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Fees and expenses charged by private equity funds have been at the heart of the SEC’s priorities. Last month, the SEC’s OCIE agreed to settle proceedings involving a New York-based private equity fund manager to the tune of nearly two million dollars. The manager was alleged to have charged portfolio companies for the services of the fund manager’s in-house operations group without fully disclosing the practice and the related potential conflicts.
What stands out in this case is the use of the manager’s in-house operations group, or “operating partners”. Like many other private equity fund managers, the manager provided portfolio companies with in-house operational services related to making business improvements. The operations group was disclosed to investors and the manager claimed the team added value to portfolio companies.
But, according to the SEC Order, the manager billed fund portfolio companies for the cost of providing the operations group services rather than covering the costs out of the management fee. Between 2012 and 2016, the fees received by the manager from the portfolio companies for these services totalled approximately 13% of all revenue received by the manager from the fund over the four-year period.
It’s important to note that the practices described are not, on the surface, a violation of the Advisers Act or any federal securities law. Additionally, the LPA for the fund disclosed that portfolio companies were responsible for paying the manager certain fees, including “closing fees, investment banking fees, placement fees, monitoring fees, consulting fees, directors fees and other similar fees”, which would be partially offset against management fees unless they were for services provided to portfolio companies in the “ordinary course of business.”
The LPA didn’t mention the operations group nor disclose that the manager would receive compensation-related fees for its operations group from portfolio companies. During the relevant period, the manager filed a Form ADV which disclosed that “under specific circumstances, certain Manager operating professionals may provide services to portfolio companies that typically would otherwise be performed by third parties,” and that the manager “may be reimbursed” for costs related to such services.
However, according to the SEC, the problem arose because:
“(the manager) did not fully and fairly disclose the fact that the manager did, in fact, routinely provide such services, that [the manager] did, in fact, receive reimbursements from portfolio companies for such services and that the reimbursement rates were designed to recoup most (but not all) of the manager’s costs of maintaining its operations group.”
The SEC claimed the manager violated Section 206(2) of the Advisers Act, which prohibits investment advisers from directly or indirectly engaging…
“.. in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.”
The fund manager has now agreed to pay disgorgement, prejudgment interest and civil monetary penalties of over $1.9 million. In determining the penalty and punishment, the SEC noted its cooperation stating the manager had:
“.. voluntarily and promptly provided documents and information” and “was prompt and responsive” in addressing the SEC inquiries.
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