SEC Announces Continued Scrutiny of Private Equity Fees and Expenses in 2015

January 26, 2015

On January 13, 2015, the SEC's Office of Compliance Inspections and Examinations ("OCIE") announced its "Examination Priorities for 2015." Notably, OCIE stated it will continue to focus on private equity fees and expenses "given the high rate of deficiencies that we have observed among advisers to private equity funds in connection with fees and expenses." The announcement signals added scrutiny of the private equity industry, which began intensifying in 2014. The SEC's focus on private equity fund fees and expenses has already resulted in multiple enforcement actions, including those against Lincolnshire Management, Inc. and Clean Energy Capital, LLC, and more are expected.

Below is a summary of certain practices of private equity fund advisers relating to fees and expenses that have been identified as issues during SEC examinations and/or ACA reviews of private equity fund advisers. Some of these practices also have been scrutinized by the national news media.

Dead Deal Expenses

Advisers may incur expenses associated with deal due diligence for prospective investments that are not consummated. In these instances, standard allocation methodologies may not be the most appropriate. Additionally, certain funds' governing documents may not dictate how such "dead deal" expenses should be allocated. The following dead deal expense-related issues have been cited:

  • Advisers failed to contemporaneously document the intended allocation of prospective deals, resulting in potential misallocations of due diligence expenses when deals are ultimately determined to be dead.
  • Advisers improperly allocated expenses associated with dead deals and capitalized them as part of future, successful deals.

Consideration of Co-Investment and Parallel Vehicles

Advisers may structure vehicles that participate in all deals alongside main funds on a pro-rata basis ("parallel vehicles") and/or vehicles that participate alongside main funds in a single investment on a case-by-case basis ("co-investment vehicles"). In both instances, advisers should be thoughtful about how expenses associated with such vehicles are allocated. The following related concerns have been noted:

  • Parallel vehicles were not allocated their share of ongoing expenses related to deal sourcing and due diligence, including dead deal expenses.
  • Co-investment vehicles were not allocated their share of ongoing expenses related to the investments in which they participated.
  • Advisers did not specify each distinct allocation methodology associated with parallel vehicles and co-investment vehicles when drafting their internal expense allocation policies and procedures.

Transaction, Monitoring, and Other Fee Income

Advisers may negotiate agreements with portfolio companies that provide for payment of fees when a transaction is consummated or on an ongoing basis for advisory or other services rendered. In addition, employees of an adviser may receive fees directly from a portfolio company, such as for board service. Such fees may create a conflict of interest. The following potential issues have been cited:

  • Advisers did not clearly disclose each specific type of fee that they, their employees, or their affiliates received from funds, portfolio companies, or other third parties.
  • Fees that should have offset management fees were misclassified, allocated inaccurately, or not applied in a timely manner.
  • Advisers failed to disclose fees received in conjunction with their management of group purchasing programs.
  • Advisers did not disclose potential conflicts associated with receipt of accelerated monitoring fees after sales or initial public offerings of portfolio companies.
  • Advisers failed to adequately oversee and track cash and noncash compensation (e.g., restricted stock, options) received by employees for portfolio company board service.
  • Advisers did not disclose the receipt of discounted or free portfolio company goods or services by employees or affiliates.

Policies, Procedures, and Controls

According to a survey administered by ACA in mid-2013, only 50% of private equity fund adviser responders indicated they had adopted written expense allocation policies and procedures. SEC examination staff generally expects advisers to implement written policies and procedures governing fee and expense allocations. The following potential issues in this area have been cited:

  • Advisers failed to maintain detailed written policies and procedures governing employee travel and entertainment, which may cause inappropriate expenses to be allocated to funds or portfolio companies.
  • Advisers failed to maintain formal procedures for reviewing and approving agreements with "senior advisors" and/or "operating partners," preventing the advisers' compliance departments from assessing whether new or enhanced disclosures or policies were necessary or whether fee offsets or expense allocations should be considered.
  • Advisers allocated portions of in-house employee salaries and other overhead to funds and/or portfolio companies without clearly disclosing such practices and maintaining procedures for accurately tracking time allocated to fund and portfolio company matters.

We hope this summary helps you identify potential issues at your firm, and we encourage you to take any corrective action necessary. As a reminder, ACA offers assistance to private equity fund advisers seeking to gain comfort with, or enhance, their current fees and expenses practices, policies, procedures, and disclosures. In addition, our services include mock regulatory audits, detailed reviews of compliance policies and procedures, annual compliance program reviews, and on-site assistance during actual regulatory exams, among other things. Our experienced team of regulatory experts provides compliance advice and assistance to some of the most respected and well-known private equity fund managers around the world. Our services can help your firm detect potential compliance issues and prevent unwanted regulatory exposure.

For more information on ACA's services, please contact Luke Wilson via email or at (312) 505-0307 or Jack Rader via email or at (973) 631-1085.