The Securities and Exchange Commission (“SEC”) has prioritized investigating private equity firms this year, particularly, their fee structures. This increase in enforcement highlights the SEC’s concern for transparency in fee disclosures (see our previous article on private equity fees) made to investors; a concern that was articulated by Andrew Bowden in his “Spreading Sunshine in Private Equity” speech. Specifically, Mr. Bowden stated that the SEC’s recent examinations of private equity firms indicated that 50% of the examined firms had material weaknesses in their disclosures. Recent enforcement areas include:
- Accelerated monitoring fees. As a part of a private equity firm’s investment, portfolio companies may enter into agreements that include monitoring fees for, on average, 10 years. These fees provide the portfolio companies with valuable advisory services on matters such as restructuring, IPOs and mergers or buyouts. A term associated with these types of fees is that if a company is sold or taken public, these monitoring fees are accelerated into a lump sum. That lump sum payment can reduce the value of the portfolio company before sale, negatively impacting the earnings of the funds and, ultimately, the investors’ returns. While monitoring fees were discussed in the offering documents, the SEC found that the acceleration clause was often not disclosed until later when it was triggered by the sale of a portfolio company. Going forward, firms should ensure their offering documents clearly describe these fees and all of their material terms.
- Broken deal expenses. Firms incur costs for deals that do not close, such as unsuccessful buyouts. These expenses, including diligence of the deal and related costs, are then allocated to the fund. This can become an issue for fund complexes that include a primary fund comprised of the majority of the outside investors, along with parallel vehicles for investors with specific needs, and employee co-investment and others. The SEC found that some managers allocated broken deal expenses to the primary fund and not the parallel vehicles. In particular, not allocating these expenses to the employee co-invest raised concerns for the SEC. Firms should establish a uniform process for distributing fees among all vehicles in a fund complex and disclosing this process to investors. (See our article on private equity co-investment)
- Conflicts of interest. Occasionally firms use the same service provider for firm business as they do for their funds. It is also fairly common in private equity, venture and real estate investing to retain the same specialty service providers for multiple funds, deals or projects. In one case, the SEC found that retaining a law firm that provided discounts to the firm in exchange for the fund’s business created a potential conflict of interest. Specifically, the SEC believed that this benefitted the firm at the cost of investors (even though there may well be an argument for overall cost savings and efficiencies for the firm and funds alike). In order to avoid SEC scrutiny, firms should evaluate all service providers to funds, portfolio companies, deals and projects, paying particular attention to those in common with the firm. Even when these arrangements ultimately benefit funds and their investors, the SEC may find the potential for conflicts of interest.
The SEC does not expect firms to carry all the expenses of their funds’ investment activities. However, firms should act on the SEC’s concerns about fees, expenses and other potential conflicts of interest. Key initiatives may include reviewing and revising their fee disclosures for transparency, establishing policies and procedures for selecting and monitoring service providers, allocating fees and expenses among various funds and reviewing potential conflicts of interest.