Even setting aside the Securities and Exchange's possible oversight of most US private equity firms, GPs everywhere are giving more thought to how certain expenses – especially entertainment – are accounted for.
For instance, the chief compliance officer of an $8 billion firm, which became an Registered Investment Advisor around three years ago, says that certain things that used to be paid for by the fund are now charged to the management company. He said that post registration, the firm decided it would not be proper for many entertainment-related expenses to be charged to the fund.
“Things like when we have our annual LP meeting, if there’s any entertainment involved that’s not of the normal course – golf, spa, things like that – the management company now pays for that whereas before the fund would,” he said. “We had to take a hard look and say, anything to do with entertainment is purely a management company cost. Even though if you go into our LP agreement it says meeting costs are borne by the LPs, from a regulatory standpoint we didn’t think that was right.”
Such considerations are likely to be faced by many more firms in the future, as recent financial regulations proposed by the Treasury Department – requiring investment advisors with $30 million or more in assets under management to register with the SEC – would likely capture all but the smallest private equity firms under the regulatory umbrella. Michael Sherman, an associate at Dechert, says that while there are no specific rules under the Investment Advisers Act of 1940 about what can and can’t be expensed to the fund, the likelihood of more rigorous SEC inspections may be causing more fund managers to change their accounting habits.
“We all have to be aware of appearances at all times, but particularly in tough times,” Sherman said. “Frankly, if I was an investor I might question why other investors were getting entertained on my dime. I would view that as a manager expense.”
Expenses that would raise a red flag among investors, or auditors, are not always black or white situations. Not all expenses are a flagrant as, say, the recent example of Chicago's AA Capital Partners, which got into hot water with the SEC for, among other things, receiving reimbursements for expenses the firm was not entitled to charge back to clients, including millions in political contributions, tickets to sporting events and visits to casinos and strip clubs. When it comes to grayer areas, firms have to make their own decisions based on the nature of entertainment.
How many LPs?
“I’ve had a lot of questions, for example, about offsite meetings with limited partners, and the first question out of my mouth is, ‘Who is invited, all the LPs or just a few of them’,” said Julie Corelli, co-chair of the funds practice at law firm Pepper Hamilton. “Are you trying to take care of your big investor or are you trying to convey information about the fund to all? The latter is much more likely to be a fund expense, and the former is entertainment that should be a management company expense.”
When it comes to annual meetings, firms should be careful of anything too lavish in this environment. The actual costs for a room and drinks for a meeting is easily a fund expense, but hosting a meeting with horseback riding and fly-fishing for the weekend is not. Corelli says that she knows of one fund in particular that takes its portfolio company CEOs out to a ranch every year for a networking forum, but although it helps solidify relationships with those CEOs and helps the fund get good references from them when competing for another deal, that expense is paid by the management company.
“They would never put that into a fund expense, no matter how directly related it is to the investments they already have,” she said. “Common sense should prevail on all of these decisions where you have to draw a line in the sand and ask, 'If it was you paying this money, would you be upset?' And I think I would be upset if my fund was using my money to take all those CEOs to a ranch in Wyoming.”
In general, network-building expenses are borne by the management company, but expenses directly related to specific deals are typically charged to the partnership from which the equity for that deal will be drawn. Still, common sense dictates that in taking prospective sellers to dinner in the latter stages of pursuing a deal, when such expenses are charged to the fund, you should go for the $90 bottle of wine over the $700 bottle, especially as an SEC inspection will focus on gifts and entertainment, according to Fiduciary Compliance Associates principal Charles Lerner. Even if that kind of entertainment is necessary for investors to feel comfortable with the management team, frankly, an SEC examiner making around $80,000 a year is going to be looking at it from an average person’s idea of what’s excessive and what’s not, and will likely not think highly of spending $700 on wine.
“You always want to think about how things look, because there is a decent amount of discretion examiners have over what they report as a deficiency or decides to refer up the chain, so you want to be aware of that,” Sherman said. “The regulator is not going to view it the same way as the average manager or investor. It's similar to the change in my driving habits when they started putting speed cameras up, the speed limit never changes but the chances of the regulator looking at my driving increased exponentially.”
As such, Corelli says that more people are exhibiting caution and are inclined these days to not even risk getting close to the line between what’s considered a fund or management expense. “If it is not explicitly stated in the fund agreement, then it’s a management company expense,” she says.
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