Tag: Co-investments

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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Co-investments and Conflicts

I have seen a few indications from the Securities and Exchange Commission showing that examiners are concerned about co-investments. I have yet to see a large over-arching activity in the industry that has been identified as problematic. I saw an action last week for a fund advisor related to co-investments so it caught my eye. Upon closer inspection, the issue was less one of co-investments and more one of an affiliate transaction.

New Silk Route Advisors is registered as an investment advisor. It manages two private equity funds that primarily invest in India. those funds invested in four companies along side another unnamed fund.

That unnamed fund was managed by a separate registered investment advisor. That advisor was run and co-founded by the same person who ran and co-founded New Silk Route Advisors.

The SEC claims that the fund documents for the New Silk Road funds treated that unnamed fund as an affiliate and therefore the co-investments were affiliate transactions. According to the fund documents, New Silk Road should have disclosed the co-investments to the fund boards of advisors and obtained approval.

The misstep resulted in a fine of $275,000.

The charge does cite any specific harm to investors in the New Silk Route funds. It does note that the unnamed fund ran out of capital and was not able to make a follow up investment in one company. New Silk Route stepped in and contributed the additional capital and took a bigger chunk of the company. At the time of the unnamed fund’s dilution, New Silk Route sought the board of advisors approval for the co-investments.

Adding in a related party does create many concerns, especially if the funds have different timelines and different investment styles. It was sloppy to not treat this an affiliate transaction and seek approval.

According to my tally, these are the cases that the SEC has publicized on co-investment problems:

  1. New Silk Road – failing to treat a co-investment with an affiliate as an affiliate transaction
  2. Co-investment allocation – No cases, but concerns about luring investors with co-investments and not making them available.
  3. Improper allocation of broken deal costs with co-investments – KKR

Let me know if you aware of others.

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Co-Investments and the SEC

Last year, regulators from the Securities and Exchange Commission raised concern about co-investments. The statements were vague about what was bothering the regulators.

Co-investments allow a private equity to lower its exposure to an investment and give others an opportunity to invest along side the fund at a discounted rate. It can be an opportunity to lure investors into the fund by granting them preferential treatment to co-investments. This would lower the effective management fee costs the investor pays to the manager.

Many fund investor are interested, but its hard to spread the opportunities equally out to all of those interested. Splitting the co-investment equally will result in opportunities being so small per investor that it’s not worth the time, effort and money.

The biggest concern for fund managers is execution. It takes a great deal of effort to put the capital stack together for an acquisition. The fund manager needs a potential co-investor to be able to act quickly and decisively.

From the SEC’s perspective, I assume examiners would not be happy to find fund managers dangling the possibility of co-investments as an incentive for an investor to commit to the fund and then not actually offering co-investments to that investor.

Fund managers need to be honest with investors and let them know where they stand in line for co-investments. If a fund manager has offered priority co-investment rights to certain investors, the manager disclose this.

The other concern of regulators and one which should be a concern is allocating deal costs. If the deal goes ahead, co-investors should pay their portion of the deal costs. Last year, the SEC raised concerns about broken deal costs when co-investments are used on a regular basis. The SEC felt that not all of the broken deal costs should be paid by the fund when co-investments were a routine part of the investing strategy.

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