Private Fund Advisers: SEC Focuses on Misallocation of Portfolio Companies’ Shared Expenses
The Securities and Exchange Commission ("SEC") recently announced a settled administrative proceeding against a private equity fund adviser based on charges that the adviser had breached its fiduciary duties to two private equity fund clients by improperly allocating expenses between the funds in a manner which benefited one fund to the detriment of the other. To settle the charges, the adviser consented to an order (the “SEC Order”) finding it in violation of Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 (the “Advisers Act”) and agreed to pay more than $2.3 million in disgorgement, interest and penalties.
This recently settled proceeding serves as a useful reminder of the SEC’s continuing focus on these issues and highlights how expense sharing among an investment adviser’s clients can quickly become problematic without a clear policy that is consistently followed.
The adviser involved in the SEC proceeding (the “Adviser”) sponsors and advises private equity funds participating in leveraged buyouts and recapitalizations. It registered with the SEC as an investment adviser in 2012. [i] The SEC proceeding stems from actions taken by the Adviser as it integrated two portfolio companies (“Company A” and “Company B”, respectively, and together, the “Companies”) owned for many years by two different private equity funds (“Fund A” and “Fund B”, respectively, and together, the “Funds”) advised by the Adviser. The Funds were legally separate entities, had separate management agreements with the Adviser, and had two distinct sets of investors.
Fund A acquired Company A in 1997; Fund B acquired Company B in 2001. At the time of Fund B’s acquisition of Company B, the Adviser disclosed to limited partners of both Funds that because of valuable synergies between the Companies it intended to integrate the two Companies where possible in order to position the Companies for a joint sale. As the integration process progressed, a joint management team managed the Companies and a number of financial, business and operations functions were combined, including payroll, human resources, marketing and technology. The Companies also entered into a joint line of credit and had a joint logo. The SEC Order observes that the two Companies effectively operated as one company for more than seven years, although they remained two separate legal entities with separate audited financial statements. The Funds eventually sold the Companies pursuant to a joint sale in January 2013.
The Adviser charged each Company an annual consulting fee for certain advisory services relating to the Company’s financial and business affairs pursuant to separate consulting agreements with the Companies. A portion of the consulting fees charged to Company B was used to offset investors’ share of the management fees owed to the Adviser under Fund B’s limited partnership agreement. No portion of the consulting fees charged to Company A was used to offset management fees under Fund A’s limited partnership agreement.
The SEC Order states that expenses of the Companies’ joint operations and functions were generally allocated between the Companies pursuant to an allocation policy whereby each Company would pay a percentage of various operating and administrative expenses that benefitted both Companies, based on the proportion of each Company’s revenue to the combined revenue of both Companies. However, the SEC noted that “there was no written guidance or detail that accompanied this expense allocation policy” and further that the Adviser did not follow this allocation policy in all instances, resulting in one Company occasionally paying more than its share of expenses that benefitted both Companies. Although expense allocations were generally documented in the Companies’ financial records and subject to review during the annual audit process, the SEC observed that the Companies had no written agreements setting forth the rights and obligations of the Companies in respect of the allocations and that in some cases expenses were misallocated and undocumented.
The SEC Order cites a few examples of expense misallocations, including the failure to allocate third-party administrative expense for payroll services between the Companies (Company A paid this expense for both Companies over an eight year period without reimbursement from Company B); the failure to allocate salaries of employees who performed work that benefitted both Companies; the failure of Company B to contribute to overhead expenses of employees of a subsidiary of Company A devoted solely to performing work for Company B; and the allocation of 10% of certain transaction bonuses of Company B executives to Fund A in connection with the joint sale of the Companies.
The SEC concluded that the Adviser’s conduct in misallocating expenses to the Companies (and, indirectly, to the respective Funds that owned them) constituted a breach of the Adviser’s fiduciary duty to the Funds and therefore a violation of Section 206(2) of the Advisers Act, which prohibits an adviser from directly or indirectly engaging “in any transaction, practice or course of business which operates as a fraud or deceit upon a client or prospective client.”[ii] Further, the SEC found the Adviser to have violated Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder by failing to have adopted and implemented written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules arising from the joint operation of the two Companies.
While the integration of portfolio companies’ operations, management and administration and sharing of resources can create efficiencies and may be reasonable in the context of potentially creating long term value for fund clients, an investment adviser must tread carefully when allocating these shared expenses between companies that are owned in whole or in part by different funds. As a fiduciary to each of the funds, the adviser must be vigilant in ensuring that each fund client is treated fairly in the allocations -- one fund cannot benefit to the detriment of another. Accordingly, the adviser should (i) develop a comprehensive policy for allocating shared expenses at the outset of the integration process, (ii) follow the policy consistently, and (iii) continually evaluate the expenses to be shared or borne separately by each fund as the integration process evolves.
For more information regarding this Corporate and Securities Alert, please contact Neil Casey (212.631.4414 | firstname.lastname@example.org) or Lori S. Smith (212.714.3075 | email@example.com) in our New York office.
[i] Although the Adviser was not registered as an investment adviser with the SEC at the time either Company was acquired by the Funds or, for that matter, at the time when many of the expense misallocations occurred, it subsequently registered with the SEC in March 2012, thereby becoming subject to the Advisers Act and related rules in question.
[ii] Violations of Section 206(2) of the Advisers Act may be based on simple negligence; scienter is not required.