Expenses – Compliance Building

First Enforcement Action for Private Equity Fund Expense Allocation

The Securities and Exchange Commission has been making lots of noise about how its unhappy with how private equity firms are allocating expenses to portfolio companies. And it has finally hit its first target. The SEC charged a a private equity fund manager with breaching its fiduciary duty to a pair of private equity funds by sharing expenses between a company in one fund’s portfolio and a company in the other fund’s portfolio in a manner that improperly benefited one fund over the other.

Lincolnshire’s Fund I bought Peripheral Computer Support, Inc. in 1997. PCS primarily serviced and repaired computer hard disk drives. In 2001, PCS thought an acquisition of Computer Technology Solutions Corp. would be a great strategic acquisition. CTS serviced and repaired laptop computers and handheld devices.

But by 2001 Fund I’s commitment period had expired. So Lincolnshire had Fund II acquire CTS. Lincolnshire integrated PCS and CTS together and sold them together in 2013 to a single buyer.

Commingling investments across different funds is tricky. You need to be concerned about different expectations for investors in the different funds with different investment horizons for the exit. Operationally, you need to be careful how fees and expenses are allocated to treat each fund fairly.

Lincolnshire did set an unwritten policy where it tried to treat each fairly. Generally, shared expenses were allocated based each company’s revenue. So, PCS, the smaller company, paid 18% of the shared expenses. However, PCS and CTS had no written agreements about how to share expenses or the company’s rights and obligations toward each other.

Even though the revenue-basis sharing was the general practice, there were variations. Lincolnshire failed to document why some shared expenses were allocated differently.

Lincolnshire was in a tricky situation and mishandled it.

The SEC based its enforcement action on a violation of Section 206(2) as a “transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.” The SEC is quick to point out that a violation of 206(2) can be based on a finding of simple negligence. The SEC does not need to prove scienter.

The SEC made no charges that Lincolnshire benefited from the misallocation. The SEC makes no charges that either Fund I or Fund II was harmed by the misallocation. Although, presumably, Lincolnshire did benefit and one fund did end paying more than its fair share of expenses.

The SEC merely charges that Lincolnshire was negligent in not having a written policy on the allocation of expenses and not following that policy.

Without any charges that it intended to defraud its investors, Lincolnshire has to pay $2.3 million to the SEC.

Private equity fund managers should take this as a warning to properly document investments combined across more than one fund and to take extra steps to ensure that they are treating each fund fairly.

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The SEC Has Seen Your Private Equity Fees And Is Not Happy With Them

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According to a story in Bloomberg, the Securities and Exchange Commission has examined about 400 private equity firms and found that more than half have charged “unjustified fees and expenses without notifying investors”. The editor decided to change the headline from “unjustified” to “bogus”.

Fees and expenses charged by a fund manager to investors in the fund is always a conflict. The manager is taking cash from the limited partners.

The first question is whether the fees and expenses are adequately disclosed in the private placement memorandum or the partnership agreement. Most funds give the manager broad discretion to charge expenses for managing the investments to the investors in the fund. I have a hard time believing that over 50% of fund managers are charging expenses that are not permitted by the fund documents.

The story used “unjustified” when disclosing what the “person with knowledge of the SEC’s findings” stated about the fees. That may be more about the SEC not being happy with the fees charged, not necessarily that the fund manager is not legally entitled to the fees.

The second issue to think about with fees is whether the fees distort behavior. Certainly, a fund manager could be tempted to operate its private equity investments in a way that maximizes its fee revenue. That may cause the manager to make decisions that are in its best interest and not necessarily in the best interest of the fund investors. If a fund manager earns a fee for raising additional debt for a portfolio company, but not for raising additional equity. You might think the fund manager would be inclined to more often raise debt instead of equity.

To counter that inclination, private fund mangers earn the best returns by deliver great returns to their investors. Most managers earn a carry, taking an extra piece of the profit for good returns to investors. Taking a fee in the short term would hurt the long term, bigger return.

Compliance has a role to monitor fees to make sure they comply with the disclosures and legal agreements. It also has a role to monitor whether the nature of the additional fees distorts behavior in a way that could be perceived as adverse to investors.

The story mentions three types of bogus fees:

miscalculating fees,
improperly collecting money from companies in their portfolio and
using the fund’s assets to cover their own expenses

One is failing to comply with the documents. Two is a potential disclosure failure. Although, the SEC may be expecting more specific disclosure than exists in the fund documents. Three may be a difference of opinion by the SEC over what should be a fund expense and what should be a management company expense.

As for expenses, the story mentions the Clean Energy Capital case where the SEC has accused the fund manager of grossly over-allocating expenses to the fund instead of the management company.

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