Insight Analytical Note

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SEC Enforcement related to Accelerated Monitoring Fees, and a GP-Led Transaction

Summary:

  • On September 22nd 2023, the Securities and Exchange Commission charged a private fund manager1 with inappropriately accelerating a monitoring fee, executing a conflicted adviser-led transaction and improperly allocating expenses between the manager and various funds.
  • This manager paid a total of $1.6 million in fines, disgorgement and interest.
  • This is the first matter the Commission brought against a private funds manager that alleged a violation of the Duty of Care and fiduciary duty, which may signal a shift to an even more aggressive posture.

Allegations and Conduct:

  • Accelerated Monitoring Fees – The SEC alleges that nine years after investing in a portfolio company, the investment adviser amended a monitoring agreement to insert an acceleration provision. Two years after, the manger collected an accelerated monitoring fee after the fund exited the investment. There were no disclosures about the manager’s ability to accelerate fees in the formation documents and LPAC consent was not sought. Additionally, there were several exacerbating factors.
    • Terrible optics – A 10-year acceleration clause was included in the monitoring agreement after the company was already held for nine years making it appear like the sole purpose for acceleration clause was to generate cash flow for the manager.
    • Ignoring previous signals from the SEC – The conduct occurred after significant Commission activity revealed the risks associated with monitoring fee accelerations, however the manager ignored those signals and didn’t take precautions.
    • Complete lack of disclosure – There was no disclosure of accelerations in formation documents.
    • No LPAC consent – The LPAC was not consulted about the acceleration.
    • No offsets – No management fees were charged and therefore none of the accelerated fee was attributed to investors through the offset.
    • Analysis:
      • Despite the poor optics and lack of disclosure, the enforcement order makes a point of identifying the failure of the manager to consider whether accelerating monitoring fees was in the investors’ best interests. This focus on Duty of Care is a departure from how similar enforcement cases were charged in the past.
  • Continuation Fund – The manager caused a soon-to-be expiring private equity fund to sell assets to another fund advised by the same manager. In exchange, the soon-to-be expiring fund received LP interests forcing investors in the original fund to continue to hold this investment for an extended period. This lock up extended the manager’s fee stream and reduced liquidity for investors. Investors were informed post hoc about this transaction had no opportunity to consent or object.
    • Analysis:
      • While post hoc notification may be appropriate in certain circumstances, this transaction affected investors to such an extent that consent should have been obtained.
  • Undisclosed Loan / Mishandling of Broken Deal Expense Allocation – The SEC alleges that the manager effected an improper and undisclosed loan from one of its managed funds to another. In June 2018, an older fund expended $1.3 million dollars pursuing a certain investment opportunity, however the fund never made this investment and soon thereafter ran out of capital. The next month, the manager formed a new fund and the Manager reimbursed the first fund the $1.3 million of pursuit costs that it originally expended. Six months later, the manager appeared to reverse its decision and the Manager collected $1.3 million from the old fund while at the same time recording a $1.3 million liability on the books of the new fund. By doing this the Manager made it it appear as though the old fund lent $1.3 million to the new fund. Six months later the “loan” was repaid when the new fund reimbursed the old fund.
    • Analysis:
      • This appears to be a case of misallocated broken deal expenses in a situation where two funds pursued the same investment at different times. It is often challenging to allocate broken deal expenses where potential transactions reemerge and are pursued by other funds.

Takeaways:

  • Fiduciary Duty / Duty of Care:
    • Duty of Care as Evidenced Through Conflicts Committees and Documentation: The underlying claim behind every Duty of Care violation is that the manager is not acting in the best interest of its clients2. This claim almost always leverages hindsight where final outcomes are clear and decision could be second guessed. Contemporaneous documentation and conflicts committee processes can help evidence proper care even if future outcomes create doubt. Documentation which sets forth key facts as known and interpreted at the time, compellingly argues that the actions undertaken are in the best interests of clients and is vetted through key decision makers, significantly reduces the risks of Monday morning quarterbacking.
    • Disclosure is still key: While this matter appears to be the first private fund case to focus in large part on a breach of the Duty of Care, disclosure is still central. All three violations involved (a) post hoc, dated disclosure; (b) incomplete disclosure which did not include all material facts; or (c) no disclosure at all. While disclosure and Duty of Care are different concepts, good disclosure will make it more difficult for the Commission to accuse a manager of a Duty of Care violation and is still an important and effective risk mitigant.
  • Allocating broken deal expenses
    • The fact pattern described in this order is not uncommon in private equity and being thoughtful about allocating broken deal expenses is important in complex situations. Two principles to consider in such allocations are: (1) waiting as long as possible to allocate expenses so there could be increased certainty around the ultimate investment allocation; (2) creating contemporaneous documentation to evidence that the allocation was in the best interest of clients.
  • Accelerated Monitoring Fees
    • The adopting release of the recently adopted Private Fund adviser Regulations states that accelerated monitoring fees could be illegal even if disclosed3 and it is tempting to view this as an example of that philosophy. However, the facts in this case don’t support that notion because in this case there were significant disclosure deficiencies along with substantial exacerbating factors without which this enforcement action may not have been brought.
  • The importance of careful conflicts analyses
    • Like many in the private fund industry, this manager faced significant conflicts which it did not properly identify or mitigate. And while compliance professionals tend to understand conflicts of interest well, explaining the difference between a conflict and a synergy to persons outside the compliance department can be challenging. Undertaking a conflicts review and/or providing guidance and training, especially in the case of an adviser led transaction may be the best way to crystallize the distinction.

1 American Infrastructure Funds; Administrative Proceeding File No. 3-21704

2 2019 Commission Interpretation Regarding Standard of Conduct for Investment Advisers

3 Page 369 of the Release.