A settled enforcement action announced by the U.S. Securities and Exchange Commission (SEC) on November 3, 2015 is but one in a growing list of SEC settlements concerning the allocation and disclosure of fees and expenses by private equity managers. In this case, the SEC issued a cease and desist order (Order) against: Fenway Partners LLC (Adviser), an investment adviser registered under the Investment Advisers Act of 1940 (Advisers Act); principals Peter Lamm and William Gregory Smart; former principal Timothy Mayhew Jr.; and chief compliance officer and chief financial officer Walter Wiacek (collectively, Officers).1 Just days after the Order was issued, the SEC reached a settlement with another private equity fund adviser.2

According to the SEC, between 2011 and 2013, the Adviser failed to: fully disclose certain conflicts of interest to a private equity fund client, Fenway Partners Capital Fund III, L.P. (Fund); and to fully disclose to investors in the Fund information relating to payments made to an affiliate for consulting services. As described in the Order, the disclosure failures related to transactions involving more than $20 million in payments made out of fund assets or by portfolio companies to the Adviser’s affiliate, as well as to former employees of the Adviser for services performed in large part while employed by the Adviser, which was in addition to the compensation received while so employed. Because of these alleged failures, the SEC found that the Adviser and certain of the Officers had violated Section 206(2)3 and Section 206(4) of the Advisers Act, and Rule 206(4)-84 thereunder.

Without admitting or denying the SEC’s findings, the Adviser and the Officers submitted offers of settlement, pursuant to which the SEC: (i) ordered the Adviser and the Officers to cease and desist from violations of the Advisers Act; (ii) censured the Adviser, Lamm, Smart, and Mayhew and ordered them to pay $8.7 million in disgorgement and prejudgment interest; and (iii) fined the Adviser $1 million; Lamm, Smart, and Mayhew $150,000 each; and Wiacek $75,000.

Since Dodd-Frank, SEC Scrutiny of Private Equity Advisers Has Increased Significantly

Prior to the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), many advisers to private funds were exempt from registration as investment advisers, pursuant to former Section 203(b)(3) of the Advisers Act. Title IV the Dodd-Frank Act eliminated the exemption previously provided by Section 203(b)(3) – as a result, many previously unregistered advisers to private funds (such as hedge funds and private equity funds) were required to register with the SEC and became subject to its regulatory oversight and enforcement authority.

In 2012, the SEC’s Office of Compliance Inspections and Examinations (OCIE) instituted a Presence Exam Initiative, in order to better understand the unique issues and risks surrounding the newly-registered advisers to private funds. After examining more than 150 private equity firms, OCIE identified several “key risk areas,” including improper expenses, hidden fees, and issues in the marketing and valuation of private equity funds.

Since 2014 – and increasingly so in 2015 – SEC enforcement actions have made clear that the SEC is closely scrutinizing “improper expenses” and “hidden fees.” As SEC Enforcement Director Andrew Ceresney said in connection with one recent settled enforcement action: “[f]ull transparency of fees and conflicts of interest is critical in the private equity industry and we will continue taking action against advisers that do not adequately disclose their fees and expenses ....”5 Director Ceresney’s comments echoed those of OCIE Director Marc Wyatt, who observed that “[b]y far the most common deficiencies ... in private equity relate to expenses and expense allocation.”6 Throughout 2015, the SEC has continued to beat this drum, indicating repeatedly that it intends to bring enforcement actions against private equity firms, and that those actions would relate to “undisclosed and misallocated fees and expenses as well as conflicts of interest.”7

The Adviser is just one of a number of private equity firms that have settled with the SEC in connection with alleged violations of the federal securities laws arising out of the allocation of fees and expenses.8

In the Matter of Fenway Partners, LLC

The SEC Order focused on fees and conflicts of interests, and the disclosures of the same, relating principally to three arrangements.

First, the SEC alleged that the Adviser and Officers had failed to disclose conflicts of interest to the Fund’s Advisory Board, relating to certain agreements made with an affiliate of the Adviser. According to the Order, by 2011 the Adviser had entered into contracts with certain portfolio companies held by the Fund, under which the companies paid fees to the Adviser for certain consulting services. Under the contracts, these contractual fees were offset against the fees paid by the Fund to the Adviser for management services. Starting in December 2011, the Adviser and Officers allegedly “caused” certain portfolio companies to terminate the contracts with the Adviser and to enter into “consulting agreements” with an affiliate of the Adviser, Fenway Consulting Partners LLC (Adviser Affiliate). Pursuant to these consulting agreements, the Adviser Affiliate provided similar services to the portfolio companies as the Adviser had previously provided, often through the same employees. However, $5.74 million in fees paid to the Adviser Affiliate under these agreements were not offset against management fees paid by the Fund to the Adviser. According to the SEC, the failure by the Adviser and Officers to disclose conflicts of interest to the Fund’s Advisory Board relating to agreements made with the Adviser Affiliate was contrary the Fund’s organizational documents, and breached the Adviser’s fiduciary duty to the Fund as its client. The SEC alleged that the “inherent conflict of interest” of the payments to the Adviser Affiliate was not adequately disclosed or authorized by the Fund’s organizational documents, and that the Adviser could not “effectively consent” to the payments to its affiliate.

Second, the SEC alleged that the Adviser, Lamm, Smart and Wiacek made material omissions in connection with a January 2012 “capital call.” According to the Order, in January 2012 the Adviser, Lamm, Smart, and Wiacek asked the Fund’s investors, through a capital call notice, to provide $4 million in connection with a potential investment in a portfolio company. The capital call notice did not disclose to the Fund’s investors that $1 million of the requested amount would be used to pay the Adviser Affiliate, through a contract that would be executed at the same time that the Fund received the $4 million from the investors.

Finally, the SEC alleged that the Adviser, Lamm, and Mayhew failed to disclose a conflict of interest to the Fund’s Advisory Board, and made material omissions in communications with the Fund’s investors in connection with payments made to Mayhew and two former employees of the Adviser. According to the Order, the Adviser, Lamm, and Mayhew caused Mayhew and the two former employees to receive $15 million in incentive compensation from the sale of a portfolio company for services performed almost entirely when they were employed by the Adviser, in addition to the compensation received as employees. In June 2012, the Fund sold its equity interest in a portfolio company and, as part of the deal, Mayhew and the former employees were included the portfolio company’s cash incentive plan (CIP). Because the existing CIP was expanded to accommodate payments to Mayhew and the former employees, the Fund’s return on its investment in the portfolio company was reduced. The SEC alleged that the CIP payments should have been disclosed as a related-party transaction, because the payments were granted at a time when Mayhew and the former employees of the Adviser were also employees of the Adviser Affiliate, and were for services performed while they were employed by the Adviser. The SEC further alleged that the Adviser, Lamm and Smart made, and Wiacek made or caused to be made, material omissions to investors concerning the CIP payments.

Conclusion

It is anticipated that the SEC will continue to scrutinize the manner in which private equity fund advisers allocate fees and expenses, especially where limited disclosure relating to the allocation may be deemed insufficient, or where a potential conflict of interest may exist in connection with the allocation. Private equity advisers should ensure that they have written compliance policies and procedures that govern the allocation of fees and expenses, and such policies and procedures should be reviewed on a regular basis to ensure ongoing compliance. In addition, offering or disclosure materials provided to investors should reflect the terms of the adviser’s compliance policies and procedures. Finally, advisers’ principals and employees should highlight to investors and any advisory board any potential conflicts of interest caused by the adviser’s allocation of fees and expenses.