New ILPA Fee Reporting Template

Investors look for transparency in fees. The Institutional Limited Partners Association published a Fee Reporting Template Last Week to encourage uniformity in the fee disclosures being made to private fund investors.

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The aim of this proposed template is to encourage increased uniformity in the fee disclosures the fund managers provide to limited partners in private funds. ILPA proposes two benefits:

  1. Providing limited partners with an improved baseline of information that lends itself to more streamlined analysis and informed internal decision making
  2. Reducing the compliance burden on fund managers, who face a variety of bespoke template formats

Only two fund managers have signed on as endorsing the template.

Already, the California controller is pitching the SEC to mandate the template as a reporting obligation.

Fees in all investments have disclosure problems. How much are you paying in fees for your mutual funds? I, like many of you, don’t know. Most investors look at overall performance. Low fees are great, but not if it’s for low performance.

Private funds are obviously different form mutual funds. It’s not easy to sell and re-invest the money.

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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:

  1. miscalculating fees,
  2. improperly collecting money from companies in their portfolio and
  3. 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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Fees and Conflicts

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I sat down with a few people last week to discuss various fee structures with fund managers and investment advisers. One fee was raised as potentially problematic. “I’m not sure if this fee is a conflict.”

My thought is that every fee is an inherent conflict. You are taking money from the fund investor or client and putting it into the hands of the fund manager / adviser.

The first step of the fee analysis is whether it is disclosed. One of the primary commands of the Investment Advisers Act is disclosure. You must make your clients and investors aware of the fees you charge. Compliance must make sure that the fee information is clearly disclosed in accordance with the regulations and SEC actions.

The second step is the analysis of whether the fee could cause a distortion in behavior that could cause the fund manager / adviser to act in a different way because of the fee income.

If the fund charges an acquisition fee, then the fund may be more likely to make acquisitions because it gets extra income when it does so.

Even the asset based management fee that most people think keeps the fund manager and investor most aligned can cause distortions. In June 2012, the SEC announced its pursuit of zombie funds. It was concerned that fund managers are keeping portfolios together merely to collect the management fee instead creating realizations to return capital to investors.

Fees are always a conflict. You must disclose them and understand the distortions so you can keep your fund’s interest aligned with the investor’s interest.