“Really quite surprising” is how Jack Rader described findings that more than half (55 percent) of private equity firms are failing to test the reasonableness of their expense allocation policies.
Rader’s firm, ACA Compliance Group, recently conducted wide-ranging research into managers’ compliance practices and discovered that the percentage of GPs with written expense policies has spiked from 50 percent to 74 percent in the past two years.
The reason why is pretty simple. The SEC is closely scrutinizing the fees and expenses that private equity firms charge to investors and portfolio companies. Adequate controls and policies are expected to ensure that charges are being allocated fairly, and managers are responding accordingly.
More difficult to explain is why fund managers aren’t testing these provisions. Our best guess is that GPs are unaware it’s a requirement. As excuses go, this one won’t do: “To the extent you have a policy written in your compliance manual, the SEC absolutely expects you to test it,” advises Rader. Testing should also be completed on an annual basis, and not just when news of an enforcement case sparks a one-off review.
It’s also possible that, after writing an expense policy for the first time, managers are more confident than ever about allocating routine charges such as legal and accounting fees. However, what should worry them are smaller, less noticeable “gray” expenses like travel and entertainment, which inspectors have made a focus area.
Fortunately, testing need not be a laborious process, nor do compliance staff need to be involved in personally signing off every last item. A good starting point, compliance consultants advise, is to have the finance and compliance teams sit down together and create a spreadsheet for mapping out the various ways of allocating the different fees and expenses. When gray areas arise, a conversation can be had to determine the best way forward.
In some instances, that may mean more disclosure is needed in fund documents, the form ADV or during limited partner advisory committee meetings. In other instances, when it is determined the expense cannot be reasonably justified, a reimbursement may be in order.
The meetings can bring the CCO’s attention to compliance risks the CFO is unaware of too. For instance, it recently came to light that SEC inspectors were questioning perceived discounts on dead deal expenses, which an increasing number of managers are footing the bill for. The idea is that service providers are willing to provide these discounts, to managers’ benefit, in exchange for continued business on deals that eventually close (and paid for fully by fund investors). Where this is a long standing practice, the CFO may not think to second-guess it.
It’s also worth noting that any review (and any subsequent reimbursements where necessary) should stretch back further than 2012, or whenever the firm first registered with the commission. The SEC could interpret a mishandled expense allocation as an anti-fraud violation, which is equally applicable to both registered and unregistered advisors.
Most of the industry is about three years out now from SEC registration. But clearly there are still some growing pains left to experience.
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