Fees and Expenses: What Examiners Want to Know
Do what you say, and say what you do.
Securities regulations have been described as a disclosure regime. As long as a firm discloses to clients what it plans to do with their investments – and does so in a way that will be read and understood by a reasonable person – the firm in many instances can rest easy that it is not breaking its fiduciary duty to those clients.
There are few areas where this principle is more central than fees and expenses. "It’s very much a disclosure issue," said Zaccaro Morgan partner Nicolas Morgan. SEC examiners, when they visit firms, want to determine if "what the adviser is telling investors is matched by the practice on the ground."
"Informed consent is the key. So long as you fully and fairly provide disclosure, and investors have a chance to accept or reject, charging that fee or expense generally should be acceptable," said Mayer Brown partner Rory Cohen, provided, of course, that what you charge is within the legal charge limits.
Hedge funds and private equity funds are where fee and expense issues typically come up when examiners visit, said Cohen. In that vein, SEC Office of Compliance Inspections and Examinations former director Andrew Bowden addressed the issue of fee disclosure in a May 2014 speech, "Spreading Sunshine in Private Equity," in New York City.
"Many limited partnership agreements are broad in their characterization of the types of fees and expenses that can be charged to portfolio companies (as opposed to being borne by the adviser)," Bowden said. "This has created an enormous grey area, allowing advisers to charge fees and pass along expenses that are not reasonably contemplated by investors. Poor disclosure in this area is a frequent source of exam findings. We’ve also seen limited partnership agreements lacking clearly defined valuation procedures, investment strategies, and protocols for mitigating certain conflicts of interest, including investment and co-investment allocation."
"By far, the most common observation our examiners have made when examining private equity firms has to do with the adviser’s collection of fees and allocation of expenses," he continued. "When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50 percent of the time."
With that in mind, it should not come as a surprise that examiners visiting your firm will bore deeply into how you disclose fees and expenses. Expect examiners to look at your Form ADV, limited partnership agreements, operating agreements and periodic reports, said Morgan. They will look for differences between what is said in these documents and what is actually being done, such as:
Where is compensation coming from? Some advisers, particularly those managing private equity funds, sometimes work with professionals whose employment status is not clear, said Morgan. For instance, if an adviser is considering having one of its funds invest in a solar energy company, it might draw on the expertise of a subject expert to get advice on solar energy to help guide the fund’s investments. "The expert might start off giving advice to the adviser and be paid by the adviser, but as time goes on, the adviser might want to shift some of that cost to the fund," he said. The issue is not so much whether it would be a reasonable expense for the fund to bear – many might say that it would be – but whether it had been previously disclosed to fund investors that the adviser might retain such an expert and charge his or her compensation to the fund. If the adviser did, then it is probably in the clear, he said. But if the adviser did not, and that failure to disclose is found by examiners, it will, at a minimum, need to be addressed. It might, particularly if the problem is seen as systemic, be referred to enforcement. This situation can also occur with back-office administrative functions, such as accounting. Is the fund or the adviser paying for these employees, and was that disclosed to investors?
Are fees charged in excess of what was disclosed? Take that same adviser who is considering investing in a solar energy company. Prior to making any investments, the adviser will want to investigate the company through due diligence. But in order to pay for that research, investors, who were told that only $100,000 would be spent on individual investments, would now have expenses of $200,000. In such cases, to avoid problems with examiners, "firms should monitor their compliance with any fee limits. If it goes over, the overage should be addressed. One way would be through charging any overage back to the adviser," Morgan said.
Is there improper shifting of expenses or fees among an adviser’s funds? Misallocation of this sort might occur when firms are managing side-by-side funds that make similar investments, and one set of clients absorbs fees or expenses that should be allocated to other clients, said Cohen.
Are fees being mischaracterized? This is when fees that are personal or considered investment management overhead are represented as fund-related expenses or fees for services that are misrepresented or are not provided, said Cohen. Among the recent actions that the SEC has brought in this regard are two: a January 2014 case in U.S. District Court where the agency brought charges against a private equity manager for allegedly concocting a sham due diligence arrangement under which fund assets would be used to pay fake fees (ACA Insight, 2/17/14), and a February 2014 administrative action against a private equity manager and his advisory firm for allegedly mischaracterizing fees charged to fund investors that actually were used to pay firm expenses (ACA Insight, 3/10/14).
Are firms utilizing fund expenses for their own benefit? Such fees might include an adviser’s compliance or internal marketing costs; the costs of completing a major document, such as Form PF; or even the cost of attending a conference, Cohen said. In many of these cases, one can argue that it is justifiable to charge the costs to a fund rather than the adviser. For instance, an adviser has an obligation to complete Form PF, but if the adviser is doing the form for the fund, it can make the case that it would be proper to charge the fund. The key, though, is not whether charging the fund for completing Form PF is justifiable, but whether it was disclosed to investors, Cohen said.
Firms preparing for an examination would be wise to self-audit. "Look at your disclosure in offering documents and other documents, look at your expenses and how they were passed through to funds," said Cohen. "Look at the layering of fees, the kinds of fees charged, such as those used to pay for adviser expenses rather than underlying vehicle fees, such as management fees. Are you disclosing?"