US Focus: SEC Presence Exams for PE Funds-Emphasis on Fees and Expenses

In January 2014, the U.S. Securities and Exchange Commission (“SEC”) reiterated its initiative to conduct “Presence Exams” on newly registered investment advisers, particularly private equity firms. The SEC has set a goal to examine 25% of newly registered private advisers by the end of 2014.

According to SEC Office of Compliance Inspections and Examination Director Andrew J. Bowden, over 50% of firms examined in 112 recent cases had allocated expenses and collected fees either inappropriately or illegally. The SEC has been concentrating on several key areas regarding fees and expenses, including:

According to SEC Office of Compliance Inspections and Examination Director Andrew J. Bowden, over 50% of firms examined in 112 recent cases had allocated expenses and collected fees either inappropriately or illegally. The SEC has been concentrating on several key areas regarding fees and expenses, including:

Disclosure and appropriateness of fees. Perhaps most importantly, any fees charged to investors must be properly disclosed in the funds’ Limited Partnership Agreements (“LPAs”). Because fee disclosures contained in the LPAs are often worded in vague and general terms, a certain degree of discretionary judgment must at times be taken to determine whether the fees being charged are consistent with the terms provided for in the documents.

Additionally, there may be cases where, although correctly described in the fund documents, the fees may not be appropriate and therefore, a determination must be made to conclude whether the private equity firm is fulfilling its fiduciary duty to investors. The SEC may take the view that limited partners do not have enough information to effectively understand the disclosures in the LPAs, and do not have the resources to properly monitor whether fees are being charged in accordance with the documents.

Allocation of expenses. Generally, expenses should be allocated between funds on a pro rata basis. If this is not the case, such as a broken deal expense that may be allocated to a particular fund, the firm should be prepared to provide comprehensive support and a detailed explanation. Additionally, expenses that benefit both the firm and the fund(s) must also be properly allocated and backup records must be kept.

Fees paid to Operating Partners. Some managers use outside consultants, or “Operating Partners,” to perform certain services such as compliance, legal or accounting work. The Operating Partners are not employees of the adviser and may at times be compensated directly from the fund or portfolio company. If an Operating Partner is paid out of the fund, not the management company, the costs should be offset against the management fee.

Undisclosed or “hidden” fees. Transaction fees, placement fees, monitoring fees and other fee arrangements not disclosed to investors will require sufficient recordkeeping support. In particular, fees paid to affiliated entities may be carefully reviewed by the SEC.

Fees charged by “zombie” funds. Management fees charged by funds at the end of their terms that still hold portfolio investments (“zombie” funds) will likely also receive special attention from the SEC.

Newly registered private equity advisers should expect an SEC presence exam by the end of 2014. It is highly recommended that firms conduct a thorough review of fees and expenses, giving particular consideration to the topics outlined above.

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