Energy Innovation Capital — Management Fees in Private Equity

EIC is a venture capital firm and an Exempt Reporting Adviser managing EIC Fund I, LP and EIC Parallel Fund, LP (collectively, the “Funds”).
On September 2nd 2022, the Securities and Exchange Commission (“SEC”) settled an administrative proceeding with Energy Innovation Capital (“EIC”) concerning three separate violations related to improperly calculating its management fee base.
As part of this settlement, EIC has returned $678,681 plus interest to the funds and their limited partners and has agreed to settle the SEC’s charges by paying a $175,000 penalty.

EIC made multiple investments in different securities of each portfolio company.
According to the Fund LPA, during the Post-Commitment period, individual security write-downs or write-offs should reduce the management fee.
EIC, however, evaluated each portfolio company in aggregate so the value of any security which was written down or written off was offset by any increase in value of other securities in the same portfolio company. This improperly inflated the management fee.
- Analysis:
  - EIC’s LPA provided that write-downs as well as write-offs reduce management fees. This unusual provision made EIC particularly susceptible to aggregation issues.
  - Restructured portfolio companies, where securities may have been extinguished and others created, would also be at risk for this type of improper aggregation. The SEC’s settlement with ECP Managers (Release No. 5373) demonstrates this risk.

EIC incorrectly based the Funds’ management fees for the entire first quarter of 2020 (January 1, 2020 – March 31, 2020) on LPs’ committed capital, when it needed to switch the management fee base to the invested capital in the middle of that period.
- Analysis:
  - Based on our experience, this is a common error for which compliance programs should design testing.

EIC improperly charged management fees for accrued and unpaid interest on certain securities.
EIC did not incorporate any write-downs in its Post-Commitment management fee calculation.
- Analysis:
  - Compliance departments often rely on finance to accurately calculate management fees and do not always review the results for compliance with LPAs. This may cause errors such as these.

Finance – Compliance Gap: Calculating management fees, running distribution waterfalls, developing valuations, and allocating expenses are important activities implicating the federal securities laws, but are often performed by finance with little compliance oversight and testing. This creates a finance-compliance gap where errors such as the ones highlighted in this case can occur. Depending on risk and business model, compliance programs might consider providing additional oversight.
Overreliance on Audits: Many firms gain significant comfort from fund audits especially around the calculation of fund fees and expenses. However, while auditors perform an important function, they do not perform the same function as compliance. This settlement demonstrates how auditors could fail to identify significant fee calculation issues. Managers should take this dynamic into account and adjust their compliance programs accordingly.
Mid-Period Dispositions: Many managers take the position that if there are dispositions during any given quarter in the Post-Commitment period management fees, which are typically charged quarterly in advance, do not need to be retroactively refunded to adjust for the change in Invested Capital. While this case doesn’t address this issue head on, it does highlight that this practice might need to be reconsidered.