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Private equity funds must maintain strong operational standards in the face of increased enforcement actions by the SEC.  Fees passed on to private equity funds by the fund manager have recently come under increased scrutiny.

The SEC put the private equity world on notice with enforcement actions against some of the industry’s biggest players in the summer of 2015.  Blackstone incurred a $10 million fine and was required to reimburse investors an additional $29 million due to failures of disclosure on accelerated monitoring fees.  Around the same time, KKR was fined $30 million for failing to disclose, in sufficient detail, information regarding broken deal fees expensed at the fund.

The focus on fees at private equity funds continued into the fourth quarter of 2015.  Several fund managers were fined by the SEC in November.  In one example, the fund manager ran afoul of the SEC for allocating expenses incurred for the fund manager’s legal and compliance requirements, while not disclosing this fully to investors.   In another similar action, the SEC fined a fund manager for improperly passing on compliance consultant fees and expenses for the fund manager’s supplies, computers, and utilities to the fund without proper disclosure.

Considering the zeal with which the SEC is investigating PE funds’ fees and expenses, what are the key takeaways for PE fund managers?  First, general disclosures in a fund’s offering documents regarding the allocation of fees and expenses do not give a manager as wide a discretion as the managers may have thought.  For example, language that allows a fund to be charged for expenses arising out of the operation of the fund made in a good faith judgment of the manager does not allow the manager to charge the fund for expenses incurred for the manager’s legal and compliance requirements.  These general disclosures are very common in fund legal documents, but recent SEC actions show this language is narrower than perhaps expected.

Second, managers need to examine their legal agreements to address the SEC’s approach.  The SEC’s actions demonstrate that the fees and expenses of the fund manager cannot be expensed to the fund unless expressly stated in the fund’s legal documents.  If a fund’s legal documents are silent or vague in this regard, the managers need to review their compliance procedures to be sure that policies and practices are in place to determine and monitor how expenses are allocated.

PE fund managers should also be aware that the SEC plans to continue down this path of focusing on fees and expenses at private equity funds.  At the SEC Speaks conference in Washington, DC in February 2016, Marshall Sprung the Chief of the Asset Management Unit of the SEC’s Division of Enforcement said he expects the SEC to bring cases involving misallocations of fees and expenses in the private equity context in 2016.  So expect much of the same in 2016.

In conclusion, the SEC will continue to focus on managers’ allocation of fees and expenses in PE funds.  A manager should be clear when writing their legal agreements and be sure they are knowledgeable on the terms of their current agreements. Should you have any questions on your current allocation methodology, Piedmont is prepared to lend our experience.