The lesson drawn from several early SEC enforcement actions taken against sponsors is that they shouldn’t keep investors in the dark on how they handle the allocation of fees and expenses. It is especially problematic when their allocation happens to benefit them at the expense of investors.
According to a new study, investors refuse to wait for private equity firms to voluntarily improve their disclosure practices. They are negotiating as part of limited partnership agreements the right to see more details on fees and expenses than they have in the past.
Recent private-equity settlements show just how seriously the SEC takes disclosure. In four cases since June involving The Blackstone Group, Cherokee Investment Partners, Kohlberg Kravis Roberts & Co, and Fenway Partners, the SEC expressly pointed to a lack of disclosure about fees and expenses as being at heart of the infraction.
In an October settlement with The Blackstone Group, for example, the SEC said it found that the firm “failed to fully inform investors” about two of its accounting practices. One involved the acceleration of monitoring fees paid to the firm on the sale or IPO of portfolio companies; the other involved discounts secured by Blackstone Group on legal fees that it didn’t fully share with the funds it managed.
Said Andrew J. Ceresney, director of the SEC’s division of enforcement, in a prepared statement: “Full transparency of fees and conflicts of interest is critical in the private equity industry and we will continue taking action against advisers that do not adequately disclose their fees and expenses, as Blackstone did here.” Without admitting or denying the findings Blackstone Group agreed to pay almost $39 million to settle the case.
Investors want action to prevent abuses like this. The fourth edition of PE/VC Partnership Agreements Study 2016-2017, due to be published next month by Buyouts Insider, finds investors are demanding disclosure requirements be baked right into their limited partnership agreements (LPAs). According to the study, more than half of North American buyout funds (54.2 percent) require their sponsors to disclose to investors any fees charged to portfolio companies (see accompanying chart). About a third (29.2 percent) require sponsors to disclose any expenses charged to portfolio companies.
One fund attorney says there has also been a big push by both investors and sponsors to bring greater clarity in LPAs to who is responsible for paying various expenses. Who shoulders the cost of annual meetings? Who pays the cost of outside consultants brought on in the due diligence phase of an investment? Is it the sponsor, the fund, or do they share the expense? Whereas past LPAs may have left these questions unanswered or answered only vaguely, the attorney said, investors and sponsors are making sure they now get spelled out.
The SEC’s settlement this month with Cherokee Investment Partners suggests why. Its LPAs failed to directly address the question of who would pay compliance and legal expenses associated with the firm registering as an investment adviser and with its handling of an SEC exam and subsequent investigation. Still, the firm charged its funds more than $450,000 for these expense. Without admitting or denying the findings the firm agreed to pay a $100,000 penalty.
Investors have other disclosure efforts under way. Most notably the Institutional Limited Partners Association, whose more than 300 members manage more than $1 trillion in private equity assets, last month introduced a draft template for reporting fees and expenses.
Don’t be surprised in coming months to see investors try to negotiate in their LPA a requirement that sponsors use it.