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SEC Undisclosed Fees, Expense Shifting, and Failure to Disclose

MyComplianceOffice and guest speaker Timothy Goodwin of Blueriver partners presents a discussion from our July webinar on SEC Undisclosed Fees, Expense Shifting, and Failure to Disclose



Timothy Goodwin

Mr. Goodwin has over 13 years of regulatory compliance, internal audit and management experience. Prior to joining Blue River Partners, Mr. Goodwin spent over six years with TPG Capital, LP, a leading global private investment firm with more than $70 billion in assets under management. He most recently served as Director of Enterprise Risk Management and Internal Audit with a focus on documenting and testing TPG’s fee and expense allocations across private equity funds and business platforms.


 You can download a full copy of the slides from this webinar.



Full video transcript available below:

Related Enforcement Actions

Next slide, related enforcement actions. Because there aren't any real legislative framework to dictate how to categorize, I'm sorry, that governs the allocation of fees and expenses, I though the best way to figure out where problems can come up is to just go through some of the selected enforcement actions over the past year since the Sunshine and Private Equities speech, just to get an idea of what the SEC is looking for. The framework I used here, the related enforcement actions, is actually something that the SEC has spoken about, these 3 areas and how they categorize the enforcement actions that have happened so far. It's not something that we're making up here in a vacuum.

Next slide. The first item is undisclosed fees and expenses. Under the bucket of undisclosed fees and expenses, an issue that came up for Blackstone in an enforcement action was, there's 2 here, first one is accelerated monitoring fees. Typically Blackstone would enter into monitoring agreements with its portfolio companies, whereby it would provide services to the portfolio companies in exchange for a fee. In certain cases though, when Blackstone would sell an asset that it had had an agreement to provide monitoring services for a given period of time, at the time it sold the company it would accelerate those monitoring fees via a lump sum payment. Those lump sum payments were not included in any other their disclosure documents prior to 2012. What the SEC stated was that Blackstone had essentially accelerated and received those fees without disclosing them in their documents. Interesting point about the case is that prior to the onset of the SEC's investigation, Blackstone had self-corrected all of these items. They decided to no longer accelerate the monitoring fees in certain cases and then if they were, as you see, in the event of an IPO, they disclosed the practice in the relevant offering documents.

The second one here is legal fee discounts. In this case, what Blackstone did was, they entered into a legal services arrangement in 2007, for both a management entity and a related funds. The amount charged to the management entity was less than what was charged to related funds. According to the SEC, the SEC didn't state this but, it looked like Blackstone was leveraging the relationship and their ability to direct the fees of the funds to benefit the management company. Again, you see there, Blackstone, prior to the SEC coming in and examining this practice, Blackstone voluntarily terminated the arrangement and then disclosed in to its investors.

The end result here was a pretty large settlement against Blackstone. They had a disgorgement of 28.9 million dollars and a civil penalty of 10 million. Pretty draconian response and settlement in the end for Blackstone.

On the next slide we get into the second category that the SEC identified and that is expense shifting. You see the 2 examples here, broken deal expenses and portfolio company expenses. In the case of broken deal expenses, that was an action against KKR. At these large private equity firms like KKR, they're going to have flagship funds, which are your classic private equity funds that pay 2 and 20, but then they're also going to have co-investments. Those co-investments can take the form of individual co-investment vehicles that are formed for 1 investment so that would be an instance where a flagship fund does not want to take on a huge position.

Additionally, there can be instances, and there was at least 1 at KKR, where they will have co-investment funds. The co-investment funds will be used to invest alongside the flagship funds in certain cases. Those co-investment funds, the key difference between a co-investment fund and a co-investment vehicle formed for one investment, is that a co-investment vehicle typically will not charge fees while a co-investment fund will. The reason why that's interesting here, or relevant here, is because in the case of broken deal expenses, the flagship funds in their agreement stated that they would bear the cost of any broken deals but the co-investors did not, obviously, because they don't pay any fees. The co-investment fund though, do pay fees. Regardless, the SEC stated that all the co-investors, the investors in those vehicles and the investors in those funds, should have been allocated those broken deal expenses because expenses that did not happen, even though they do not result in a co-investment, the co-investors are receiving the benefit of that research for the broken deal that did not happen.

This one is tricky in that it didn't exactly occur to a lot of people in the industry that this would be an issue, specifically because co-investments typically do not charge any fees so it wouldn't make sense that you could allocate broken deal expenses. Obviously what the SEC wants firms to do is to take a look at all types of expenses that other, either funds or other entities can benefit off of, and to make sure that you allocate an appropriate amount for all investors that receive that benefit.

The next one, portfolio company expenses. This is another tricky one as far as in the industry whether it was expected something like this to happen or not. In this case, Lincolnshire Management managed 2 funds that purchased separate portfolio companies. Their practice was to generally allocate those expenses based on each company's respective revenue, because at one point Lincolnshire decided to combine the operations of the 2 portfolio companies. When the SEC, in the SEC's release about this case, they talked about the different types of expenses that 1 portfolio company bore versus the other portfolio company. You see there, on that last bullet, the detail that they went into.

When I explain to people how you have to think about fees and expenses, this is the level of detail that we're talking about. The SEC is really not considered, it's not thinking about any materiality standard. The materiality, I think is effectively 0. You have to allocate expenses correctly according to a methodology and categories that are disclosed in your relevant offering documents. The details I'm talking about there would be the overhead for certain employees that were providing shared services was allocated to one portfolio company and then certain products were purchased at cost. You see the level of detail there that they're thinking about. The case is a little unique, in that one of the portfolio companies in this case was not paying monitoring fees so it looked like there may have been some financial distress on one of the portfolio companies, so I think that the SEC was thinking that it was the one portfolio company that was under financial stress was, and the fund that owned that portfolio company, was disadvantaged versus the other portfolio company. That's the key there but, even then, the level of detail that they went to for all of the expenses was quite surprising in my opinion.

The next slide, just a continuation of the expense shifting. Something that is probably top of mind for attorneys and compliance consultants like myself, you see there that Cherokee was charged with allocating the funds of legal consulting and other expenses. This was for registering as an investment advisor, responding to a SEC examination and responding to an SEC expense allocation investigation, which is likely what ultimately resulted in the settlement. The disclosure documents did not specifically state that the funds would be [borning 00:22:53] these costs for the advisor. It's key to remember, even if the fund triggers a registration, the advisor, unless specifically stated otherwise, the advisor should be bearing those expenses.

Next one is failure to disclose conflicts of interest. This is a good one, just because the SEC is definitely very focused on any operating partners that are performing services on behalf of portfolio companies. In this case, an egregious example of what this private equity firm did. They were providing service to portfolio companies and those services that was paid to the advisor were offset against management fees, at least 80% of them were. When Fenway Partners created a new entity and had some of those same employees switched over to that entity and then provide the same services, then that portfolio company, because the portfolio company was paying Fenway Consulting and Fenway Partners, they were no longer offsetting those fees. Fenway Consulting was an affiliate and so the SEC thought that they were just shifting the expenses to avoid that management fee and the inherent conflict there.

On the next slide, this one is more about affiliated transactions but still relevant about a disclosure of conflict of interest, just because of the fees that would be involved with a loan, which was referenced in this case. 

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