In the US, the SEC has recently fined three private equity firms for mis-use of client assets, typically in relation to passing management company expenses onto the fund vehicle. Without the SEC, these cases would likely not have come to light - which raises broader (and familiar) questions about governance around PE investing.
Firstly, Dyal - the well known series of funds sponsored by Neuberger Berman - buys stakes in a range of alternative asset managers. According to the SEC:
"Certain employees of DCP [Dyal Capital Partners] handled investing activities on behalf of the Dyal Funds, including identifying potential investments by, and investors in, the Dyal Funds. This group of employees was referred to as the “Investment Team.” Consistent with the terms of the LPA and IMA, which specified that NBAA and/or the general partner would pay the compensation expenses of their professionals and other expenses of providing their services, Neuberger paid the compensation-related expenses of each Investment Team member.
A second group of DCP employees, the BSP, was established to provide advice and support, including client development, talent management, operational advisory services, and sourcing potential new investors, to the Partner Managers in which the Dyal Funds invested. The BSP was intended to increase the return on the Dyal Funds’ investments by helping Partner Managers attract new capital, launch new products and optimize their operations. A substantial number of investors in the Dyal Funds also invested directly in the Partner Managers."
SEC documents state that the offering materials for the Dyal funds allows the firm to spend up to 50 basis points of aggregate commitments on these operational improvement initiatives.
However, the SEC continues:
"From 2012 through 2016, certain BSP employees did not work exclusively on providing services, advice and support to Partner Managers. Certain of those BSP employees spent a percentage of their time on tasks that assisted the investment team, such as raising capital for the Dyal Funds, as well as identifying and meeting with alternative asset management companies in which the Dyal Funds might seek to invest. While some of those tasks may have incrementally benefited the Partner Managers, they did not involve providing services, support or advice to Partner Managers in which the Dyal Funds already had invested."
As a result, "NBAA [Neuberger Berman Alternative Advisors] will disgorge $2,073,988 and pay prejudgment interest of $284,620, which NBAA is required to distribute to harmed investors. NBAA also will pay a civil monetary penalty of $375,000."
Next, Yucaipa Master Manager, LLC, based in Los Angeles, California (regulatory assets under management of $2.67 billion per the firm's most recent ADV filing), agreed to settle claims that Yucaipa failed to disclose several financial conflicts of interests and misallocated fees and expenses. Per the SEC:
First, Yucaipa did not disclose to the funds its practice of charging the funds for the cost of certain in-house employees who assisted in preparing the funds’ tax returns.
Second, Yucaipa did not disclose its arrangements with two third-party service providers that resulted in expense allocation decisions that posed actual or potential conflicts of interest:
(1) Consulting Firm A provided services to two of the funds and also provided general deal sourcing services to Yucaipa. Yucaipa’s Principal also made a personal loan to Consulting Firm A’s principal that was secured by money owed by Yucaipa or its affiliates, including the funds, and repaid through consulting fees paid by one of the funds to Consulting Firm A. These undisclosed conflicted arrangements resulted in the misallocation of a portion of Consulting Firm A’s fees.
(2) Consulting Firm B provided services to one of the funds, a portfolio investment of the fund, and two of the Principal’s personal investments. Yucaipa’s Principal also made a personal investment in Consulting Firm B while it was providing services to the portfolio investment. These undisclosed conflicted arrangements resulted in the misallocation of Consulting Firm B’s fees, the failure to credit funds received by Yucaipa’s Principal from Consulting Firm B to the fund, and the failure to offset fees received by Consulting Firm B against Yucaipa’s advisory fee.
For this one, Bloomberg reports that the firm agreed to pay a $1 million fine and about $1.9 million in disgorgement (as the owner of Yucaipa also owns the Pittsburgh Penguins hockey team, presumably this will come out of Sydney Crosby's salary...sorry, Canadian hockey joke!)
Finally, we have the case of Lightyear Capital LLC, a $2.2 billion registered advisor based in New York. Apologies for the length of this extract, but the SEC's narrative raises multiple interesting diligence points - across expense allocations, use of segregated investment manager vehicles (the manager did not invest solely alongside external investors in the main fund) and arrangements with co-investors.
Allocation of Expenses to Flagship Funds.
Lightyear launched its first Flagship Fund in 2000 and its first Employee Fund in 2001. From that time through 2016, Lightyear allocated certain expenses, including broken deal, legal, consulting, insurance and other expenses solely to the Flagship Funds. Although the Organizational Documents disclosed that the Flagship Funds would be allocated expenses incurred in connection with potential or actual Flagship Fund investments, Lightyear did not disclose in the Organizational Documents or elsewhere that the Employee Funds would not be allocated a proportional share of such expenses. Lightyear should have disclosed this conflict of interest in the Organizational Documents or obtained approval from the Flagship Funds’ Advisory Committees. Instead, Lightyear failed to disclose in the Organizational Documents or elsewhere that the Flagship Funds would pay all of the expenses in connection with the transactions, despite the fact that the Employee Funds participated in and benefitted from the transactions. Lightyear also failed to obtain approval from the Flagship Funds’ Advisory Committees for this practice. In the absence of such disclosure or approval, Lightyear should have allocated the proportional share of such expenses to the Employee Funds. The failure to allocate such expenses to the Employee Funds and the allocation of those expenses to the Flagship Funds benefitted Lightyear’s Employee Funds at the expense of the Flagship Funds. As a result of Lightyear’s conduct, from approximately 2000 through 2016, the Flagship Funds paid approximately $167,000 more in expenses than they should have paid.
In addition to Employee Funds which invested in Portfolio Companies alongside the Flagship Funds, certain co-investors were permitted at times to invest in particular Portfolio Companies. These co-investors similarly were not allocated their proportional share of certain post-closing expenses despite participating in and benefitting from Lightyear’s private equity 4 investments. Although the Organizational Documents disclosed that the Flagship Funds would be allocated expenses incurred in connection with potential or actual Flagship Fund investments and permitted the general partner of the Flagship Funds to negotiate different investment terms for coinvestors, Lightyear did not disclose in the Organizational Documents or elsewhere that coinvestors would not be allocated a proportional share of such expenses. In the absence of such disclosure, Lightyear should have either allocated the proportional share of such expenses to the co-investors or borne those costs itself. The failure to allocate such expenses to co-investors and the allocation of those expenses to the Flagship Funds benefitted co-investors at the expense of the Flagship Funds. As a result of Lightyear’s conduct, from approximately 2000 through 2016, the Flagship Funds paid approximately $221,000 more in expenses than they should have paid.
In connection with its funds’ investments in Portfolio Companies, Lightyear often entered into “advisory agreements” whereby Lightyear provided services to the Portfolio Company in exchange for advisory fees. According to the Organizational Documents governing the Flagship Funds, advisory fees received by Lightyear from Portfolio Companies would offset the management fees paid by the Flagship Funds.
Between 2010 and 2012, Lightyear entered into fee-sharing agreements with certain co-investors regarding three of the Flagship Funds’ Portfolio Companies. Pursuant to these agreements, Lightyear agreed to share a portion of the advisory fees it received from the Portfolio Companies with the co-investors.
Between 2010 through 2015, approximately $1 million from two of these Portfolio Companies was paid to co-investors. The co-investors provided no services to the Portfolio Companies for these fees. Sharing advisory fees with co-investors reduced the management fee offset and thus increased the management fees paid by the Flagship Funds. In addition, because the payments were generally paid by the Portfolio Companies directly to the co-investors, the Limited Partners of the Flagship Funds had no way of knowing that the Flagship Funds did not receive the management fee offset that they would have received absent the fee-sharing agreements. While the Flagship Fund LPAs permitted the general partner of the Flagship Funds to negotiate different investment terms for co-investors, Lightyear did not disclose either the feesharing agreements or the payments in the Organizational Documents or elsewhere. Lightyear’s failure to disclose these agreements and failure to provide the Flagship Funds with the relevant management fee offsets benefitted the co-investors at the expense of the Flagship Funds. As a result of this conduct, between 2010 through 2015, the Flagship Funds did not receive approximately $1 million in management fee offsets.
It is safe to say that these cases are likely the thin end of the wedge: they are only being surfaced because of the detail of the SEC examination process. We will consider potential lessons learned for investors in our next post.
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