The Office of Compliance Inspections and Examinations (“OCIE”) of the Securities and Exchange Commission (“SEC”) recently completed a two-year review of private equity firms. This review, spurred by concern about transparency on issues such as fees, expenses and valuations, was not to uncover any real wrongdoing, rather, it hopes to lead to increased clarity between firms and investors.
PE firms make most of their profits by restructuring the portfolio companies leading to a merger/acquisition, recapitalization or an initial public offering (“IPO”). The SEC worries that, by not clearly describing fees and expenses, firms are effectively hiding fees from their investors. To avoid confusion and regulatory scrutiny, we have some suggestions for firms to consider in reviewing their fee and expense arrangements:
- The title “Operating Partner” is often given to consultants that are integral in the process of restructuring the portfolio company. Firms should ensure that their roles, titles and any associated fees or expenses are clearly described in the offering documents;
- Ensure that the typical costs associated with operation of the fund or parallel vehicles are correctly described in the offering documents and allocated fairly among all vehicles in the fund structure. Any atypical costs or unusual methods of allocation should be emphasized;
- Investor reporting can be extremely time consuming. To the extent that a firm uses an outside vendor or software platform to prepare reports for investors and charges the cost to the fund, the offering documents should disclose the arrangement;
- Unlike hedge funds which rely on a management fee to cover most of a fund’s operations, PE funds may charge a variety of fees either at the fund or portfolio company level to maintain operations;
- For example, firms may charge the portfolio companies a monitoring fee for providing advisory services, which may or may not include directors’ fees. Fund documents usually disclose these, however care should be taken to ensure that anticipated holding periods are accurate and that any acceleration provisions are clear. One strategy for making sure that these disclosures remain accurate over time is to review and re-execute these agreements annually to minimize the possibility of excess fees generated upon exiting the investment;
- All fee and expense descriptions in the Form ADV, marketing materials and investor reporting should be reviewed and revised as needed for consistency with the fund’s offering documents;
- All policies relating to fees and expenses should be stated in the firm’s compliance manual and reviewed regularly to keep up with new funds or evolving practices.
The SEC is just beginning to fully understand the workings of private equity funds and their managers. As such, scrutiny of fees and expenses is likely to continue as the SEC examines firms in this space. Investor demand may also increase in favor of more and better transparency. As the SEC begins to roll out new regulations governing these disclosures, firms proactively implementing these tips and best practices may find themselves ahead of the regulatory curve and attracting new investors.