For several years the U.S. Securities and Exchange Commissions (“SEC”) has focused its enforcement efforts on how private fund advisers allocate fees and expenses to their fund clients and the adequacy of their disclosures to those clients regarding such practices. Consistent with this focus, the SEC recently settled two enforcement actions targeting inappropriate fee and expense allocations, one of which resulted in the fund manager paying more than $3 million in disgorgement and civil penalties.
Platinum Equity Advisers, LLC
On September 21, 2017, Platinum Equity Advisers, LLC (“Platinum”) settled the SEC’s claims that Platinum violated Sections 206(2), 206(4) and Rule 206(4)-7 of the Investment Advisers Act of 1940 (the “Advisers Act”) by charging three of its private equity fund clients approximately $1.8 million in broken deal expenses. Specifically, the SEC alleged that Platinum allocated all of its broken deal expenses to its three fund clients and allocated none of such expenses to the co-investors who intended to participate in the deals that ultimately fell through. The SEC also alleged that the funds’ governing documents did not disclose that the funds would be responsible for any expenses other than their own.
Without admitting or denying the SEC’s allegations, Platinum settled the claims, agreeing to disgorge more than $1.9 million and pay a $1.5 million civil penalty.
Potomac Asset Management Co. Inc.
Earlier in September, another investment adviser, Potomac Asset Management Co. Inc. (“Potomac”), settled claims by the SEC that it inappropriately allocated fees and overhead expenses to two of its private equity fund clients. Specifically, the SEC alleged that Potomac charged one of its fund clients $2.2 million in fees for services provided to a portfolio company, collected $726,000 in management fees that it failed to offset with other Potomac income as required under the applicable fund’s governing documents, and allocated more than $703,000 in rent, compensation and other business and regulatory expenses to two of its fund clients without authorization.
Without admitting or denying the SEC’s allegations, Potomac agreed to pay a $300,000 civil penalty, for which it is jointly and severally liable with its principal.
In both of these cases, the SEC also claimed that the investment advisers did not have or implement adequate policies and procedures to protect against the alleged misallocations.
These cases are instructive. The SEC has not relented in its enforcement efforts regarding private equity advisers’ fee and expense allocation and disclosures to their fund clients on how fees and expenses would be allocated to the funds. To avoid these issues, fund managers should (1) analyze their fund documents to determine whether they clearly disclose how and what expenses and fees will be allocated to the funds, (2) evaluate their policies and procedures regarding fee and expense allocation to ensure that the written procedures are reasonably designed to protect against fee and expense misallocation and (3) assess whether the allocation practices in the fund documents and the advisers’ allocation policies and procedures are being appropriately implemented. It is not uncommon in the industry for co-investors to not be charged for broken deal expenses, but this should be clearly disclosed in a fund’s governing documents or otherwise disclosed to limited partners.