Fee and expense allocation between funds and their managers has been the subject of renewed scrutiny by regulators and investors. The allocation of such fees and expenses directly impacts the performance of the fund and the manager. In particular, the SEC's Office of Compliance Inspections and Examinations (OCIE) is focusing on the allocation policies, procedures, and practices of fund managers and, in some cases, is levying penalties ranging from thousands to millions of dollars.
Following OCIE's "Presence Exam Initiative" in 2012 and the establishment of its Private Funds Unit in 2014, OCIE Director Andrew J. Bowden identified certain risks inherent in the private equity model, ranging from the allocation of expenses to the lack of transparency in a fund's organizational documents.1 Director Bowden has indicated that poor disclosure in these areas is a frequent source of exam findings, and, in particular, shifting expenses during the middle of a fund's life, absent proper disclosure, is problematic.
Among OCIE's examination observations, it has specifically noted the allocation of legal and consulting costs of fund compliance, and costs associated with registering as an investment adviser. Similarly, based on the terms typically included in many fund organizational documents, Director Bowden noted that costs associated with client relationship management software, automation software, and various back-office functions generally would be borne by the manager. Another common deficiency noted by the SEC involves the allocation of "dead deal" expenses to co-investment vehicles (i.e., legal and diligence costs associated with unconsummated transactions). Here, too, Director Bowden indicated that co-investment vehicles investing alongside the main fund often are not allocated a portion of such dead deal expenses.
In a recent SEC investigation, the SEC found that a private equity firm and certain of its executives failed to disclose conflicts of interests to a fund client and investors. In this instance, fund and portfolio company assets were used for payments to former firm employees and an affiliated entity. The SEC stated that by making the payments, the firm avoided management fee offsets that would have benefitted their fund clients.
Fund managers ought to tread carefully when allocating expenses and be mindful of the impact such allocations can have on performance, particularly given regulatory scrutiny in this area. To the extent that an expense would fall into one of the risk areas identified by the SEC, fund managers may be wise to consider disclosure in the fund organizational and offering documents.