Fees and Expenses in Private Equity

In April, the SEC's OCIE (Office of Compliance Inspections and Examinations) issued a Risk Alert, "Overview of the Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers" (available here).

The US regulator noted that their onsite regulatory inspections of asset managers had identified multiple concerns:

• Managers calculating fees based on incorrect asset valuations
• Billing fees in advance or with improper frequency
• Applying incorrect fee rate
• Omitting rebates and applying discounts incorrectly
• Disclosure issues involving advisory fees
• Advisor expense misallocations

To give one example, in the latter category, the SEC noted that their inspections had identified cases where "staff observed advisers that allocated distribution and marketing expenses, regulatory filing fees, and travel expenses to clients instead of the adviser, in contravention of the applicable advisory agreements, operating agreements, or other disclosures."

Ouch.

For institutional investors conducting due diligence, fee issues are typically a greater issue in private equity as compared to hedge funds. Put simply, many of the expense practices which were pushed out of hedge funds more than a decade ago continue to exist in the PE space.

A Castle Hall client recently forwarded a helpful summary of a compliance discussion hosted by Private Funds Management (available here). Per the conference sponsor: "The Message To GPs from our Private Fund Compliance Forum is Clear: The SEC will be Back".

Expense issues, ultimately, come to two questions.

First, is the expense disclosed? This is the emphasis of the SEC's enforcement activities: the SEC is not making a judgement as to whether an expense is "justified", but is rather asking whether the expense was disclosed. As such, were investors aware of the potential sources of income to the investment manager when they decided to invest?

As one example, the PE firm Welsh Carson was recently fined almost $1 million for receiving undisclosed fees from a company which provided group purchase and procurement services to portfolio companies within the Welsh Carson fund complex (see complaint here).

Second - and this IS the difficult question - is the expense "justified"?

In our mind, this comes down to a question of business model. If a private equity manager wishes to accept capital from traditional high net worth investors, private banks etc...so be it. If, however, a PE manager wishes to raise $2 billion, not $200 million, by accessing capital from sovereign wealth funds, public pension plans and corporate pension plans, then there needs to be focused awareness that the owners of capital are pension beneficiaries, many of whom earn salaries of significantly less than $100,000.

Among the points noted by the PFM conference was "Funds can expect the regulator to ask detailed information on how expenses are allocated, down to asking for lists of passengers on private jets."

To this point, the issue is not so much the scope of SEC inspections and the potential landscape of enforcement actions. The real question, of course, is even more straightforward - why are pension beneficiaries paying for an investment manager's staff to fly in private aircraft in the first place?