Over the past few years, the SEC has increased its scrutiny on the private equity industry, placing particular focus on the conflicts inherent in private equity business models, and the manner in which fees and expenses are charged to funds and their portfolio investments.  To date, the SEC’s enforcement actions and guidance have focused primarily on traditional private equity sponsors.
Last year, Marc Wyatt, the Acting Director of the SEC’s OCIE, indicated the SEC’s expanded focus on other asset classes, in particular on private equity real estate advisers that operate more “vertically integrated” platforms, including sponsors that often provide a variety of third party services directly to portfolio investments after acquisition. 
As the SEC expands its focus on vertically integrated platforms, infrastructure funds should take note and place particular focus on the types of fees they charge their funds and the manner in which fees and conflicts are disclosed to their fund investors.
SEC Focus on Fees and Expenses
Over the years, the SEC has been clear in its focus and scrutiny on the private equity industry, in particular its emphasis on how conflicts, fees and expenses are managed and disclosed. In a recent speech, Andrew Ceresney, Director of the SEC’s Division of Enforcement, summarized private equity enforcement actions into three categories: 
Advisers that receive undisclosed fees and expenses: Mr. Ceresney cited a recent SEC action in which the private equity sponsor failed to properly disclose its monitoring agreements with its funds’ portfolio companies. In particular, although the sponsor disclosed in its offering documents the payment of monitoring fees from portfolio companies for board and advisory services, it failed to disclose their practice of receiving accelerated monitoring fees upon termination of the monitoring agreements (in particular, upon an IPO). 
Advisers that impermissibly shift and misallocate expenses: Mr. Ceresney highlighted three enforcement actions. The first action involved an adviser that allocated broken deal expenses entirely to its flagship funds (and not to other managed co-investment funds that typically invested alongside the funds in completed acquisitions);  the second action involved an adviser that misallocated portfolio company expenses between two managed funds;  and the third action involved an adviser that misallocated expenses between the adviser and the fund. 
Advisers that fail to adequately disclose conflicts of interest, including conflicts arising from fee and expense issues:Mr. Ceresney highlighted two cases in which the private equity sponsor failed to disclose conflicts of interest, which arose after the initial capital commitments by the investors, to the limited partner advisory committees of their funds (“LPAC”s).
In one case, the adviser caused the funds and their portfolio companies to enter into affiliated contracts without properly disclosing them to investors in advance, and without properly disclosing or seeking LPAC approval. In particular, the adviser (1) entered into certain monitoring agreements with its portfolio companies that did not offset management fees as required under the fund’s operating agreements (these agreements were not disclosed to the LPAC or investors); (2) asked fund investors to provide $4 million in connection with an investment in a portfolio company without disclosing that $1 million of the capital call would be used to pay its affiliate; (3) caused three former employees of the sponsor to receive $15 million in incentive compensation from the sale of a portfolio company for services that they had already provided when they were employees of the sponsor without disclosure to the LPAC or investors; and (4) failed to disclose each of these payments as related-party transactions in the financial statements they provided to investors.
In the second case, the SEC charged the sponsor with failing to disclose and obtain LPAC consent for (1) a series of loans to the funds’ portfolio companies, resulting in the adviser obtaining interests in portfolio companies that were senior to the interests held by the funds; (2) causing multiple funds to invest in the same portfolio company at differing priority levels, potentially favoring one fund client over another; and (3) causing the funds to exceed investment concentration limits set forth in the funds’ governing documents.
SEC Focus on Conflicts
Last year, Julie M. Riewe, Co-Chief of the Enforcement Division’s Asset Management Unit, emphasized similar themes in a speech on compliance and other issues affecting investment advisers at the IA Watch 17th Annual IA Compliance Conference.  She emphasized that “in nearly every ongoing matter in the Asset Management Unit, we are examining, at least in part, whether the adviser in question has discharged its fiduciary obligation to identify its conflicts of interest and either (1) eliminate them, or (2) mitigate them and disclose their existence to boards or investors. Over and over again we see advisers failing properly to identify and then address their conflicts.”
She added that to fulfill their obligations as fiduciaries, and to avoid enforcement action, advisers must identify, and then address (through elimination or disclosure) those conflicts. She recommended a manager at a high level “take a step back and rigorously and objectively evaluate its firm, its personnel, its business, its various fee structures, and its affiliates.” Where conflicts have been identified, she offered a number of important questions to be vetted internally:
- For each conflict identified, as a threshold matter, can the conflict be eliminated? If not, why not? If the adviser cannot, or chooses not to, eliminate the conflict, has the firm mitigated the conflict and disclosed it?
- Is there someone — a person, a few individuals or a committee — at the firm responsible for evaluating and deciding how to address conflicts? Is that person, individuals or committee sufficiently objective?
- Is the process used to evaluate and address conflicts designed to be objective and consistent?
- Does the firm have policies and procedures in place to identify new conflicts and monitor and continually re-evaluate ongoing conflicts?
- As to mitigation, are the firm’s policies and procedures reasonably designed to address the conflicts the firm has identified, and are they properly implemented?
- As to written disclosure, has the firm reviewed all of the relevant disclosure documents — among others, Forms ADV, private placement memoranda, limited partnership agreements, client agreements and prospectuses — to ensure that all conflicts are disclosed, and disclosed in a manner that allows clients or investors to understand the conflict, its magnitude, and the particular risk it presents?
- Does the firm review those documents regularly to ensure that new or emerging conflicts are disclosed in a timely way?
- Is the adviser keeping the chief compliance officer and boards of directors (if any) informed about conflicts of interest, particularly the adviser’s analysis and decisions on whether to eliminate or mitigate a conflict?
As noted above, the SEC has indicated its expanded focus on asset classes adjacent to traditional private equity. In particular, the SEC’s Private Funds Unit (PFU) has undertaken a “thematic review” of private equity real estate advisers based on the observation that real estate managers, especially those executing “opportunistic and value-add strategies,” tend to be much more vertically integrated than traditional private equity fund managers, and often provide property management, construction management and leasing services for additional fees, and potentially charge back the cost of their employees who provide asset management services and their in-house attorneys.  Accordingly, in examining private equity real estate advisers, the SEC can be expected to focus on those ancillary services being provided to managed funds and their projects, and whether the LPs are being provided with adequate disclosure regarding fees and expenses (at both fund level and project level).
Infrastructure fund advisers tend to operate similar vertically integrated platforms. They may provide some of the following ancillary services and activities to their managed funds and their portfolio companies and project investments:
Development activities and fees:The infrastructure fund adviser or its affiliates may provide early-stage, pre-construction development services to their project investments, including siting, permitting and negotiating power purchase or other offtake agreements. These activities may be funded by the infrastructure fund in the form of equity contributions or loans to the project company or pursuant to a monitoring agreement with the fund adviser. Infrastructure funds tend to seek compensation for development efforts by negotiating reimbursement of development costs or payment of a developer fee by subsequent equity investors in the project or as loans from the project’s construction lenders. 
Construction management services and fees: Some infrastructure funds may cause their project company to enter into a construction management agreement with the fund’s adviser or its affiliate as construction manager, typically on or around financial closing of construction debt. Under the construction management agreement, the construction manager will agree to be responsible for day-to-day supervision and management of the project’s construction contract (including, without limitation, supervising and monitoring the construction of the project, the project schedule and budget, all project costs and the performance by the construction contractors of their obligations and covenants, among others).
Operations and maintenance (O&M) services and fees: The infrastructure fund adviser or its affiliate may also provide O&M services to the project company upon completion of the project. The O&M agreement may cover a portfolio of projects or may be project-specific. The O&M agreement will typically require the service provider to provide materials, equipment, spare parts and inventory, perform maintenance services, maintain records of all operation and maintenance activities, provide periodic reports to the project company and provide personnel.
Asset management services and fees:Management services may include causing or supervising the carrying out of all day-to-day management, secretarial, accounting, banking, treasury, legal, administrative, human resources, liaison, representative, regulatory and reporting functions and obligations; establishing and maintaining or supervising the establishment and maintenance of corporate books and records; recommending and assisting in the raising of funds whether by way of debt, equity or otherwise; and managing the project company’s contracts.
Action Items for Infrastructure Funds
Based on the SEC’s speeches and actions over the years and its focus on the private equity industry, as well as its expanded focus on real estate advisers and other vertically integrated managers, infrastructure managers should focus on how they manage and disclose fees and conflicts. In addition to the questions cited above, infrastructure sponsors should focus on the following questions while fundraising:
- What are the types of services expected to be provided by affiliates of the sponsor to the fund and the fund’s portfolio companies?
- Is the sponsor or its affiliates the exclusive provider of those services, or may services be bid out to third parties?
- How are fees and the rates therefor disclosed to and/or approved by the LPs? Do they represent market rates being charged by the provider? How may such fees and rates be altered throughout the life of the fund?
- Are there any fee offsets under the fund’s operating agreement? Does the operating agreement expressly provide which services are included within or excluded from the offset?
- What is the role of the LPAC in disclosing or mitigating conflicts, and in reviewing affiliated contracts and the fees charged thereunder?
For infrastructure fund managers, vetting and disclosing the conflicts and fees described above may pose particular challenges. For example, unlike typical monitoring fees that may be charged by private equity fund managers, it may be difficult to maintain consistency of service fee pricing among project companies in the portfolio, as fee amounts are usually subject to approval by third party debt or equity providers. Furthermore, debt or equity providers may agree to compensate the infrastructure fund for third-party, out-of-pocket costs, but not for “soft” or “internal” costs such as salaries, travel or overhead costs of the fund adviser (plus, the definition of soft or internal cost may differ from one project to another). This could result in the infrastructure fund covering the fees under the monitoring agreement for certain projects in the portfolio, but not others.
Thus, infrastructure sponsors will be required to balance the need for flexibility while satisfying their disclosure obligations. Also, while it may be tempting (for LPs and GPs, often for different reasons) to seek to ‘solve’ all conflicts by requiring LPAC approval for all affiliated services contracts and fees, such a mechanism may create uncertainty for the sponsor, as well as delays in the process, and thus may not be optimal for the sponsor or the management of projects.
As the SEC focuses more on real estate advisers, their findings and actions will offer insights and guidance as to best disclosure practices for advisers of both real estate and infrastructure fund platforms. For example, in summarizing the SEC’s experience on the types of disclosure already being provided by real estate advisers, Mr. Wyatt noted that the types of ancillary services to be provided by real estate advisers to their managed funds and portfolio companies were often not disclosed.  He also added that, in the cases where investors did allow the manager to charge these additional fees based on the understanding that the fees would be at or below market rates, the vertically integrated manager was often unable to substantiate claims that such fees were “at market or lower.” 
Ultimately, infrastructure sponsors should be mindful of the SEC’s statements and guidance in respect of both private equity and real estate funds, and assume that the SEC will in turn begin to scrutinize other asset classes in a similar manner and at the same level of detail. Advisers should work hand-in-hand with their internal compliance staff and outside legal counsel in reviewing their disclosures and fund operating agreements to ensure that the fund investors are being provided with full and fair disclosure, that the sponsor is meeting its fiduciary obligations as an investment adviser, and moreover, that the sponsor (and its affiliates) will be able to operate the entire fund and project company platform in a manner that comports with the fund’s disclosure and terms.