Client Alert

The SEC Continues to Spread Sunshine on Private Equity: Reflections on Two Recent Enforcement Actions

30 Jan 2019

The end of 2018 was notable for two SEC enforcement actions against private equity fund managers for violations of the Investment Advisers Act of 1940 arising from improper allocations of expenses, undisclosed conflicts of interest, and insufficient compliance policies and procedures.  The two actions demonstrate the SEC’s continued focus on private equity fund managers’ use of “operating partners” or consultants and the particular issue of how the expenses of such operating partners or consultants are allocated.

The Two New Enforcement Actions Are Grounded in the SEC’s Continuing Commitment to Spread Sunshine in Private Equity

In his 2014 “sunshine” speech to the Private Fund Compliance Forum, the then-Director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), Andrew Bowden, discussed various compliance issues observed in examinations of more than 150 private equity fund managers.  By far the most noteworthy observation was that private equity fund managers were engaging in violations related to the handling of fund fees and expenses “over 50% of the time.”  Among the specific violations noted were the following:

  • Inadequate disclosure with respect to whether operating partner expenses are paid by the manager, by one or more funds, or by one or more portfolio companies; and
  • Inadequate disclosure regarding whether expenses related to various back-office functions, such as compliance, legal, and accounting, are allocated to the manager or to the manager’s funds.

The SEC’s recent enforcement actions demonstrate the SEC’s continued attention to how managers allocate private equity fund fees and expenses (particularly those related to operating partners and back-office services).  In addition, the enforcement actions underscore the need for fund managers to carefully scrutinize disclosures regarding the allocation of fund expenses and related conflicts of interest, and to ensure that they have adopted comprehensive compliance policies and procedures tailored to the specific risks of their fund business.

Fees and Expenses of “Operating Partners”

On December 17, 2018, the SEC announced a settlement with a registered investment adviser concerning the way in which it allocated compensation-related expenses for employees of an internal operating partner.   

According to the SEC, the adviser and its affiliates (the “Adviser”) established an unincorporated business unit to manage three private equity funds the Adviser sponsored and managed.  The Adviser formed a group of employees within this unit to provide “advice and support, including client development, talent management, operational advisory services, and sourcing potential new investors” to the portfolio companies in which the funds invested (the “Business Services Platform” or the “BSP”).  The BSP was effectively an internal operating partner.

The SEC found that the funds’ operating agreements and disclosure documents represented that the funds would pay fees and expenses “relating to the utilization of the [BSP] in an amount not to exceed 50 basis points per annum of aggregate Commitments” and that the Adviser would bear other costs and expenses of the Business Services Platform.  The SEC further found that certain BSP employees not only provided the funds with the types of services contemplated by the various fund agreements, but also spent time on tasks unrelated to the BSP.

According to the SEC, notwithstanding the disclosure in the funds’ agreements, the Adviser negligently failed to adjust the amount of compensation-related expenses of the BSP that were allocated to the funds.  As a result, approximately 7% of the expenses paid by the funds for the BSP employees during the relevant period, or $2 million, “was paid for time spent on tasks not related to [the funds’] utilization of the BSP.” 

The SEC also concluded that although the Adviser maintained expense allocation procedures, it did not maintain compliance policies and procedures designed specifically to prevent the misallocation of compensation-related expenses.

The Adviser agreed to pay disgorgement of the approximately $2 million in expenses it failed to allocate properly, plus approximately $284,000 in prejudgment interest.  The SEC also imposed a civil monetary penalty of $375,000.  As part of the settlement, the SEC took into consideration the Adviser’s remedial efforts and cooperation, including voluntary steps to cease allocation errors and prompt responses to the SEC staff’s inquiries.

Internal and External Conflicts of Interest

On December 13, 2018, the SEC announced a settlement with a registered investment adviser concerning its alleged failure to disclose (i) the allocation of certain in-house employee costs to its private equity fund clients and (ii) arrangements with third-party consultants that resulted in expense allocation decisions that posed actual or potential conflicts of interest.

Failure to Disclose Allocation of In-House Employee Costs

The SEC alleged that the adviser allocated to its private equity fund clients a portion of the costs of two employees who, in addition to preparing the tax returns for the adviser, its affiliates, and certain of its principals, assisted in the preparation of the funds’ tax returns.  According to the SEC, the operating agreements for each of the private equity funds managed by the adviser stated that each fund would pay expenses for the “preparation of the Partnership’s financial statements, tax returns and schedules K-1,” but that the adviser would pay “the costs and expenses incurred by the [adviser] in providing for its or the General Partner’s normal operating overhead, including salaries, other compensation and benefits of the [adviser’s] employees.”  The SEC found that the adviser failed to adequately disclose that it was charging the funds a portion of the costs of its employees who were assisting in the preparation of the funds’ tax returns. 

In addition, seemingly in contravention of provisions of the funds’ operating agreements related to conflicts of interest, the SEC concluded that the adviser failed to adequately disclose how it allocated the costs of its in-house tax personnel across the funds, the adviser, and its affiliates to the funds’ limited partner advisory committees (LPACs) or investors.

Failure to Disclose Third-Party Consultant Expense Allocation Decisions

The SEC order also found that the adviser inappropriately allocated operating expenses of two consulting firms, “Consulting Firm A” and “Consulting Firm B,” to private equity funds managed by the adviser.  

Consulting Firm A provided services to two of the adviser’s private equity fund clients and also provided general deal sourcing services to the adviser.  The SEC order found that two of the private equity funds managed by the adviser were improperly allocated operating expenses incurred by Consulting Firm A during time periods when Consulting Firm A was also providing services to the adviser, and that there was no offset of those expenses.  The SEC also found that the adviser used payments that a fund client owed to Consulting Firm A to pay off a loan that the adviser’s principal made to Consulting Firm A’s principal.  The SEC concluded that these undisclosed conflicted arrangements resulted in the misallocation to the funds of a portion of Consulting Firm A’s fees.

Consulting Firm B, a talent management and marketing company, was engaged by the adviser to provide consulting services to one of its private equity fund clients and to that fund’s portfolio company.  During this period, the SEC order states that Consulting Firm B was also providing services to the adviser’s principal with respect to the principal’s personal investments and that the principal made a personal investment in Consulting Firm B.  The SEC concluded that these undisclosed conflicted arrangements resulted in the misallocation to the fund of Consulting Firm B’s fees, the failure to credit funds the principal received from Consulting Firm B to the fund, and the failure to offset fees received by Consulting Firm B against the adviser’s fee after the principal made an investment in Consulting Firm B.

The SEC also concluded that, despite the potential risks surrounding its use of consultants as well as the allocation of related expenses, the adviser failed to adopt policies and procedures reasonably designed to prevent conflicts of interest arising from the allocation of these expenses and payments.

The adviser agreed to pay approximately $1.93 million in combined disgorgement and prejudgment interest and a $1 million penalty, and to retain (and pay for) a compliance consultant.  In accepting the settlement, the SEC noted the adviser’s voluntary reimbursement of $940,244 improperly charged to the funds and improved compliance measures.

Key Takeaways

The SEC continues to carefully scrutinize the allocation of fees and expenses among investment advisers and their private equity fund clients.  These recent enforcement actions serve as a reminder for private equity fund managers to evaluate their expense allocation procedures and to ensure that fund governing and offering documents accurately disclose how such allocations will be made.  In light of the potential conflicts of interests inherent in such business arrangements, advisers should pay particular attention to allocations when operating partners or consultants are providing services to both the adviser and its private equity fund clients. 

Advisers should take following steps:

  • Review expense allocation disclosure in fund operating and disclosure documents to ensure accurate disclosure;
  • Review your firm’s expense allocation compliance policies and procedures to ensure they are tailored to your specific structure and relationship, including specific conflicts of interest; and
  • Audit your firm’s compliance with your expense allocation compliance policies and procedures and make changes if necessary.


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