Five years ago GPs didn’t have to discuss things like the EU Alternative Investment Fund Managers Directive (AIFMD) or the US Foreign Account Tax Compliance Act (FACTA) when negotiating limited partnership agreements (LPA). But now that this alphabet soup of new rules and regulations has come into effect in the US and Europe, how to allocate the costs of corresponding legal and compliance work has become a talking point with fund managers and their investors.
A standard LPA will state the fund bears all costs of its operations, including dead deal fees, the use of outside consultants, taxes owed by the fund and third party legal and accounting services employed on the fund’s behalf.
And with respect to unexpected expenses – which happen for instance when legislators impose new compliance burdens on the industry – the partnership agreement should be “written in a way that it is clear enough to account for expenses that spring up throughout the life of the fund,” says one US fund formation lawyer.
When these unexpected costs spring up, the LPA typically provides GPs discretion where to allocate said fees. LPAs with ambiguous language, “invite debates about who pays for what,” warns Michael Harrell, who chairs the fund formation practice at law firm Debevoise & Plimpton.
WHO PAYS FOR WHAT
Such debates could be difficult as both parties can reasonably argue the other should pay for unexpected costs. From the fund manager’s perspective, the management fee – which is used to pay for GPs’ overhead costs – could have been negotiated years ago without expenses in mind like registration with the Securities and Exchange Commission (SEC). Last year, US funds managing north of $150 million – the threshold for registration – spent hundreds of thousands of dollars jumping past that one legal hurdle alone.
But the stronger point in GPs’ favor is that many of the new regulations in place are directly related to fund upkeep.
“Some costs, like FATCA, are clearly a fund expense,” says the private funds lawyer. It’s the same principle as the fund paying for its own tax returns.”
Michael Elio, a managing director with the Institutional Limited Partners Association (ILPA), sees it somewhat differently. He argues that “though it is acceptable for a GP to charge back some FATCA and accounting related costs at the fund level, depending on the specifics of the fund and the parallel funds, regulatory and compliance expenses are commonly a firm management issue.”
Other sources who believe a firm should pick up FATCA-related costs note reporting systems will need to be updated at a firm-wide level, which can make it difficult to know how each individual fund under the GP’s management can or should be charged for the upgrade. Elio adds a rhetorical question to the conundrum: “If the fund paid for a system upgrade, would they then own that system and lease it back to the manager? Clearly that would be a firm expense.”
Other recent regulations create similar expense allocation challenges. For example, most sources toldPE Manager that Form ADV, an information brochure document that SEC-registered GPs are required to file, was clearly a management expense, given the reporting obligation is part of the cost that comes with being a registered investment advisor. But a minority of sources disagree, noting that Form ADV is shared with LPs as a due diligence tool, and so of value to both the firm and its funds.
In much the same way Form PF – which some GPs began filing a year ago as part of regulators’ efforts to monitor systemic risk in the industry – is another gray area. “The form requires data collection from portfolio companies, which seems like a fund expense, but also requires information on the GP’s firm-wide exposure to risk, or leverage, which seems like a management expense,” says Harrell.
A separate legal source, however, says that the “law is clear in that Form PF is a reporting obligation of the fund, which must pay for its own operating expenses. In the same way that if the government said every hedge and private equity fund had to paint LPs’ toasters purple, then the cost of paint is a cost of the fund.”
ILPA’s Elio, meanwhile, counters that “there is no benefit to the fund for filing Form PF, the benefit accrues to the GP”. Elio elaborates that “Form PF is an ordinary cost of business for fund managers as regulated entities.”
John Malfettone, head of operations at large-cap private equity firm Clayton Dubilier & Rice, acknowledges the “different points of view on this debate” and notes each firm “will take a different approach when allocating fees”.
However, Malfettone adds that limiting the conversation to what the LPA does or does not allow would be a mistake. “Our firm decided to take on all these new reporting and regulatory expenses at the firm level. It’s not something we bang our chest about during negotiations, but if we’re asked about it, I’m glad knowing we’re LP-friendly on the issue.”
Likewise GPs should also consider what regulators might think about fee allocations. At a time when the SEC and other market watchdogs are investigating potential conflicts of interest in the industry, GPs should properly disclose to investors how are fees are shared, advises Harrell.
More generally, GPs will begin seeing a shift “where LPs will begin demanding more transparency on fund expenses,” says Jason Scharfman of Corgentum Consulting, a firm that helps LPs vet fund managers seeking their capital. “They want to know exactly who’s paying for what so that more questionable expenses can be discussed.”
A number of LPs told PEM that they are becoming increasingly concerned about what types of expenses are being charged to a fund.
“They can easily bury outsourcing costs in the financial statement,” says one fund of funds executive. “It isn’t an itemized expense report.”
The fund of funds manager went on to say he was suspicious of firms with billions of assets under management that, for example, never hired a general counsel to handle various legal services. “A general counsel could handle forms like Form ADV if they are SEC-registered. But if you don’t have that in-house lawyer, are we paying for that [to be outsourced]?”
Scharfman doesn’t expect partnership agreements to change much in light of LPs’ increasing concerns over fund expenses – allowing GPs discretion reduces administrative burden and there’s a level of trust embedded in the partnership agreement that fees will be allocated fairly – but changes may come in other ways.
“These types of expenses can be more openly discussed during negotiations, or brought to the attention of the limited partner advisory board,” says Scharfman. And fund formation sources add it is possible more GPs will begin splitting expenses between fund and management company as a compromise solution in this debate.
It may go against the spirit of the LP-GP relationship for every nickel and dime to be discussed. But as legal expenses enter seven-digit figures, that is no small change to ignore.
PICKING UP THE TAB
Despite SEC expectations, half of GPs do not have controls in place to monitor the reasonableness of expenses allocated to investors, according to fresh ACA research, which discovered the percentage of GPs that…
50% …have formal policies and procedures in place to ensure that only reasonable expenses are charged to LPs
25% …rely on employees’ own judgment to allocate expenses (no written allocation policies)
30% …charge all costs of private jet travel to the fund
35% …charge a first class ticket equivalent when jet setting
43% …require the investment process to progress to a certain point before the firm is able to allocate dead deal expenses to funds
18% …disclose expenses to LP advisory boards
38% …have the fund pay for annual limited partner meeting expenses
86% …eat all Form PF expenses at the management level
Source: ACA Compliance Group, 2013 Compliance Survey for Alternative Fund Managers