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SEC Expense Case Highlights Perennial Issue in Private Equity
Background:
- On January 10, 2025, the SEC reached a settlement in an administrative proceeding a private fund manager and its principal owner, for charging improper expenses to the two funds and failing to disclose the resulting conflicts of interest.1 The SEC initially launched their investigation in 2021 following complaints from investors relating to the two manager’s fund expenses procedures.
- The two affiliated investment managers and their owner were found in violation of Sections 206(2) and 206(4) of the Investment Advisers Act and Rules 206(4)-7 and 206(4)-8(a)(2). They were required to reimburse the funds approximately $2,000,000 and pay a $250,000 civil penalty.
Key Facts:
- Two Private Funds: The manager advised two private funds making private equity investments in emerging markets.
- Disclosures: The funds Limited Partnership Agreements (LPAs) identified which expenses should be paid by the managers and which expenses should be paid by the funds.
- Violative Conduct:
1. Between 2019 and 2023, the managers repeatedly improperly charged expenses to their funds relating to payments for outsourced financial services, public relations and legal fees. The Private Funds’ limited partnership agreements (“LPAs”) and other governing documents did not disclose these types of expenses as permitted funds expenses.
2. Several of the expenses, such as outsourced CFO services and public relations services, were previously paid directly by the managers. When the managers changed their approach and began charging the funds, they didn’t disclose the change or seek consent from investors.
3. In one case, the manager passed through a legal expense to a fund for legal work performed on behalf of the manager. This payment wasn’t permitted by the fund’s governing documents.
4. The managers maintained poor and/or incomplete records delineating between manager expenses and fund expenses. Many of these records related to areas of heightened fiduciary conflict of interest like personal living expenses and personal travel expenses. This lack of records, coupled with a lack of written policies and procedures, created an environment that was not reasonably designed to prevent the misallocation of expenses to the funds, a violation of Advisers Act Rule 206(4)-7.
Takeaways:
- Undisclosed Expenses – Many managers mistakenly believe they have the flexibility to charge expenses to funds if their LPAs are silent on the matter. However, federal securities laws take the opposite approach: any expense not explicitly disclosed cannot be charged to clients without proper disclosure. While this case appears particularly egregious, this misunderstanding is fairly common.
- Manager Expenses – Many LPAs specify certain expenses that must be covered by the manager. Unless the document explicitly includes an exception elsewhere, these Manager Expenses cannot be charged to the funds. Examiners typically review these expenses first during compliance checks.
- Written Documentation in Areas of Conflict of Interest Is Important – Especially in areas where there could be post-facto ambiguity and questions about an adviser’s fiduciary motivations, written records that demonstrate that a process was followed in a manner consistent with policies and disclosures can significantly mitigate an adviser’s compliance risk.
- Testing – Managers face numerous daily expenses, making the potential for misallocation inevitable. Fortunately, errors in expense allocation can often be corrected if identified promptly. To mitigate such risks, implementing a robust expense allocation testing program is essential.
1 In the Matter of One Thousand & One Voices Management LLC; Family Legacy Capital Credit Management, LLC; and Hendrik F. Jordaan; Administrative Proceeding File No. 3-22392