Private fund managers should take an overly cautious approach to assigning fees and expenses attached to investment in their funds, particularly in the wake of the coronavirus pandemic, as the Securities and Exchange Commission maintains a laser-like focus on the issue.

The warning follows an SEC Risk Alert, which said some private fund managers have inaccurately allocated fees and expenses; did not provide adequate disclosure regarding the role and compensation of operating partners; and have had issues around valuation and monitoring board, deal, fees and fee offsets. It is the second of three areas of deficiency found by the regulator's Office of Compliance Inspections and Examinations.

The issue has been raised by the SEC for a number of years, Proskauer Rose's litigation head Tim Mungovan said, but based on the risk alert "it seems as though some managers are still struggling with determining which fees and expenses are to be borne by the fund and which are to be borne by the manager."

As managers navigate unprecedented circumstances during the pandemic, this is particularly pertinent. They may conclude, for example, that the manager needs to use a private jet to visit a prospective investment in a different country, Mungovan explained. The manager must evaluate whether that cost, which seems necessary in order to do business, is borne by the manager or the fund and look at its agreement. "That's a really simple and basic example, but that is the type of thing that is going on right now, and people do need to be thinking about that," he said.

Over the past five years, fees and expenses have been emphasized by the SEC, Duff & Phelps LLC managing director David Larsen said. Firms have moved away from a handshake agreement with limited partners on fees and expenses after private fund managers were brought under the SEC's remit by the Dodd-Frank Act. General partners now have strong disclosure around how fees and expenses are spent, and compliance teams are much more circumspect to make sure they are following the agreement.

But there is an ebb and flow for fees and expenses reporting and related issues, Larsen said. "The risk alert kind of reminds people, hey, just because you fixed it three years ago, doesn't mean you can let your guard down."

The Institutional Ltd. Partners Association's senior policy counsel Chris Hayes said fees and expenses reporting and transparency is critical and remains an area of concern. "The SEC has been highlighting continued problems being expense transparency and misallocation of fees and expenses since they started examining these folks back in 2012."

Compared to European regulatory bodies, such as the U.K.'s Cost Transparency Initiative tasked by the Financial Conduct Authority in 2018, Hayes notes, the SEC has not taken "any action really to address this beyond conducting exams and a limited number of enforcement actions."

Competition concerns

Todd Cipperman, founder of outsourced compliance firm Cipperman Compliance Services LLC, said private equity firms like taking "little bite-sized fees all over the place, which makes them wealthier." He has told clients to charge one fee: "roll it all up and stop charging these other fees. There's no limitation on your management fee and your carry, charge whatever you want, but once you start trying to do a little side deals and add ons, it gets very difficult unless you maybe have a third-party LP committee approve it." Under private funds' fiduciary duty "you can't line your own pockets to the detriment of your clients, and to a large extent, not even with disclosure, can you do that."

There is no logistical reason why firms raising new funds couldn't do this, but managers often tell Cipperman that it will hurt them competitively. Investors are still looking at the carried interest and management fee, while fees and expenses at the portfolio and company level are more opaque. "In some sense, it makes it easier for everyone to sort of not be as transparent as they probably otherwise should be," Cipperman said. But the competitive downside to rolling up fees into carry and the management fee "is not nearly as bad as if you get an enforcement action, because that will hurt you really badly as compared to competitor funds."

The traditional asset management industry "has sort of gotten there" with regards to fees and expenses following "a lot" of enforcement actions, and hedge funds, which Cipperman described as a "middle ground," have stopped charging additional fees, instead rolling everything into their management fee and carry. Private equity managers are behind, and while there have been instances of wrongdoers hiding fees, that has not been Cipperman's experience. "[Managers] are stuck with their current structure within their fundraising or they're concerned about the competitive effect."

The increasing exposure the asset class has to retail clients — the Department of Labor recently issued guidance that allows 401(k) plans to offer investments in private equity — will put a lot of regulatory pressure on the industry to evolve and be more transparent.

Changing times

Highlighting shortfalls in the SEC's approach to fees and expenses, Joshua Cherry-Seto, co-chair of the Association for Corporate Growth's middle market focused Private Equity Regulatory Task Force, or PERT, said the long dated nature of funds does create difficulties. LP/GP negotiation over a funds' limited partnership agreement, or LPA, 12 years ago is "nothing like the way things are now."

This leads GPs to treat funds differently because issues that are relevant now were not on the table when a funds' LPA was formulated 10-plus years ago. If an item is not "mission critical," managers will have to weigh getting an LP consent — where many LPs do not have the capacity to reopen old structures — or continuing on without that item, Cherry-Seto said. "You have to manage that. And that's unfortunate, but you make a choice."

"I think the SEC has made it pretty difficult to even ask the advisory board for approval to start doing something you haven't done in the past or wasn't clearly articulated in your LPA or your Private Placement Memorandum. So I think that creates some friction. But at the end of the day, I think people sort of accept, or GPs accept, that if what you're doing makes sense and is appropriate, you should be able to get an LP consent if you need to."

The "system is fine as it is" and is not a fatal issue, Cherry-Seto said. He mooted if the SEC accepted that an LPA gives the advisory board "more latitude" to approve new expenses so a fund amendment is not needed, this could be a useful tool but added he was not sure this would even be acceptable to LPs. "LPs also don't want to consider consents on minor issues, but there is no middle ground."

There have been private fund managers who have been more opaque and secretive compared to being open with disclosures, but "we're living in an age now where disclosure is the best policy because 99.99% of the time actions are taken in the best interest of the fund and the LPs — and it may not look the same if you don't disclose what you're considering and somebody looks back two or three years later" Cherry-Seto said. "The most important thing is a good dialogue, a sense of good disclosure, set the tone between the advisory board meetings, and the annual meeting. And if those two things are done well, you'll have a healthy relationship with your LPs."