Who picks up the tab?

It is just over three years since Andrew Bowden, then director of compliance inspections and examinations at the US Securities and Exchange Commission, first shone a light on the allocation of fees and expenses by private equity firms, in his now-famous Sunshine Speech. Since then, GPs the world over have worked hard to get their accounting and fee procedures up to scratch in the face of both regulatory and investor pressure, but still they find themselves under greater scrutiny than ever before.

“There’s been a lot of movement in Europe in the last year,” says Michael Halford, a private equity partner in law firm Goodwin’s London office. “People are getting up to speed with the pressure to be more transparent about their fees and expenses, whereas a couple of years ago people really just weren’t aware of the issue.”

While the issue came to light in the US, and that is where several regulatory investigations and enforcement actions have since taken place, the knock-on effect has been global. Limited partners everywhere have become much more sophisticated in the information they expect to have access to with regards to the allocation of fees and expenses between the advisor and the funds, and European funds with even a limited number of US investors are exposed to the US enforcement authorities.

EXEMPT STATUS

“There’s now a deep appreciation that if you have even only one US investor in your European fund, you will get brought into the US regime,” says Halford. “Most European houses have exempt reporting advisor status with the SEC, but even with that limited obligation to disclose on an ongoing basis, they are still subject to the SEC requirement in relation to fee disclosures.”

“The focus is on transparency and disclosure, which means managers are looking at what they will be charging to the fund” Jeremy Elmore

In the pfm/EisnerAmper CFO Survey, we asked respondents which policies and processes their firms had modified in the past year, in relation to fees and expenses. Most firms had tightened all the three areas that we focused on: reporting fees and expenses paid by portfolio companies; allocating expenses between the advisor and funds, or across funds managed by the advisor; and disclosing conflicts of interest to limited partners, including conflicts arising from fee and expense issues.

While all three are under scrutiny, the biggest emphasis appears to be on allocating expenses between the advisor and funds, or across funds managed by the advisor, where 83 percent said they had tightened their policies in the last 12 months. A year ago, in 2016, the most popular choice was reporting fees and expenses paid by portfolio companies, which was a focus for 69 percent of respondents.

While European managers have been working on getting procedures in place, without facing the regulatory scrutiny of their peers in the US, for American managers this has been a live issue for longer.

Kenneth Berman is a partner in the investment management practice at the law firm Debevoise & Plimpton, based in Washington DC. He says: “This has been on the radar screen since the Dodd-Frank Act required private equity fund managers to register as investment advisors five years ago, and even more so in response to the SEC exams and enforcement cases. Fund managers probably believe they were transparent about fees and expenses all along, but we are now seeing a lot more granularity in disclosure than there ever was before.”

And despite managers having spent several years enhancing the sophistication of their accounting and fee procedures to ensure transparency, Berman says there are still areas that GPs are working on. “Where I see continuing focus is around services provided by affiliated third parties,” he says. “Significant efforts are being made to make sure fees being charged to the fund are arm’s length, and are at market rates. GPs are making efforts to validate disclosures concerning those fees, and obtaining metrics to demonstrate to investors and SEC staff that those representations are true.”

TRANSPARENCY COMMITMENT

Another hot topic concerns the use of subscription lines of credit facilities by general partners, and how those might give rise to conflicts of interest between GPs and investors. The Institutional Limited Partners Association issued guidance on the use of subscription lines in June, when Jennifer Choi, its managing director of industry affairs, said: “ILPA wants to ensure that LPs have access to the necessary information regarding GPs’ use of these facilities, and how they impact the alignment of interest between the two parties. Therefore, our recommendations are centred on a fundamental commitment to transparency and disclosure.”

Jeremy Elmore, a partner in the investment funds practice at UK law firm Travers Smith, says the focus is on transparency and disclosure, “which means managers are looking at what they will be charging to the fund, and making sure that in the fund documentation they disclose as much as possible so there can be no claim down the line that something wasn’t disclosed, whether that’s from a regulator or an investor.”

While he says there has been little change to the way in which fees and expenses are divvied up – just more disclosure – Elmore says he has witnessed some managers agreeing to put caps on travel expenses charged to the fund, though typically only where there is a single influential investor.

“From the investor point of view, when they are going in to a fund, the scope of their due diligence is extending,” he says. “They are looking at managers’ balance sheets to see whether there is any fat in the management fee, and an investor will often ask about the projected level of travel expenses that will be charged to the fund, or will want to look back at the expenses on the last fund.”

One new matter coming up for discussion is around abort costs on co-investments, says Elmore: “We are seeing a big desire from a lot of investors to get co-investment allocations, and if a manager is planning to syndicate 20 percent of a deal out to investors, they want to know what will happen if there are abort costs down the line. Historically co-investors have not picked up any of the abort costs, but we are seeing a bit of chat about that.”

Halford agrees that co-investments could be the area where fees and expenses next come under scrutiny. He says: “One area that’s quite interesting is the allocation of fees on co-investments. That’s going to be an increased area of focus in Europe, and is certainly something the SEC is looking at as well.”

The good news is regulators have not so far been prescriptive about what can and cannot be charged to a fund, and so once a manager has got systems and controls in place to ensure full disclosure to LPs of how fees and expenses are being allocated, then it is in good shape.