Broken-deal expenses were one of the first anomalies to pique the interest of the SEC in the years after the regulator brought private markets into its fold. In 2015, KKR was charged with misallocating more than $17 million in broken-deal expenses to its funds, in breach of its fiduciary duty – it was the first case of its kind. A rush to specify details surrounding the treatment of broken-deal fees in LPAs ensued and, as a result, many now see this as an issue that has been resolved.
Two-thirds of respondents to the Private Funds CFO Fees & Expenses Survey 2022 said they charge all broken-deal expenses to the fund, equal to the 2020 findings, adding weight to the idea that the market has found an equilibrium. “Broken-deal fees make up an area where there has been increased specificity in fund documentation,” says Patrick Bianchi, a private investment funds associate at law firm Troutman Pepper. “It used to be vague, but now everything has been spelled out.”
Joshua Cherry-Seto, CFO of venture capital firm StartUp Health and until recently of Blue Wolf Capital, adds: “The issue of broken-deal fees comes down to your take on who should be responsible for the deal-sourcing function, and how that should therefore be paid for. But fundamentally, it is something that is negotiated directly in the LPA, so in that sense, it should be a non-issue.”
If anything, Tom Angell, financial services practice leader at Withum, says managers that erred on the side of caution in the wake of initial SEC scrutiny have now been able to relax their broken-deal stance.
“Andrew Bowden’s ‘Spreading sunshine in private equity’ speech at [affiliate title] PEI’s Private Funds Compliance Forum in 2014, put broken-deal fees and other expenses in the spotlight. General partners responded by taking on costs that may have been properly allocated to the fund in their LPAs because they were concerned it would attract the wrath of the SEC,” Angell explains.
“The pendulum now appears to be swinging in the other direction, with expenses that would have previously been absorbed by the management fee as a precaution now reverting as firms get comfortable from a compliance perspective, based on prior SEC rulings and enforcement actions.”
Indeed, there are rational reasons why it does not make sense to charge broken-deal fees to the management company, including potential incentivization to curb due diligence spending or even to shy away from pulling out of a dubious deal. The problem, as Blinn Cirella, CFO of Saw Mill Capital, says, is that broken-deal fees can add up.
“We’ve not had many truly broken deals – meaning a deal that gets within weeks of transacting before it is pulled – but on one of the bigger deals, we spent around $700,000 on fees and expenses. Those expenses were 100 percent paid for by the fund,” Blinn says. “We’ve not made any significant changes in how we manage potential deal costs, but we are careful to not start running up costs until we are fairly deep into our diligence process.”
Where broken deals do remain a subject of considerable controversy, however, is when it comes to the responsibilities of co-investors – which, of course, includes any co-investment made by the general partners themselves. While LPAs typically now explicitly state the division of broken-deal costs between the management company and fund, allocation issues persist when it comes to deals a manager intended to strike alongside third parties.
“The treatment of broken-deal expenses with respect to co-investment continues to be the topic of much discussion,” says Stephanie Pindyck-Costantino, partner at Troutman Pepper. “Should those fees be charged exclusively to the fund, or should they also be borne by the co-investors? In many cases, the fund continues to bear the cost, and this remains a topic of discussion.”
It is an issue the SEC is pursuing with determination, but the industry is resisting with equal force. “To lessen the burden on the fund LPs, the SEC wants private equity firms to require the co-investors to share in broken-deal costs,” says Cirella. “As you can imagine, co-investors are not agreeable to this. One co-investor even told me that if this ever really came to pass there would be no more co-investments.”