On August 7, 2020, the Securities and Exchange Commission (“Commission”) entered a settled order1 against private equity fund adviser Rialto Capital Management, LLC (“Rialto”) for misallocating expenses relating to its performance of certain “Third Party Tasks” to two real estate private equity funds it managed, in violation of §§ 206(2) and 206(4) of the Investment Advisers Act of 1940, and Rules 206(4)-7 and 206(4)-8 promulgated thereunder. Under the terms of the settlement, Rialto was censured and required to pay a $350,000 penalty. Rialto fully reimbursed the funds.
Rialto manages and advises multiple real estate private equity funds and, as of December 31, 2019, had approximately $4.8 billion in regulatory assets under management. From 2012 to 2017, the Commission found, Rialto misallocated more than $3 million in costs and expenses to two funds it managed, referred to in the order as Fund I and Fund II, that should have been allocated to certain co-investment vehicles. Both Fund I and Fund II, and the co-investment vehicles which invested alongside each of them, invested in real estate properties, real estate loans, and asset-backed securities. Rialto advised and managed both the Fund I and Fund II co-investment vehicles. While the order did not cite the related conflict of interest, it did note that Rialto held limited partnership interests in the co-investment vehicles.
A primary selling point of the Funds, according to the order, was Rialto’s ability to perform certain Third Party Tasks in-house, including asset-level due diligence, accounting, valuation, and similar services. According to the Funds’ governing documents, including each Fund’s limited partnership agreement (“LPA”), Rialto was entitled to be reimbursed for the costs and expenses of performing the Third Party Tasks for the Funds. Each Fund had its own Advisory Committee which, the respective LPAs provided, was responsible for approving costs and expenses charged to the Fund. According to the order, the costs for the Third Party Tasks included an allocable portion of the time Rialto employees spent performing such tasks, and any related costs and expenses.
Each year, in advance of the annual meeting of each Advisory Committee, Rialto provided to the committee a written memorandum requesting reimbursement for the costs and expenses related to Rialto’s performance of the Third Party Tasks for the respective Fund. The memoranda detailed, among other things, the Fund’s allocable costs associated with the tasks for underwriting; loan management; real estate owned asset management; and accounting, tax, and legal costs. Following consent by the committee, Rialto was reimbursed the approved amount.
From 2012 to 2017, Rialto charged Fund I approximately $2.75 million and Fund II approximately $275,000 more than their respective pro rata shares of costs and expenses for Third Party Tasks. These amounts, according to the Commission, should have been allocated to and paid by the co-investment vehicles.
Furthermore, the Commission took issue with the adequacy of certain disclosures related to the expenses. First, Fund I’s LPA required that prior to the Fund paying or reimbursing Rialto for Third Party Tasks, Rialto must “provide the Advisory Committee a schedule of the fees and costs of such Third Party Task related to such payment and/or reimbursement and evidence indicating such fees and costs are at or below market rates.” From 2013 to 2017, Rialto’s annual Advisory Committee memoranda represented that Rialto “[w]as able to obtain information” supporting that Rialto’s costs for providing Third Party Tasks “were at or below market rates.” Rialto had conducted a market rate analysis in 2012, but did not do so thereafter. The order took issue with the fact that Rialto’s disclosures for the latter years failed to state that it had not obtained updated information.
Second, Rialto disclosed to Fund I’s Advisory Committee that the costs for the Third Party Tasks in 2011 added 11% to the total cost for each employee to cover general overhead expenses, referred to in the order as the Overhead Factor. The cost allocation methodology Rialto used from 2012 through 2017 to calculate these same costs resulted in an increase in the Overhead Factor from 11% to 25%, a fact not fully disclosed, according to the order, to the Advisory Committees.
S&K Observations
This is the second recent enforcement action the Commission has brought against a private equity fund adviser related to fees and expenses for services provided by the manager or an affiliate to clients. On April 22, 2020, the Commission charged Monomoy Capital Management, L.P.2, for failure to disclose adequately certain fees charged to fund portfolio companies for the services of its in-house operations group and related conflicts of interest. This case is more evidence that, when an adviser makes disclosures concerning the services it or an affiliate provide to a fund, the Commission expects the adviser to have a record confirming the accuracy of those disclosures. We recommend you take this opportunity to review your disclosures concerning fees and expenses, and conflicts of interest, and the implementation of your allocation procedures. Fee and expense related practices can change over time. Related disclosures in offering and fund documents may not be as accurate as they once were.
Please contact your primary attorney at Seward & Kissel if you have any question or would like any assistance in connection with your disclosure review.