At a Glance…

The Securities and Exchange Commission (the “SEC”) has been scrutinizing transparency of fees and expense allocations by fund managers for several years. Such transparency is required of any fund manager in the United States, as well as any non-US fund manager / adviser that markets its fund(s) to U.S. investors. In 2015, the SEC had charged Kohlberg Kravis Roberts & Co. L.P. (“KKR”) with misallocation of broken-deal expenses. Even though KKR’s co investors, including KKR executives, participated in the firm’s successful transactions efforts, KKR largely did not allocate any portion of these broken-deal expenses to them. In that instance, KKR agreed to a $10 million penalty and to pay more than $14 million in reimbursements.

On September 21, 2017, the SEC announced that it had settled an enforcement proceeding against a private equity fund manager alleging that the manager’s private equity funds were inappropriately allocated, and charged broken-deal expenses attributable to affiliated co-investors.

According to the SEC’s order, from 2004 to 2015, the three main private equity funds of the fund manager (the “PE Funds”) invested in 85 companies, and several co-investors participated in these investments. During this time, the PE Funds incurred expenses attributable to investments that did not proceed to completion. Such expenses are typically defined in the fund documents as “Broken-Deal Expenses” or “Abort Costs.” While the co-investors participated in the fund’s successful transactions and benefited from sourcing of investments (and were allocated proportionate expenses), the fund manager did not allocate any of the broken-deal expenses to the co-investors.

For each portfolio investment by the Private Equity Funds, co-investment occurred via a separate co investment vehicle. The fund manager did not have a standing committed capital co-investment vehicle. Rather, the fund manager used a separate vehicle to co-invest in each consummated private equity transaction. While certain of the co-investors, who were typically officers, directors, executives, and employees of the fund manager, repeatedly co-invested through these co-investment vehicles, some of the co-investors did not, and the make-up of the co-investors varied to some extent from transaction to transaction. The contracts governing these co-investment vehicles provided that these vehicles paid their pro rata share of expenses related to the investment held by such vehicle, but they did not provide for allocation of broken-deal expenses of the PE Funds.

The SEC alleged that the PE Funds’ governing documents did not contain sufficiently detailed disclosure to permit the PE Funds to bear the entire amount of broken-deal expenses, without an appropriate allocation to the co-investors.

Typically, the governing documents of a private equity fund include provisions to the effect that broken-deal expenses (i.e., research costs, travel costs and professional fees, and other expenses incurred in deal-sourcing activities related to specific investments that never materialize) are borne by the fund, as expenses incurred by the manager in sourcing deals for the benefit of the fund and its investors. Fund managers have also been reimbursed for broken-deal expenses by deducting such expenses from “other fees” that the adviser may receive in connection with investments (e.g., monitoring, transaction and break-up fees) that would otherwise be applied to offset the management fee charged to the fund. In light of the SEC actions summarized above, fund managers must ensure that the disclosures in the fund documents are sufficiently detailed, and explicitly address the issue of sharing of broken-deal expenses with any co-investment vehicles.

This SEC action confirms the SEC’s continued focus on transparency of fees and allocation of expenses. Therefore, fund managers would be wise to reevaluate their policies and disclosures relating to fees and expense allocation.