation in 2011. In January 2012, KKR implemented its new allocation policy and began charging less in broken deal expenses to the fund and some to co-investors and executives.

Then in 2013 OCIE knocked on KKR’s door and conducted an exam. During the exam, KKR refunded $3.26 million to the fund for mis-allocation from 2009 to 2011.  The SEC wanted more and claimed that there was another $17.4 million in broken deal expenses that were improperly allocated to the fund based on the 2012 allocation policy.

The period in question goes back to 2006. That pre-dates KKR’s 2008 registration and most private equity fund’s Dodd-Frank registration in 2008. The SEC’s claim is under 206(4) of the Adviser Act which applies regardless of whether the fund manager is registered.

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