November 6, 2015
By: Jaqueline M. Hummel, Managing Director
As promised, I am continuing my two-part series, with this article providing additional recommendations for private equity and hedge fund managers for 2016. First and foremost, I recommend performing a top-to-bottom review of all fees and expenses earned and charged by private funds to determine whether disclosure to investors is required. Second, if your firm is interested, develop procedures for establishing a “substantive relationship” with potential investors using the internet following the latest guidance from the SEC.
Perform a comprehensive review of all fees and expenses earned and charged by private funds to determine whether disclosure to investors is required and/or adequate
For private fund advisers, the message is the almost the same as in 2014: focus your efforts on ensuring appropriate disclosure of fees, scrutinize the allocation of fund expenses, and look for undisclosed conflicts of interest. SEC Chair Mary Jo White highlighted the Commission’s concerns in a speech given October 16, 2015. For example, three private equity fund advisers in The Blackstone Group agreed to pay nearly $39 million to settle charges that they failed to disclose to investors about their receipt of accelerated monitoring fees and discounts on legal fees. In a case brought against Kohlberg Kravis Robert & Co., L.P. (“KKR”), the SEC found that KKR had misallocated more than $17 million in broken deal expenses to its flagship private equity funds. The SEC said that KKR required the funds to pay the costs for nearly all expenses incurred to pursue unsuccessful investment opportunities, while KKR’s co- investors, including KKR executives, were not required to pay any of these costs. KKR ended up paying almost $30 million to settle the charges, as well as a $10 million penalty. In yet another case, the SEC charged a private fund adviser, its principal, general counsel and its outside auditor with using fund assets to pay the adviser’s operating expenses without disclosing the practice to investors. The firm and its principal were required to pay disgorgement of approximately $470,000, and a penalty of $200,000.
Here is where it gets tricky for compliance officers. There is no accepted standard for private equity funds to report their fees and expenses, and in some of these cases, disclosure was provided. For example, the Blackstone Group disclosed the fact that it was receiving monitoring fees both before and after receipt. The SEC objected to the fact that the group did not disclose the acceleration of the monitoring fees upon a sale or initial public offering. Blackstone did, however, disclose to investors that the accelerated fees were paid, and investors did not object. Similarly, in at least one of KKR funds (the 2006 Fund), the limited partnership agreement stated that the fund would pay all broken deal expenses.
The SEC seems focused on the issues of fairness and fiduciary obligations. In both the Blackstone and KKR cases, the fees were disclosed to investors, but the SEC found the advisers guilty for not providing more explicit disclosure, specifically in those situations where the adviser seemed to be getting extra benefits. The SEC was clear in both cases that because the advisers were cooperative with staff in discussing and addressing the issues, the fines and penalties were less onerous than they might have been.
So as a compliance officer, how do you address this type of issue in the compliance program? One place to start might be the Institutional Limited Partners Association (ILPA), which recently proposed a disclosure template. At a minimum, this document provides a list of various categories of fees and expenses and common definitions. A compliance officer can also review the limited partnership agreement, operating documents and the confidential private offering memorandum to determine whether all the disclosures regarding fees and expenses are consistent. Focus on the disclosure of how fees and expense are allocated – are these practices described in the offering memorandum or discussed in the limited partnership agreement? Are there written procedures regarding these allocations and are they being followed?
It is also important to review the fees paid by the fund to the General Partner, Investment Adviser, directors, operating partners, consultants, or service providers related to the General Partner. Are the fees disclosed in the offering memorandum? Are all related-party relationships and related-party transactions being disclosed? Are fees and expenses being charged consistently with the disclosure provided? Are there fees being charged to investors that are not disclosed or contemplated by the partnership agreement, such as for administrative expenses, or reorganizations? Are there any fees received by the General Partners, Investment adviser or other related parties that should be offset against the management fees, and are those offsets being taken? Consider whether the investment adviser has received any other benefits that should be disclosed, such as a discount on legal fees as a result of the extensive legal work required by the fund. In the Blackstone case, the SEC found the firm breached its fiduciary duties by failing to disclose a legal fee arrangement, where the adviser got a discount on its legal fees that was not passed along to the funds due, in large part, to the significant legal fees generated by the funds.
In a recent case, the SEC charged Fenway Partners, an investment adviser, with breaching its fiduciary duty by failing to disclose conflicts of interest to investors in its fund, when fund assets were used to pay a consulting firm that was primarily owned and operated by the principals of Fenway. In that case, Fenway Partners originally had contracts to provide management services to portfolio companies held by one of its funds. The fees paid to Fenway Partners for these services were offset against the advisory fees paid by the fund. However, the contracts were terminated at the end of 2011, and a new entity, Fenway Consulting Partners, LLC, provided the same services to the portfolio companies. The fees paid to the new consulting firm were not offset against the management fees paid to Fenway Partners, resulting in a higher advisory fee paid by the fund. The principals of Fenway Partners owned 84% of Fenway Consulting.
As a result of the SEC’s administrative proceeding, Fenway Partners, and its principals agreed to jointly and severally pay disgorgement of $7.892 million and prejudgment interest of $824,471.10. The principals and the CFO/CCO also agreed to pay penalties totaling $1.525 million. The SEC will put the total amount of $10,241,471.10 in a fund for harmed investors.
But without an accounting or audit background, it may not be easy to determine whether disclosure to fund investors is adequate. Compliance officers should be able to rely on fund accountants and the fund’s independent auditor, but the SEC has not provided much guidance on this issue. For example, the independent fund accountants were not even mentioned in the KKR or Blackstone cases. In the Alpha Titans case9, however, the SEC found that the lead engagement partner on the audit, Lesser, had shirked his responsibilities to conduct the fund audits from 2009 through 2012 in accordance with generally accepted accounting principles (GAAP). He failed to exercise “professional skepticism” throughout the audit process, failed to supervise the audit, and failed to adequately document audit work.
Similarly, in the Fenway Partners case, the firm’s Chief Financial Officer and Chief Compliance Officer was cited by the SEC for his failure to preparing the financial statements in accordance with U.S. GAAP, since he did not consider the payments to Fenway Consulting as related party transactions, and therefore did not include disclosure of the arrangements in the fund’s financial statements. In 2013, when an independent auditor was hired to prepare the fund’s financial statements, the firm was forced to disclose the relationship and the payments to Fenway Consulting.
Compliance officers can take some comfort in the fact that the SEC has begun to hold accountants and auditing firms responsible for failing to perform their duties in accordance with the standards of their profession. It is encouraging (at least for compliance officers) that in the Alpha Titans and Fenway Partners cases, the SEC specifically noted that the accountants should have disclosed the conflicts of interest to fund investors. These cases seem to indicate that it may be reasonable to rely on fund auditors to determine whether fund fees and expenses are appropriately allocated and related party transactions disclosed.
Develop Policies for Documenting a Substantive Relationship with Potential Investors through a Website
Last year there was a lot of buzz around the new Rule 506(c) under Regulation D, which allows private placement issuers to use “general solicitation” to raise money from qualified investors. To take advantage of this rule, however, all fund investors must be accredited, and the requirements for verifying accredited status are more stringent than under the existing Rule 506(b). So many private fund advisers continue to rely on Rule 506(b) under Regulation D, which allows them to avoid publicly registering their funds with the SEC, as long as they do not use “general solicitation and advertising” to find investors. To avoid engaging in “general solicitation and advertising”, issuers have to have a prior “substantive, pre-existing relationship” with potential investors.
The good news is that the SEC recently came out with no-action relief on this issue, providing specific guidance on how issuer can establish a substantive relationship with a potential investor using a website. The request was made by Citizen VC Inc. (“CitizenVC”), a venture capital firm that offers interests in limited liability companies of special purpose vehicles (“SPVs”).
So CitizenVC proposed the following process:
- Require an interested investor to complete an online “accredited investor” questionnaire, which is evaluated by CitizenVC and, if appropriate, the company initiates a “relationship establishment period” with the potential investor;
- Contact the investor via telephone to evaluate the investor’s sophistication and financial situation, including calling to discuss the potential investor’s “experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist CitizenVC in understanding the investor’s sophistication”;
- Communicate online with the potential investor, notifying him or her that the minimum investment is $50,000 and encouraging him or her to explore the website and ask questions about the investment strategy, philosophy and objectives;
- Use third-party credit reporting services to confirm the potential investor’s identity and obtain credit/financial information of such potential investors’ suitability.
Once CitizenVC is satisfied that the investor has sufficient financial sophistication to appreciate the risks of the investment opportunities offered by the company, and that a substantive relationship with the prospective investor has been created, then the investor may be admitted as a member and given access to the offerings (and related offering materials) on the website.
The SEC approved the request for no-action relief based on CitizenVC’s representations. Private fund managers can use this letter as a roadmap for developing their own processes for developing “substantive relationships” with potential investors using a website.
I hope you have found these recommendations helpful. I welcome your feedback.