Raising the Bar -Key Considerations on SEC rules for Data Reporting and Liqui...
PE Expense Allocation Article (00299582x9ED28)
1. MARCH 2016
(continued on page 2)
Overview: The Securities and Exchange Com-
mission (“SEC”) has spent much of the last two
years imposing large sanctions against Private
Equity (“PE”) firms for disclosure and conflict-
of-interest problems arising from how PE man-
agers allocate expenses between management
and fund investors. After spending the first two
or three years post-Dodd Frank raising awareness
of these issues in public speeches and the pub-
lished priorities of the SEC’s Office of Compliance,
Inspections and Examination (“OCIE”), including
its Private Funds Unit (the “PFU”), and the Asset
Management Unit (“AMU”) of the SEC’s Division
of Enforcement, the SEC has begun imposing
large fines on PE funds (“PE Funds”) over expense
allocation violations. It is therefore imperative for
PE Funds to retain counsel to review their fund
offering documents, expense allocation practices,
and compliance programs to make sure they are
in compliance with the SEC’s recent decisions on
these issues.
It appears the SEC has adopted a default posi-
tion that certain expense allocations will be
presumed unlawful, unless they are clearly dis-
closed. So unless a PE Fund’s disclosure docu-
ments are very clear and specific in authorizing
a PE Fund manager (“PE Manager”) to allocate
expenses in a certain way, the SEC views it to
be a breach of fiduciary duty for a PE Manager
to allocate expenses in any way that benefits
such manager (or co-investors or other preferred
investors) at the expense of any investor. Specifi-
cally, the SEC has cracked down on disclosures
and conflicts of interest related to the allocation
of (i) due diligence and broken-deal expenses;
(ii) portfolio company monitoring and consult-
ing fees; (iii) PE Manager legal and compliance
expenses (e.g., for SEC registration, compliance
program); and (iv) PE Manager overhead, includ-
ing office supplies, equipment and salaries.
This article summarizes the background of this
focus on expense allocations and, drawing from
the recent SEC enforcement actions focused on
this issue, identifies both the types of expenses
and disclosure breakdowns that caught SEC atten-
tion and the remedial measures sought by the SEC
in forming the ensuing settlement arrangements.
erans and specialists, each with deep experience
in either a certain type of investment vehicle or
investment practice,2 to allow the SEC to con-
duct focused, risk-based examinations.3 Second,
because, in the wake of Dodd-Frank, many newly-
affected PE Managers are coming to terms with
the reality of new statutory and compliance obliga-
tions (including their first regulatory examination)4
the SEC has been transparent about its regulatory
and enforcement objectives. Third, the SEC views
the potential for conflict that are present in every
PE Manager’s decision regarding expense alloca-
tions as falling within a key SEC priority: address-
ing conflicts of interest within a fiduciary relation-
ship.5 Once the SEC identifies such a conflict, a PE
Manager will be held to a hard line of both identi-
fying and eliminating, or alternatively, mitigating
and disclosing, that conflict.6 No “well-meaning
or good faith adviser” exceptions have been made
and a “no harm-no foul” (i.e., claims that no client
was affected by the conflict) defense has yet to
prevail.7 The SEC’s rationale for this approach
is, in part, that since PE Managers (through the
fund(s) they manage and advise), harbor such a
high degree of control over the typical portfolio
company or other investment, with little transpar-
ency, such conflicts simply cannot be permitted to
exist undisclosed.8
Key SEC Cases Involving Expenses
and Related Conflicts and Disclosure
Issues
As noted above, the types of expenses that have
attracted SEC attention include broken deal fees,
portfolio monitoring fees, and legal fees, compli-
ance fees and operating expenses of the PE Man-
ager, including compensation paid to its principals
and its employees, employee benefits, rent and
consulting fees. In virtually all cases, the SEC has
Background: Initial SEC Speeches
and Publications Regarding Expense
Conflicts
Post-Dodd Frank, many PE Managers found them-
selves subject to a new set of registration and
reporting requirements. Similarly, the SEC faced a
new population of regulatory targets with unique
operational characteristics and long-standing
internal practices that have historically avoided
regulatory review. In all its regulatory enthusiasm,
the SEC has made several thematic pronounce-
ments surrounding its focus on expense allocation
practices, and the conflicts of interests so inher-
ently intertwined therewith, and why this issue has
become a key priority.1
First, the SEC has, over the last few years, endeav-
ored to build a staff of former PE industry vet-
THE SEC TURNS UP THE HEAT ON PRIVATE
EQUITY EXPENSE ALLOCATIONS
BY JOHN ARANEO AND SAMUEL J. LIEBERMAN
It appears the SEC has
adopted a default position
that certain expense
allocations will be
presumed unlawful, unless
they are clearly disclosed.
2. S&G INVESTMENT MANAGER ALERT MARCH 2016 • PAGE 2
The SEC Turns Up the Heat on Private Equity Expense Allocations (continued from page 1)
relied on the absence of clear disclosures in the
underlying offering documents, expressly granting
the PE Manager the discretionary rights to allocate
the exact expense(s) at issue. Moreover, the SEC
has considered the surrounding circumstances
regarding these allocation decisions, including
the existence and implemen-
tation of a robust compliance
program designed to identify
and eliminate the misallocation
of expenses, a demonstrated
willingness to remediate any
wrongdoing, and the subject
PE Manager’s proactive, coop-
erative efforts, as factors that
affected the SEC’s settlements.
Perhaps the seminal case in
this area, against industry
titan Kohlberg Kravis & Roberts
(“KKR”), involved broken-deal and due diligence
expenses.9 In this case, the PE Manager advised
several entities, including on the one hand, typical
funds for ordinary investors and, on the other, enti-
ties set up specifically for “co-investors” (some of
whom were KKR executives and affiliates). Analyz-
ing records spanning a six-year period, the SEC
found that the PE Manager allocated $338 million
in broken-deal and due diligence expenses exclu-
sively to its ordinary investors, without allocating
any of these expenses to the co-investment vehi-
cles – even though such co-investment vehicles
were participating in the deals that generated the
expenses. Of this $338 million, the SEC concluded
that $17 million should have been borne by the
co-investors. The SEC charged this PE Manager
with misallocating fees, disclosure violations, and
failing to implement an effective compliance pro-
gram. The SEC imposed $30 million in disgorge-
ment and civil penalties to settle this case.
Another equally high-profile case involved Black-
stone Management Partners, and focused on the
allocation of: (i) portfolio company monitoring fees
charged by the PE Manager that were accelerated
at the time of an IPO or private sale; and (ii) legal
fee discounts that were given disproportionately to
the PE Manager over the PE Funds.10 In this case,
the PE Manager elected to accelerate the payment
of long-term monitoring fees from several of its
portfolio companies, upon the sale or IPO of such
businesses. But the PE Manager did not clearly
disclose that it would do so in its offering docu-
ments – and such fees are a conflict of interest
because they pay the PE Manager while simul-
taneously making the portfolio companies less
profitable to Fund investors. The PE Manager also
lying funds to borrow money from the PE Manager,
at a high interest rate of 17%;12 (iii) having port-
folio companies pay consulting fees to a PE Man-
ager’s affiliated entities, when those consulting
fees should instead have been paid to the PE Fund,
absent clear disclosure to investors;13 and (iv)
allocating the PE Manager’s own, separate legal,
compliance and consulting fees related to register-
ing as an investment adviser and maintaining a
compliance program to the underlying fund.14
A review of these cases is helpful to show the
types of expenses that the SEC will closely scruti-
nize, and the likely focus of SEC examinations, to
identify and substantiate misallocation practices
that work to the detriment of the investors. The
SEC examines these practices through the lens
of monitoring a fiduciary for
conflicts of interest. Addition-
ally, we see that the SEC will
fault the absence of a compli-
ance program (e.g., procuring
“sham” compliance manuals
that are never implemented
or integrated) and, conversely,
will reward a PE Manager’s
proactive measures in devel-
oping a compliance environ-
ment designed to self-identify
and remediate these conflicts
and misallocations.
What is clear is that the SEC is
giving heightened scrutiny to PE Manager expense
allocations, and it is critical for PE Managers to
adapt to this new era of regulatory scrutiny. Fol-
lowing and understanding these regulatory trends
can no longer be a hobby or incidental – it is abso-
lutely critical. As to the allocation of expenses, PE
Managers must precisely draft (or amend) their
fund documents to provide clear disclosure about
how expense allocations will be made. PE Man-
agers should understand, identify and ultimately
commit to how they will treat various expenses,
and be sure to consult legal counsel, and pos-
sibly also its accountant and fund administrator
into the dialogue. Moreover, PE Managers must
invest in administering a meaningful compliance
program. No longer will the purchase of a largely
boilerplate compliance manual that is relegated
arranged for a preferential discount on the legal
fees charged to it by its lawyers, without obtain-
ing as favorable a discount for its PE Funds. Ironi-
cally, the PE Manager used the sheer volume of
legal work performed on behalf of its PE Funds as
leverage to negotiate the isolated discount applied
to its own legal fees. This action was ultimately
settled, for $39 million in disgorgement and civil
penalties.
Other notable PE expense allocations actions
include similar conduct by PE Managers such as:
(i) co-mingling two portfolio companies in separate
Funds, but making disproportionate allocations of
expenses that benefitted one fund and harmed the
other;11 (ii) charging the PE Manager’s own over-
head (including salaries, bonuses, benefits and
rent) to the funds it managed and causing under- (continued on page 3)
In all its regulatory enthusiasm, the
SEC has made several thematic
pronouncements surrounding its focus
on expense allocation practices, and
the conflicts of interests so inherently
intertwined therewith, and why this
issues has become a key priority.
…the types of expenses that have
attracted SEC attention include broken
deal fees, portfolio monitoring fees,
and legal fees, compliance fees and
operating expenses of the PE Manager,
including compensation paid to its
principals and its employees, employee
benefits, rent and consulting fees.
