The cost of compliance

The Securities and Exchange Commission is pursuing perceived private markets fees and expenses mishandling with dogged determination. Firms to have fallen foul of enforcement actions in the past 12 months include international giants such as Global Infrastructure Partners, which paid $4.5 million to settle claims that it had failed to offset fees in three of its funds despite documented promises to do so. 

Alumni Ventures, meanwhile, was censured for misleading statements about its management fees and engaging in interfund transactions that violated operating agreements. Tellingly, the SEC named and shamed, charging the firm’s CEO, Michael Collins, specifically. 

These enforcement actions come as the SEC lays out proposals for a radical overhaul of reporting and transparency rules. These changes have yet to be adopted but it is clear the regulator is not letting the industry out of its sights.

Against this backdrop, private markets firms’ approach to SEC intervention remains mixed, however. Less than 40 percent of respondents to the Private Funds CFO Fees & Expenses Survey 2022 disclose deficiencies found during routine examinations as standard practice. A further 23 percent only do so if required by individual side letters, and 22 percent only if the deficiency results in expenses to the fund. Critically, 17 percent will avoid disclosure at any cost – the antithesis of the SEC’s transparency mantra. And while the management company will typically share the cost of any remediation following an exam, that is not universally the case. Just under 30 percent of respondents would charge the cost of fixing inadequately disclosed portfolio monitoring fees to the fund, for example.

Meanwhile, in many cases, managers would also expect the fund to pick up the penalty – something that the SEC looks set to take a dim view of under the new rules. A third of respondents would pass on the penalty for a misallocation of investment opportunities between funds and managed accounts and 14 percent would pass on penalties for the misallocation of broken-deal expenses. 

“One of the biggest changes in the proposals relating to fees and expenses, is the fact that firms will not be able to pass on examination and compliance costs to the fund, even if specified in the documentation,” says Patrick Bianchi, a private investment funds associate at law firm Troutman Pepper. “I think that will result in higher management fees being charged to cover that potential cost.”

Indemnification

It is also clear that firms continue to seek indemnification of principals, something else that the SEC is seeking to crack down on. For 30 percent of respondents, this indemnity provides the advancement of expenses in all cases – admittedly a slight fall on recent years. Instead, firms are increasingly seeking LPAC approval, or limiting the circumstances in which an advance would be considered. If the SEC proposals are adopted, however, these nuances will be irrelevant – all indemnification will be banned.

Indeed, the scope of the new proposals is breathtakingly broad, covering the expedition of quarterly reporting, the detailing of expense categories and all compensation, fee rebates, waiters and offsets, including clarification around how these are calculated and cross references to governing documents.

The SEC is also proposing that firms tighten up the reporting of performance metrics, in order to ensure greater standardisation and comparability. And according to Tom Angell, financial services practice leader at Withum, one of the most challenging and contentious aspects of this reporting involves the need to present performance metrics both with and without the impact of funding facilities. 

Joshua Cherry-Seto, CFO of venture capital firm StartUp Health and until recently of Blue Wolf Capital, agrees. “Reporting unlevered returns may sound like a straightforward and reasonable request but it is not. If we didn’t have access to a line of credit, we would have to call capital in advance,” he explains.

“We would also have to return that capital if the deal didn’t complete. The reporting of an unlevered return is not the same as the return that would be generated by a fund without leverage.”

Of course, the impact of all these additional compliance costs would hit smaller firms, particularly hard. In many cases the chief compliance officer in these organizations is already stretched, wearing multiple hats – often that of the CFO. 

And the SEC has indicated it would frown on the complete outsourcing of the compliance function. “I have always held more than one title. Even having raised $1 billion for our latest fund, we were never quite big enough to separate the functions,” says Cherry-Seto. 

There is also a fear that heightened compliance costs could prevent smaller managers crossing the SEC registration threshold, or else propel them over the lower mid-market to a size where the management fee could cover these increased costs, leaving a funding gap in the SME economy.

It may also curb enthusiasm for new entrants, in what is already an extremely challenging fundraising environment for emerging managers. 

As Anne Anquillare, head of US fund services for CSC, says: “Adding more compliance to the act of registration is only going to exacerbate pressures on those firms at the lower end of the mid-market and my concern is that over time it may also stifle the next generation of fund managers.”