The tug of war over SEC exam costs

Agreeing on who foots the bill for SEC examination costs is becoming a constant battle between GPs and LPs, and the situation is unlikely to improve anytime soon.

When the Securities and Exchange Commission revealed in 2012 that it would embark on a large-scale sweep of the private equity industry, GPs were unprepared for the cost of examinations.

Fast-forward four years and GPs are not only prepared but are trying to shift the costs to the fund.

“We have started to see, from a practical standpoint, that GPs and LPs have become savvier in determining who pays for what,” says Anne Anquillare, co-founder of fund administrator, PEF Services.

“There has been a tug-of-war between the two sides with the GPs trying to convince the LPs, saying, ‘Look, the SEC came in to protect you, so you have got to bear a least some portion of the expenses.’”

This correlates with the results of our latest survey, which shows that there has been a 11 percent increase in the number of GPs that concede that regulatory exams are a fund expense, compared with the same survey in 2014.

“There is a shift towards the fund taking these expenses,” says Anquillare. “When the regulations first came out, and the exams first started to hit, nobody had contemplated it in the partnership agreement, so the management companies had to eat it. But now people are getting more sophisticated, more knowledgeable, and they are starting to make distinctions between what should be a fund expense versus a management expense.”

With the SEC ramping up its scrutiny of the private equity industry in recent years, more private equity firms have been charged with fees-related offenses as a result of discrepancies found during examinations.

In August, Apollo Global Management agreed to pay $52.7 million to settle SEC charges, relating to accelerated monitoring fees and allegations of misleading LPs in four funds about fees and a loan agreement. It was also accused of failing to supervise a senior partner who had charged personal expenses to several funds.

The same week, distressed-focused firm WL Ross & Co agreed to pay a $2.3 million civil penalty issued by the SEC for allegedly failing to properly disclose the method used to allocate certain fees it charges investors.

Managers should expect this trend to continue. “The message should be clear: we have the expertise and will continue to aggressively bring impactful cases in this space,” SEC Division of Enforcement director Andrew Ceresney warned in a speech at the Securities Enforcement Forum in San Francisco in May. During examinations, the SEC reviews all of a firm’s internal documents, including all policies and procedures, such as valuation, fee and expense allocations. The regulator also reviews fund documentation, such as the Limited Partner Agreement and Private Placement Memorandum.

Now that GPs know what to expect from an examination, many are taking the time to review their fund documentation.

“GP’s are more prepared now than before the SEC came out with its findings regarding fees and expenses,” says Thomas Angell, a partner at accounting firm WithumSmith+Brown. “They have had some time to review how fees and expenses were allocated and to make sure they have documented all necessary policies and procedures. Some funds have even gone through mock SEC audits by an outside compliance firm.”

However, many GPs are still of the opinion that the fund should bear the cost of examinations because, as Angell says, “an SEC examination is part of the cost of doing business and therefore it is a fund expense. If not for having the fund, there would be no reason for the SEC to review them.”

If the SEC finds mistakes during an examination, they will usually tell the firm if they need to take corrective action within six months of the exam taking place. Allocating the cost for this, however, depends on what the SEC has found as an issue and each fund may handle it in a different way, says Angell. “One would think that going forward GPs would bear these costs to avoid uncomfortable conversations with investors and to placate the SEC,” he adds.

We asked respondents about four possible scenarios stemming from an examination to gain a feel for how GPs allocate these expenses: accelerated portfolio monitoring fees; misallocating broken deal expenses; failure to disclose conflicts of interest around restructuring; and misallocating compliance costs.

Although many GPs reiterated these scenarios are usually a cost for the firm, smaller GPs are more willing to shift these costs to the fund. However, according to Anquillare, smaller GPs get a smaller management fee, so they are less willing to concede the issue – and they are more affected by the burdensome cost of a full-blown inspection.

“The point of SEC supervision is to protect investors, so it wouldn’t be surprising to see smaller GPs use that argument to negotiate around exams being a fund expense. It’s partly the case that some GPs simply can’t afford these new regulatory costs,” says Anquillare.

Issues often arise during the inception of a fund if examination expenses to be allocated to the fund – and to any co-investor – are not adequately disclosed in the Limited Partnership Agreement.

However, in the future, LPA’s are likely to become more involved, says Angell. “With all fees and expenses, LPAs will be more detailed in their description of what will be charged to the fund and what will be charged to the investment manager.”

The SEC’s spotlight will remain firmly fixed on the issue of fees for the foreseeable future. Negotiating terms for the allocation of exam costs will be difficult, but managers and investors need to agree on who foots the bill because the burden will not be getting any lighter.