SEC Examination Priorities for PE Firms Fee
and Expense Practices
Guy F. Talarico, CEO and Founder, Alaric Compliance Services, LLP
Jeff Blumberg, Partner, Faegre Baker Daniels, LLP
March 31, 2015
Table of Contents
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
Why is the SEC focused on Private Funds?
Examples of Problematic PE Fee and Expense Practices
Suggested Corrective Actions
Recommendations to Improve the Compliance Program
Enforcement Actions
What’s Around the Corner from the SEC?
What’s next from the NSCP PE Webinar Series?
Resources
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Disclaimer
This information is presented for general informational purposes only.
It is not a full analysis of the matters presented and should not be
relied upon as legal advice.
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I. Why is the SEC Focused on Private Funds?
“PE firms provide financial security for millions of Americans from all
walks of life. The biggest investors in private equity include public and
private pension funds, endowments and foundations, which accounted
for 64% of all investment in Private Equity in 2012.” Source: Speech by
Andrew J. Bowden, Director, OCIE “Spreading Sunshine in Private
Equity” delivered in May 2014 at Private Equity International Private
Fund Compliance Forum 2014.
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I. Why is the SEC Focused on Private Funds?
(con’t)
Certain industry practices that are areas of concern to the exam staff
• Limited Partnership Agreements – poor (or missing) fee and expense
allocation disclosures; inadequate information rights for LPs
• Lack of Post-Closing Transparency
• Industry Trends
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I. Why is the SEC Focused on Private Funds?
(con’t)
Certain industry practices that are areas of concern to the exam staff
• Limited Partnership Agreements – poor (or missing) fee and expense
allocation disclosures; inadequate information rights for LPs
• Lack of Post-Closing Transparency
• Industry Trends
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I. Why is the SEC Focused on Private Funds?
(con’t)
Limited Partnership Agreements
“Many limited partnership agreements are broad in their
characterization of the types of fees and expenses that can be charged
to portfolio companies, as opposed to the adviser. This has created a
gray area, allowing advisers to charge fees and pass along expenses
that are not reasonably contemplated by investors. Poor disclosure in
this area is a frequent source of exam findings. Source: Speech by
Andrew J. Bowden, Director, OCIE. “Spreading Sunshine in Private
Equity” delivered in May, 2014.
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I. Why is the SEC Focused on Private Funds?
(con’t)
Lack of Transparency
The exam staff has stated that there is a Lack of transparency as to fees
earned by managers and charged to investors and portfolio companies.
Some limited partnership agreements have broad, imprecise language
that leads to opaqueness when transparency is most needed and do
not provide the limited partners with sufficient information rights to be
able to adequately monitor not only their investments, but also the
operations of their manager.
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I. Why is the SEC Focused on Private Funds?
(con’t)
Industry trends
• Consolidation, complexity and rapid growth
• Structure of the vehicles
• Growth coming from separate accounts and side-by-side coinvestments.
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II. Examples of Problematic PE Fee and Expense
Practices
The most common observation made by the examiners has been
with the adviser’s collection of undisclosed fees and the
misallocation of expenses. Some examples:
Fee Issues
• Inadequate Fee Disclosures
• Monitoring, Transaction and other Fees
• Consulting Fees
• Break up Fees, Dead Deal Fees
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II. Examples of Problematic PE Fee and Expense
Practices
(con’t)
• Classification of Deal Fees
• Misclassification, misallocation and delay in the application of fees
that should have offset management
• Non disclosure of past conflicts of interests and/or potential conflicts
of interest associated with the receipt of fees
• Failure to adequately monitor the receipt of fees by employees who
serve as board members of the portfolio companies.
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II. Examples of Problematic PE Fee and Expense
Practices
(con’t)
• Allocation of fees between Co-Investment and Parallel Vehicles
• Lack of detailed compliance policies and procedures compliance
oversight on how fees and expenses are allocated.
• Hidden Fees - Charging undisclosed “administrative” or other fees not
contemplated by the limited partnership agreement or properly
disclosed to the investors
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II. Examples of Problematic PE Fee and Expense
Practices
(con’t)
Expense Allocation Issues
• Shifting expenses traditionally billed to the adviser in exchange for the
management fee without proper disclosures
• Misclassification, misallocation of expenses due to vague disclosure in Fund
governing documents.
• Exceeding the limits set in the limited partnership agreement around transaction
fees or charging transaction fees in cases not contemplated by the limited
partnership agreement, such as recapitalizations; Charging expenses for items
that traditionally are offset to the management fees.
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III. Suggested Corrective Actions
Working with the CFO
• Prepare a list of all the direct and indirect fees that are being collected
• Identify all expenses being charged to the fund including allocation of inhouse employee salaries and overhead to the funds and/or portfolio
companies
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III. Suggested Corrective Actions
(con’t)
Working with the CFO
• Determine what fees or expenses should be eliminated given
operative fund organizational and offering documents and/or other
pertinent disclosures.
• Private equity fund managers may decide to change their policies or
even go so far as to eliminate some expenses– for example,
dismissing third party consultants.
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III. Suggested Corrective Actions
(con’t)
Working with the Fund’s legal counsel
• Identify and review all the fee disclosures, and determine with the
help of the Fund’s legal counsel, if the fees have been accurately and
clearly disclosed to investors. In the best case scenario the fees will
match what has been disclosed to the investors.
• If the fees are not being charged according to what has been
disclosed to investors. Determine along with the Fund’s legal counsel,
if any change information on fees needs to be included on the Form
ADV. Note: This type of change may trigger an examination.
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IV. Recommendations to Improve the
Compliance Program
• Review the existing policies and procedures regarding the calculation,
allocation and monitoring of fees and expenses. Periodic sample
compliance testing of Fund and Management Company expenses,
allocations and payment/wire authorizations including allocations of
expenses between Funds, co-investment vehicles and parallel
vehicles.
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IV. Recommendations to Improve the
Compliance Program
(con’t)
• Implementation of a new “Conflicts of Interests Policy” designed to
identify, address and document all potential conflicts of interests for
Fund transactions and hiring of affiliated and third party service
providers and consultants including the fees and expenses prior to
such transactions. Consider establishing a Conflicts Committee for the
purposes of reviewing all Fund governing documents and Form ADV
disclosures and mitigating conflicts of interests where needed,
including fees and expenses to be incurred on such transactions.
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IV. Recommendations to Improve the
Compliance Program
(con’t)
• Implementation of policy requiring third party service provider
agreements, engaging of operating partners or senior advisors to be
reviewed and approved by compliance and/or legal staff.
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IV. Recommendations to Improve the
Compliance Program
(con’t)
• Review of Custody policies and procedures to update additional
procedures to strengthen internal controls in regards to the
authorization and processing of expenses. Consider internal controls
placed with accounting/finance to prohibit any wire transactions
relating to compensating service providers or consultants until such
compensation has been cleared for a conflicts of interest review.
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IV. Recommendations to Improve the
Compliance Program
(con’t)
• Review Gifts and Entertainment Policy to reflect Chief Compliance
Officer (compliance) approval of certain dollar amount thresholds for
gifts and entertainment and allocations of such expenses between
Funds and Management Company. Periodic compliance testing of
time/expense reports for relevant employees.
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V. Enforcement Actions
• Lincolnshire Management, Inc.
• Clean Energy Capital, LLC
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VI. What‘s around the corner from the SEC?
• Fund managers may assume that the statements in SEC staff speeches
are good predictors of enforcement priorities.
• Private equity managers can expect the SEC to scrutinize performance
claims in fund marketing materials. In anticipation of these actions,
fund managers should ensure that they review and re-evaluate their
performance data and disclosures. We expect the SEC to focus on the
transparency of the calculations, valuations and performance data
presentations.
• Reuters has reported that the SEC Examiners are probing the internal
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rate of returns cited in fund marketing materials.
VII. What’s next from the NSCP PE Webinar
Series?
In May, we are planning a webinar on Valuations and Performance
Disclosures.
If you have some topics you would like us to address please email your
suggestions to lisa@nscp.org
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VIII. Resources
OCIE Examination Priorities for 2015 www.sec.gov
Bowden, Andrew J., Director, OCIE, “Spreading Sunshine in Private
Equity”, speech delivered May 6, 2014 at Private Equity International
Private Fund Compliance Forum 2014 www.sec.gov
Heires, Katherine, “Private Equity’s Risk Management Take-Up, Caught
in the net of Dodd-Frank, FATCA and other reforms, yet another
category of financial firms is bulking up in governance, risk and
compliance”, www.garp.org, August 2014
Alden, William, “After Inspecting Private Equity Funds, S.E.C. Examiners
to Broaden Focus”, New York Times, January 22, 2015.
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