Tag: Fees and expenses

Don’t Charge Your Examination and Investigation Expenses to Your Funds

Most private fund documents allow the manager to charge the funds for expenses incurred in the operation of the funds. Most investors expect and most managers charge the funds for some of the legal expenses and consulting expenses. The Securities and Exchange Commission though Cherokee went too far in charging the funds for expenses related to registration with the SEC.

money

Like many private fund managers, Cherokee spent a great deal of time, money and energy in 2011 in preparing to register with the SEC as an investment adviser. According to the SEC order, Cherokee charged $171,000 of those expenses to the funds it managed. The expenses were for a third-party consultant and outside counsel, as well as registration fees.

Cherokee was subject to an exam in 2013 and incurred $239,362 of expenses that it charged back to the funds. In 2014, Cherokee got notice of an impending enforcement action and charged $45,000 to the funds for legal services incurred during the investigation.

The SEC takes the position in the enforcement action that the disclosure would need to specifically state that funds would be charged for a portion of the adviser’s own legal and compliance expenses. Cherokee’s partnership provided that the funds would be charged for expenses that in the good faith judgment of the general partner arose out of the operation and activities of the funds. That was not good enough for the SEC.
Sources:

Another Private Equity Fee Case from the SEC

When the Securities and Exchange Commission announced last year that it was not happy with the fees private equity funds were charging and how they were disclosed (or not disclosed) to investors, we expected enforcement cases to follow. They are here. The latest is against Fenway Partners for failing to disclose conflicts of interest to a fund client and investors when fund and portfolio company assets were used for payments to former firm employees and an affiliated entity.

fenway

According to the SEC order, Fenway had management service agreements with the portfolio companies which were partially offset against the fund management fee charged to investors.

In 2011, Fenway cancelled those agreements and entered into similar agreements with a new consultant firm largely owned and operated by the principals of Fenway. Fenway did not offset these consulting fees against the fund management fee.

The SEC found several faults with the change. The SEC found the disclosure to the fund’s advisory board to be lacking in detail. The SEC also challenged the fund’s financial statements for failing to be GAAP compliant and disclose the payments to affiliates, the new Fenway consultant firm.

I assume Fenway was taking the position that the new consultant firm did not meet the definition of “affiliate” under the fund documents and could be carved out separately. Clearly, the SEC does not like this approach. KKR was challenged on taking this position last year by the SEC.

Sources:

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.

Sources:

Can A Fund Pay for the Manager’s Office Expenses?

adoption money

This is not a question that you can answer without any background. Theoretically, a fund can directly pay a fund’s office expenses. It’s just that most investors do not expect to pay for a manager’s office expenses. Investors expect the management fee they pay to cover those expenses, with the rest as profit for the manager.

The key is what the fund documentation says. Generally you will see something like this is the partnership agreement:

The Partnership bears all of the expenses incurred by it or by others on its behalf or for its benefit, including ordinary operational and administrative expenses, expenses incurred in connection with the continuing offering of the Interests, expenses incurred in direct or indirect investment activities, financing and transaction costs, interest expenses on funds borrowed on its behalf, and extraordinary expenses, if any.

This provision came from the partnership agreement for Alpha Titans. That firm got in trouble with the Securities and Exchange Commission for using fund assets to pay more than $450,000 in office rent, employee salaries and benefits, and similar expenses. Alpha Titans was in violation of its fund documents.

In addition to the LP Agreement, the Form ADV should have also disclosed that the investors would be paying these operating expenses.

Finally, Alpha Titans financial statements failed to meet GAAP standards since the statements omitted the disclosure of these operating expenses. They should have disclosed the expenses and related party transactions. The funds were relying on the financial statement delivery option for funds under the Custody Rule. Since the financial statements failed to meet GAAP standards, they were inadequate for Custody Rule compliance, and therefore Alpha Titans failed to comply with the Custody Rule.

That is 1,2,3 punch from the SEC for expense allocation failures.

Sources:

First Enforcement Action for Private Equity Fund Expense Allocation

sec-seal

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.

Sources:

Failing to Disclose Fees

money

The Securities and Exchange Commission has been focused on fees charged by investment advisers and fund managers. The latest target is Robare Group Ltd. based in Houston. The SEC alleges that the firm was receiving a fee from certain investments made for its clients but failed to properly disclose that it was receiving the fee.

According to the SEC order, an unnamed broker agreed to pay the Robare Group a fee for client funds invested in funds sold by the broker. There is nothing inherently wrong with that arrangement. However, it should be disclosed to clients. The concern is that the adviser would direct clients to invest in those funds because it is good for the adviser, not necessarily because it is good for the client.

One interesting thing about the alleged violation is that the SEC is not stating any harm to Robare Group’s clients or even that the clients were invested in the fund for a disproportionate amount. The SEC is focused solely on a violation for failure to disclose. The disclosures were not adequate because they said the Robare Group “may” receive compensation from the broker for selling the mutual funds, when it was definitely receiving payments, the SEC said. In my opinion, that’s a very thin distinction to make.

The interesting thing about the press release for the alleged violation is the statement that the SEC’s asset management unit has enforcement initiative focused on undisclosed compensation arrangements between investment advisers and brokers. This is sounds like a similar effort focused on undisclosed compensation to private equity fund managers from portfolio companies.

 

Sources:

 

Fees, Expenses and the S.E.C.

money penny

Andrew Bowden threw a grenade at the private fund industry three weeks ago when he spoke at PEI’s Private Fund Compliance Forum. He said that the SEC found violations of law or material weaknesses in over 50% of the exams they had conducted of private equity funds when it came to fees and expenses.

Mr. Bowden pointed to two particular types of fees and expenses: monitoring fees and operating partners. Although both of these are customary in private equity deal and disclosed in PPMs and financial statements, the SEC does not like them. He lumped them together with fraudulent expenses in the Camelot case.

Two recent news stories are carrying on Bowden’s view of private equity.

Last week, the Wall Street Journal ran a story on how KKR failed to credit certain fees back to investors because the unit was not an affiliate:  KKR Error Raises Question: What Cash Should Go to Investors? KKR is required to share with investors in its largest buyout fund 80% of any “consulting fees” collected by any KKR “affiliate.” The unit in question was owned by KKR’s management and not considered an affiliate. The article specifically tied back to Mr. Bowden’s speech.

On Sunday, Gretchen Morgenson penned an article in the New York Times about monitoring fees: The Deal’s Done. But Not the Fees. The article highlighted $30 million in monitoring fees paid to Goldman Sachs, Kohlberg Kravis Roberts and TPG Capital for their oversight of Biomet. The unpaid fees under the 10-year monitoring contract became due on the sale to Zimmer Holdings. This article also specifically mentions Mr. Bowden’s speech.

In my view, it’s not that the fees are illegal or “fraudulent, manipulative or deceptive” under Section 206. It’s a matter of disclosure to investors and internal procedure. Investors deserve a right to know the fees they are paying, either directly through the fees by the fund, or indirectly by the fees paid by the portfolio company to the fund manager. Perhaps in some fund documents the fees can be laid out in more detail. Fund managers should have internal procedures for how fees are implemented and checked to make sure they comply with the fund documents.

Personally, I think Mr. Bowden is lumping a lot of customary fees and expenses into his 50% bucket. I’m offended that he is including the case of fraud, like the Camelot case, in with instances of fees that the SEC merely does not like.

References: