Some of the world’s largest private equity investors have recently sent lengthy questionnaires to their GPs seeking clarifications on fees and expenses, as the fallout continues from a now-notorious speech by the Securities and Exchange Commission.
The so-called ‘Sunshine Statement’, delivered by Andrew Bowden, director of the SEC’s Office of Compliance Inspections and Examinations, at Private Equity International’s Private Fund Compliance Forum in New York in May, has sparked a wave of disclosure demands across the global industry.
Bowden, whose team have examined more than 150 newly SEC-registered private equity advisers, flagged serious concerns about the collection of fees and allocation of expenses between managers and the funds for which they are responsible. He said: “When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law, or material weaknesses in controls, over 50 percent of the time.”
Industry sources say the SEC has since been relatively aggressive in trying to get people to pay money back. One US lawyer advising general partners says: “They are asking one of my clients to pay back tens of millions of dollars, despite there being a partnership agreement in place that allowed for the charges, and despite enhanced disclosure having been made.”
Some limited partners have used the Sunshine Statement as a rationale to send lengthy disclosure requests to their managers, asking them to explain the precise nature and quantum of their fees and expenses, with reference to the LP agreement signed at the outset of the fund. They have also demanded to know whether the SEC has examined the manager in question, and if so, what the regulator concluded about the policies in place. More requests are likely to follow.
Since the Dodd-Frank Act required that private equity funds register with the SEC, investment advisers have had to complete Form ADV. Part two of that form is primarily for client use: acting as a sort of brochure, it contains information such as the types of advisory services offered, the advisor’s fee schedule, and the educational and business backgrounds of both management and key advisory personnel of the adviser. Here, again, change is afoot.
“We are seeing people now making additional disclosures on and revisions to their Form ADV part twos, making sure everybody understands the way things work,” says another private equity lawyer.
One of the main issues highlighted by Bowden in terms of expenses related to GP’s use of operating partners, particularly for those firms whose network of operators provide services to portfolio companies that are paid for by the funds. Since these consultants will look and act like other employees of the general partner, and usually work exclusively for that GP, it does raise the question of why they are paid for by the fund rather than the manager.
In his speech, Bowden said: “In some egregious instances, we’ve observed individuals presented to investors as employees of the adviser during the fundraising stage, who have subsequently been terminated and hired back as so-called consultants by the funds or portfolio companies.”
Other expenses that have come under the spotlight have included legal, compliance and accounting costs – which investors may have assumed should be borne by the managers, only to find they are in fact borne by the fund.
One London-based private equity lawyer says: “We acted for one GP who has an in-house legal team and charges legal fees to the fund for their team working on deals. But it was all declared in the limited partnership agreement. And it was more cost-effective for the LPs to pay for the legal services that way.”
Another lawyer says: “I had one case where travel expenses were being recharged to the fund. The investors thought that travel expenses should be part of the overhead of the manager.”
Then there are fees that may be charged to investors without adequate disclosure, such as monitoring fees charged to portfolio companies for ongoing board and management services, or administrative/transaction fees.
Some argue that investors are actually pretty savvy about how fees and expenses are calculated and charged. It is also the case that the level of sophistication of documentation in partnership agreements has improved considerably, especially since the introduction of the Institutional Limited Partners Association’s Private Equity Principles in 2011, which set out to establish best practice for partnerships between LPs and GPs (the SEC will be looking at many fund documents that pre-date these).
Tom Alabaster, a partner with the law firm Latham & Watkins in London, says: “Limited Partner Agreements include pretty specific definitions of what a deal fee is or what a director fee is etc., usually with some kind of sweeper language covering ‘other similar fees’. Those mechanisms are put in place at the beginning of the fund; they are heavily negotiated and sophisticated; and the first draft very rarely bears much resemblance to what gets accepted by the investors.”
But problems can arise when circumstances change during the life of the fund; for instance, if new costs come up that the manager takes a view on offsetting, or new fees that are charged to the portfolio company. For instance, Bowden referred to advisers “using process automation as a vehicle to shift expenses” – so investors end up paying for software that produces and distributes quarterly reports, whereas previously managers would have employed people at their own expense to do that work.
Jason Glover, a partner with the law firm Simpson Thacher & Bartlett in London, says: “There is a real problem in explicitly identifying all costs, and attributing such costs specifically to the fund or the manager. For example, going back four or five years, the documentation would typically provide for managers to be responsible for costs relating to the management function, and for the fund to be responsible for the external legal costs, administration costs and the costs of the accountants incurred in relation to the fund. You probably wouldn’t have said anything about costs relating to the custody of assets, because back then third-party custodians weren’t relevant to private equity. Then AIFMD comes in, which introduces a custody regime, and the question arises as to who pays that cost.”
Time for a change?
Many lawyers are now predicting changes to the way fees and expenses clauses are drafted in fund documents going forward.
Some lawyers argue for a simplification of the language being used in LPAs, and a reduction in the number of areas where fees are chargeable – such that the agreements would define what was and what wasn’t permissible, and anything else would have to be run past the investor committee for approval.
On the expenses side, Stephen Newby, a partner with the law firm Herbert Smith Freehills, says: “We are definitely seeing more of a focus on the language in the partnership agreement around expenses, plus a focus on providing more detailed annual budgets and referencing the reimbursements and expenses around those budgets.”
He suggests: “You could put a line item in the agreement where you set a cap on annual expenses, such that the manager can reclaim up to X – and if it wants to go beyond that figure, it has to go back to investors or the advisory committee for consent. LPs don’t want to be signing off every time someone buys a stapler; but they do want a review process that they can get comfortable with.”
Some of the practices highlighted in Bowden’s speech do raise eyebrows even with the most hardened private equity lawyers – notably the accelerated monitoring fee. The SEC has apparently found that some advisers have got their portfolio companies to sign up to agreements obligating them to pay monitoring fees for ten years (or longer) – even if they exit much sooner.
Bowden said: “Some of these agreements run way past the term of the fund; some self-renew annually; and some have an indefinite term. We see mergers, acquisitions, and IPOs triggering these agreements. At that point, the adviser collects a fee to terminate the monitoring agreement, which the adviser caused the portfolio company to sign in the first place. The termination usually takes the form of the acceleration of all the monitoring fees due for the duration of the contract, discounted at the risk-free rate. As you can imagine, this sort of arrangement has the potential to generate eight-figure, or in rare cases, even higher fees.” He added that there was usually no disclosure of the practice at the point when the agreement was signed.
One US-based lawyer admits this does happen – albeit rarely: “I don’t think many LPs realize that sometimes when they enter into a monitoring agreement for ten years and they exit after four, there is an acceleration of all the fees due. But that’s not a behavior that I believe is common among GPs.”
Still, in the current tricky environment, where fund managers are having to settle for smaller funds or failing to raise altogether, it is possible that GPs are scrutinizing their agreements to find ways to push expenses back to the funds, or even to claw back more of the fees for themselves.
But for now, advisers say, investors should not shy away from asking hard questions and seeking clarifications.
Mounir Guen, founder and CEO of placement agent MVision, says: “The policy is really very straightforward: no surprises. An investor wants to have a relationship with a business that is open and transparent and has clear, clean and consistent reporting, so that they can make decisions about whether they feel comfortable with the business model of that particular GP. Maybe a GP has operating partners and has certain ways of calculating how those operating partners are compensated. But as long as that is visible to the LPs, it may be fine for them.”
“The issue is really about clarity and transparency, with problems arising through a misunderstanding of to whom charges are attributed, or in some cases a lack of disclosure regarding the attribution of charges,” agrees Glover. “Greater transparency is a good development and is something that the industry has been working hard to achieve in recent years – so there’s a clear dissemination of information relating to the attribution of costs. That in turn provides investors with the opportunity to raise any concerns with the relevant manager.”
Alabaster adds: “This industry is based on long-term relationships; GPs want investors to come in to funds two, three and four. So the idea that the GP wants to get one over on the LP is not how it works. It is in everybody’s best interests to be as transparent as possible.”
The current focus on fees and expenses is part of a much wider review of the industry by the SEC, which is fast getting up to speed on the issues. Other topics in the spotlight include valuation policies, compliance structures, co-investment and separate account policies.
Nabil Sabki, a partner with Latham & Watkins in Chicago, concludes: “The SEC is getting much smarter about private equity, and at the moment the focus seems to be expenses. The next area I’d be focusing on if I was a sponsor would be performance. The SEC hasn’t really focused on IRRs and the way people calculate performance, but expect that to be next in the spotlight.”