Expense Allocations – A Key Issue For Examinations of Private Equity Fund Managers

April 3, 2014

On February 20, 2014, the Securities and Exchange Commission (the “SEC”) announced that its Office of Compliance Inspections and Examinations (“OCIE”) is launching a 2014 initiative directed at examining a significant percentage of investment advisers that have never been examined before, focusing on those that have been registered for three or more years. Accordingly, SEC-registered advisers to private equity funds who have never been examined before should be prepared to undergo an SEC examination in calendar year 2014. As highlighted by a recent SEC enforcement action against a private equity fund manager, which arose out of the manager’s examination, expense allocations will continue to be a key area of concern for the SEC as it examines private equity fund managers.

The SEC staff has identified expense allocations as a key issue for private equity fund managers on several occasions. In particular, the staff has stressed that private equity fund managers must ensure that they properly allocate fees and expenses among various client accounts and related vehicles they manage. For example, on May 2, 2012, Carlo di Florio, then the Director of the OCIE, stated that in “cases where two funds managed by the same investment advisor co-invest in the same investment vehicle, expenses should be allocated fairly across both funds.” Similarly, on January 23, 2013, Bruce Karpati, then the Chief of the SEC’s Asset Management Unit, noted in another speech that “the temptation to misallocate fund expenses is a risk we (the SEC) frequently cite and that we (the SEC) see as a form of misappropriation.”1

Consistent with these prior pronouncements, the SEC recently brought an enforcement action against an adviser to multiple private equity funds that cites several alleged violations committed by the manager, including its improper allocation of expenses. In particular, the SEC alleges that the manager both (i) charged expenses to the funds that should have been manager expenses under the relevant fund documentation, and (ii) further, even to the extent expenses were proper fund expenses, the manager failed to properly allocate expenses among the various private equity funds it managed.

The SEC’s action in this case further underscores that the SEC staff will closely look at expense allocations in upcoming examinations of private equity fund managers. Managers to private equity funds should consider taking the following steps to prepare for this scrutiny:

  • compare the disclosure in applicable fund documentation with the expenses they actually charge to their funds and accounts to ensure that no manager expenses are improperly being charged to clients;
  • review their procedures for allocating expenses among different funds and accounts to ensure that each fund only bears expenses attributable to its activities, and that those allocations are properly documented; and
  • consider whether they are sufficiently documenting expense allocations, particularly with respect to expenses that may not otherwise obviously tie to particular funds or accounts (e.g., “broken deal” expenses where the accounts expected to participate were not clearly identified ahead of time).

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If you have any questions regarding the information discussed above, please contact your Investment Management Group attorney at Seward & Kissel LLP.


1 See Speech by SEC Staff: Address at the Private Equity International Private Fund Compliance Forum and Private Equity Enforcement Concerns.