With the US Securities and Exchange Commission calling private equity fund managers to the carpet for their fees and expenses, managers had better start preparing to be a lot more forthcoming about their practices to investors.
Regulatory exams are just around the corner, warn operations and legal experts. At issue is what expenses should be absorbed by private equity fund managers as part of their management fee and what expenses should be charged to the fund — and ultimately paid for by investors — as part of operating costs. The SEC also wants investors in private equity funds — not only high-net worth individuals, but also pension plans, endowments and insurance firms that represent pools of underlying individual participants and retail investors.
Reprimands, refunds of fees and hefty fines are within the realm of penalties for poor practices and disclosure as evidenced in a recent settlement involving Arizona-based private equity fund manager Clean Energy Capital LLC and its president Scott Brittenham. They agreed to reimburse some of their funds about US$2 million that had been charged to the funds for compensation, office space, gifts and business cards.
The US regulatory agency, which won the right to oversee private equity fund and hedge fund managers through the 2010 Dodd-Frank Wall Street reform law, discovered what it considered to be deficiencies in how fees and expenses were charged and disclosed to investors when subsequently it conducted its “presence exams.” Among the charges the SEC finds the most problematic are investment banking fees, transaction fees and monitoring fees.
The SEC believes investors are often being charged for operating costs which should be considered management fees without knowing what they are paying for. Whatever is charged as an operating expense will typically come out of the earnings of the fund and potentially reduce how much investors make.
So just what should private equity fund managers do for starters? “It’s time for chief compliance officers, chief financial officers, chief operating officers and external legal counsel to have a hard talk with each other on how to account for their fees and expenses which are typically tracked on an operating expense application,” recommends Eric Bernstein, chief operating officer for alternative funds technology provider eFront in the US. That is, all expenses are tracked in the general ledger, and some of the fees feed into a fund accounting system. Operating expense charges are broken down as line items in investor statements if the firm is required or chooses to disclose such detail.
What results should emerge from these in-house discussions? “Managers should prepare a list of all the direct and indirect fees they are collecting as well as all expenses being charged to the fund,” says James Hnilo, a partner with Reed Smith in Chicago. “Once they have done this they need to determine, with the help of counsel, if everything on the list has been clearly and accurately disclosed to investors.”
Amy Poster, a director at the financial services advisory practice for New York-based Berdon LLP, also recommends that private equity firms take an “open kimono” approach to disclosure of fees and expenses in the spirit of transparency. That would require formalized policies and procedures to define how fees and expenses are calculated as well as to review and monitor the accuracy of fee calculations and charges.
In a best-case scenario, everything will match up with what has already been disclosed to investors. If not, private equity fund managers may decide to change their policies or even go so far as to eliminate some of the expenses in the first place by doing away with unnecessary third-party consultants.
“In some cases, private fund managers may even decide to change information on fees included in Form ADV,” says Donald Babbitt, the New York-based director of compliance for Kinetic Partners, a division of Duff & Phelps. As fiduciaries the investment advisers, which file the documentation with the SEC and state regulators as part of their registration process and whenever investor brochures are updated, are required to disclose the correct data. However, as Babbitt cautions, changing data on the Part2A section of Form ADV shouldn’t be taken lightly. The reason: it could itself trigger an unwanted regulatory audit.
What should investors be told? “Disclosure will mean outlining the types of expenses accompanied by a detailed description of allocations,” recommends Poster. Private equity fund mangers should also issue an interim investor memorandum in discussing any changes to fees and expenses being charged to the fund.
Of course, investors need to do their part and stay alert. They should pay attention and periodically review and verify that fees and expenses charged to the fund are within the terms outlined in the limited partnership agreement as acceptable, urges Poster.
Private equity funds along with their hedge fund brethren are typically categorized as alternative funds, which can make up as much as eight percent of a pension plan, endowment or insurance firm’s portfolio allocation. But there is one critical difference. Hedge funds will often invest in exchange-traded or other liquid instruments, whereas private equity funds often invest in real estate or other illiquid assets. As such, private equity funds need to spend money on managing underlying portfolios, which hedge funds don’t.
Private equity fund managers claim classification of operating costs can be a matter of interpretation. And so can the extent to which they should be explained. “It’s not exactly as black and white as the SEC thinks,” says one compliance director at a New York private equity fund management shop. “We weren’t trying to hide anything, nor were we trying to rip off investors. The SEC just doesn’t understand how private equity funds really work. They are by no means the same as mutual funds.”
Mutual funds must follow the Investment Company Act of 1940, which is pretty detailed and prescriptive as to what they should explain to the SEC and investors. Not so with private equity fund advisers. “They also have a fiduciary obligation to take care of their investors under the Investment Advisers Act of 1940, but there is far less clarity as to what they should disclose,” acknowledges Babbitt.
When the general partner of a private equity fund is also its investment adviser, state laws and not federal regulation typically govern the relationship between the investment adviser and investors, say some legal experts. “State law can give managers a lot of discretion in dealing with limited partners,” asserts Aegis Frumento, a partner with the New York law firm of Stern Tannenbaum & Bell, who represented Clean Energy and its president in their proceeding against the SEC. “Granted, that leeway may not always be what the SEC thinks is in the best interest of direct investors, but the SEC often overreaches its authority when it interferes with the internal governance of private equity funds where the fiduciary obligations of general partners to their investors are governed by private agreement and not the Advisers Act.”
According to Frumento, Congress did not anticipate modern private equity funds when it passed the Investment Advisers Act. As written, the Advisers Act can only address the responsibilities of a private equity fund manager to the fund itself. “To leapfrog the fund and make the Act apply to the investors of the fund requires stretching the language of the Act,” argues Frumento. A better solution, he believes is to have Congress change the language of the Act.
However, for now, the SEC appears more than willing to use its muscle to convince private equity fund managers that it is in control regardless of what either they or their legal counsels believe is fair.
Topping the list of eggregious behaviors, say SEC officials, are expenses related to what private equity fund managers call “operating partners.” Those are everyone except the actual portfolio directors who decide just what to invest and what to divest. “They are individuals providing the additional services which help the private equity fund managers and would be considered by financial service professionals as consultants,” explains Jay Baris, director of the investment department with the law firm of Morrison Foerster in New York City.
So how do private equity fund managers account for those services? “They may suggest they are members of the management team by listing their names and credentials in the same category,” says Baris. “The SEC believes that doing so may cause investors to think these costs should be absorbed by the private equity fund manager out of the management fee. Instead it is charged as an operating cost, which comes out of the pockets of investors.”
Private equity fund managers also get paid by investors for monitoring their investments, but what if they decide to sell a particular investment in the seventh year of a ten-year agreement? Should they still get paid a monitoring fee for the rest of the term? Apparently, that’s what some private equity fund managers feel and will include those additional fees as operating expenses even if no work is done. Fairness aside, investors might not even be aware they are paying those fees.
Private equity fund managers can also pay companies in which they are interested in investing “breakup fees” in the event they are engaged for too long, but don’t get married. The compensation relates to the fact that the potential partner has spent so much time negotiating a deal which never came through that it has an “opportunity cost” for not cutting an agreement with another private equity fund manager. However, the private equity fund manager at fault might not inform investors of breakup fees are being included in operating expenses.
Advice without Guarantees
Given that private equity fund managers, like all investment managers, typically seek and rely on the advice of high-paid expert legal counsel, one would think that the legal counsel, rather than the private equity fund managers should be on the hook for disclosure practices they advice. However as with other financial regulations, the ultimate responsibility lays with the fund manager, no matter how much was paid for advice.
Legal experts contacted by FinOps who were not involved in the proceedings concerning Clean Energy were unwilling to speculate on whether external counsel is often too “liberal” in their interpretations of disclosure requirements and fee policies. In defending themselves against the SEC, Clean Energy and its president did say they followed external legal advice, setting the stage for the SEC to drop the charge of intentional fraud.
Determining whether or not a particular fee or expenses is covered under existing disclosure requirements could come down to a judgement call, but apparently better safe than sorry should be the motto. “If I’m advising the manager, I’m going to strongly recommend against pushing the envelope,” says Hnilo.
Likewise, says Poster, the administrative investment of providing proper disclosures to investors is minimal relative to problems such as being slapped with an SEC deficiency letter or even worse, the reputational risk related to an SEC enforcement action.
Frumento agrees on the need for caution and says that lawyers advising private equity fund managers should act as if the investors are their direct clients by ignoring the existence of an intervening fund. However, such a scenario also comes with its own costs, he cautions.
“Doing so destroys the efficiency of using a fund as a vehicle so as with anything, safety needs to be balanced against being able to run an effective business,” says Frumento. “It’s going to be a hard balancing act for many.”
Just what do private equity fund managers themselves think? One of the five compliance directors of US private equity fund management firms who spoke with FinOps on condition of anonymity sums it up best. “We’re going to have to err on the side of caution,” he says.