US private fund managers have generally responded well to the Securities and Exchange Commission’s concerns over fees and expenses transparency. There are differences between what firm A and firm B charge to a fund, and some managers still don’t meet SEC expectations, but most written policies have been tightened up so investors and managers know where they stand.
But broken-deal expenses still need work, particularly given the increased prevalence of co-investment. Limited Partnership Agreements tend to explicitly state funds bear the costs of failed deals attempted by the vehicle, but according to the SEC, allocation issues persist when it comes to deals a manager intended to strike with a co-investor.
Consensus during a panel discussion at the recent Private Funds Finance and Compliance Forum was that, because they typically do not have a co-investor on board at the time a deal is confirmed or collapses, a fund bears the cost of a broken co-investment deal. In the case of a co-sponsored deal, when co-investors are engaged in the process from the outset, it is expected that they would pay transaction costs, one CFO told delegates, citing a recent deal her firm worked on.
This sentiment is echoed elsewhere. “GPs have various approaches; it is something that will evolve. If you are proceeding with a transaction, co-investors need to give a clear indication to the GP of their criteria and what they think the key risks are and then go on the hook for deal costs at the right time. You should have that built into your process,” Alistair Watson, a senior investment manager at Aberdeen Standard Investments said during a recent roundtable discussion hosted by sister title Private Equity International.
As with many compliance issues, the US regulator has not been explicit on how it expects the expenses to be allocated – although it has said that it is keen to see investors “treated fairly” when it comes to co-investments – but it does expect fund managers to make their policies on broken-deal expenses clear, and stick to them.
This approach is illustrated by broken deal related action the agency has taken. In one of its first ever private equity enforcement actions in 2015, the SEC charged industry behemoth KKR with misallocating more than $17 million of broken-deal expenses to its flagship private equity funds. The regulator said the firm “did not disclose in its offering materials that flagship funds would pay all broken deal expenses.”
Its most recent broken deals case followed the same course. Beverley Hills-based Platinum Equity Advisors was fined $3.4 million in September for allegedly charging three of its private equity fund clients broken-deal expenses that should have been paid by co-investors. The agency said the fund LPAs did not disclose that the funds would pay the broken-deal expenses for the portion of each investment that would have been allocated to the co-investor, adding that the firm “failed to adopt and implement a written policy and procedure to govern its broken deal expense allocation practices.”
Broken-deal policies are among the easier areas of compliance – they require a course of action to be decided, documented and carried out. Since the KKR case firms have been advised to check the language in their LPAs and to ensure they are clear on who pays what in the event a co-investment deal falls through, advice that lawyers and compliance experts have repeated since the action against Platinum Equity was made public. With broken-deal expenses remaining on the agency’s radar, now is as good a time as any for firms to take another look at their policies and make sure they have evidence to show that when necessary, they follow them to a T.