The SEC has great interest in issues such as how investment advisors (“Advisors”) calculate fees, what they disclose to investors, how disclosures are made and how and when Advisors charge fees.
The SEC recently focused its enforcement actions on Advisors that receive undisclosed fees and expenses, impermissibly shift and misallocate expenses, or fail to adequately disclose conflicts of interests, including conflicts arising from fee and expense issues2. Several of the biggest players in the private equity industry have reached multimillion dollar settlements with the SEC related to fee allocations and disclosures.
Given the current environment, investment advisors must acknowledge rising regulatory scrutiny and embrace existing options to minimize potential risk. Investment advisors may want to conduct an in-depth review of their fees and expenses to determine whether their allocation methodologies are in compliance with industry best practices—and if not, to improve their practices and disclosures. There is no standard rule that applies to all investment advisors, as each advisor handles particular expenses differently. However, there are two particularly challenging expense allocations that investment advisors should be aware of to avoid provoking the SEC: (1) Internal fees; and (2) Due diligence expenses.
Related parties fees are considered internal fees. For example, if XYZ Company makes a decision to self-administer the fund in-house (as opposed to using an outside provider), several questions arise: Can XYZ Company pay these fees from the fund? If so, what amount of fee would be appropriate to charge? To determine if the fees are appropriate, the Advisor should ensure adequate disclosure in the limited partnership agreement (LPA) and the offering documents to allow for charging such fees. One way to do this is by engaging a third-party service provider to perform fee and expense assessments. They can determine whether existing and new fee and expense allocations practices are in compliance with investor agreements and in accordance with industry best practices. Third-party service providers can also provide market benchmarking services to determine the reasonableness of fees charged. Such benchmarking approaches vary and may include the primary market approach where one would search databases for fees paid among third parties for similar servicing arrangements.
This approach would include an adjustment for market rates for relevant comparability factors. Other approaches include: (1) relying on quotes provided by outside service providers (such as fund administrators; (2) reviewing executed intercompany and other third-party contracts to ensure there are no material differences between the services rendered; and (3) surveys of market practices. Third-party service providers can also assist in drafting the expense policies. If there are existing expense policies, the effectiveness of such policies can be tested by third-party service providers to ensure the policies are actually being applied in practice.
Due Diligence Expenses
Advisors may also need to address due diligence expenses. Due diligence expenses are costs associated with sourcing activities related to evaluating potential company investments, including research costs, travel costs and professional fees. Advisors may charge such expenses to the funds or to portfolio companies. For example, XYZ Company incurs costs while performing due diligence on a potential investment related to an underlying fund and a co-investment entity. If the deal does not materialize, who should incur the broken deal expenses and how should these costs be allocated?
To determine how broken deal expenses should be allocated, investment advisors should review their LPA and the offering documents to ensure the disclosures related to how broken-deal expenses are to be allocated to the fund and to any co-investor are clear, accurate and complete. Furthermore, Advisors should have a written policy governing its broken-deal expense allocations. The policy should include compliance policies and procedures for allocating fees and expenses among various funds, co-investment entities, potential third-party co-investors and managed accounts. The policy should take into account various factors and review determinations at various stages as the investment opportunity develops. The final allocation of the broken deal fees should be based on the policy and any subsequent reviews during the development of the investment opportunity. Third-party service providers can provide reviews of such policies and assist Advisors on ensuring the expense allocations are performed in accordance with industry best practices.
Given the current regulatory environment, it is critical for Advisors to take a proactive approach to ensure their fee and expense allocation practices are in compliance with investor agreements and aligned with industry best practices. In-depth reviews, correcting past mistakes and self-reporting any necessary corrections may not completely eliminate potential SEC fines, but they may decrease the likelihood of increased SEC fines and penalties.
1.SEC Announces Enforcement Results for FY 2016 (October 11, 2016). https://www.sec.gov/news/pressrelease/2016-212.html.
2.Securities Enforcement Forum West 2016 Keynote Address: Private Equity Enforcement (May 12, 2016). https://www.sec.gov/news/speech/private-equity-enforcement.html