KKR Settlement: SEC Ratchets Up Pursuit of Private Equity Advisers
The SEC’s settlement with advisory firm giant Kohlberg Kravis Roberts & Company is more than a statement from the agency that major investment firms are not immune from enforcement. The first-ever expense misallocation case involving broken-deal expenses against a private equity adviser is a warning that, when it comes to advisers managing private equity, the Division of Enforcement is armed and hunting for bear.
Since gaining regulatory oversight of private funds in 2012 under the authority of the Dodd-Frank Act, the SEC has spent time learning about private funds, including hedge funds and private equity funds, and where there may be practices it needs to investigate. It focused a set of exams on private funds in 2013, hired individuals with private fund experience, and formed a private funds unit in its exam division. The agency also included private fund fraud or wrongdoing as a 2014 examination priority, and listed private equity fees and expenses as an examination priority in 2015. Along the way, it took some enforcement actions.
The latest blow came on June 29, when the SEC issued an administrative order instituting a $30 million settlement with KKR. The settlement order alleged that the firm, over a six-year period ending in 2011, misallocated more than $17 million in "broken-deal" expenses to its flagship private equity funds rather than charge them to co-investors, including KKR executives. Included in the settlement total was a $10 million civil money penalty against the firm.
"Although KKR raised billions of dollars of deal capital from co-investors, it unfairly required the funds to shoulder the cost for nearly all of the expenses incurred to explore potential investment opportunities that were pursued but ultimately not completed," said Division of Enforcement director Andrew Ceresney.
KKR also allegedly failed to disclose to fund investors that it wasn’t allocating broken-deal expenses to co-investors. Nor, according to the SEC, did it have an adequate written compliance policy governing its fund expense allocation practices, although it did create such a policy in 2011, the agency said.
"The case shows the SEC’s willingness to dive deeply into the operations of even the biggest names in the private equity industry," said Zaccaro Morgan partner Nicolas Morgan. "Nothing stopped the SEC from doing something similar prior to 2012, but registration enabled the agency to conduct an exam on this issue. And certainly establishing the Asset Management Unit and hiring knowledgeable people from the industry has enabled the SEC to ask more sophisticated questions and look at more subtle issues."
The bottom line for advisers is that the SEC will likely bring more expense allocation cases, Morgan said. "Advisers should confirm that their representations match their practices. And, importantly, when an adviser is in a position to allocate expenses to one client over another, the adviser should confirm that it is not improperly playing favorites."
KKR most likely settled the case just to be done with it, said Stern Tannenbaum partner Aegis Frumento. The $30 million cost, while a significant amount for the SEC, is a "rounding error" for a firm as large as KKR, he said.
Nonetheless, he said, the agency may be "emboldened" by its success with the KKR settlement, so don’t be surprised if it attempts to reach similar misallocation settlements, whether about broken-deal expenses or some other matter, from other private equity advisers in the future. "They’ll throw this settlement on the table and say, ‘KKR settled. Why can’t you?’"
The case also is an example of the revolving door between the SEC and the firms it regulates. The investigation into KKR’s allocation practices was led by the Enforcement Division’s Asset Management Unit, which was formerly co-led by Bruce Karpati, now KKR’s global chief compliance officer, and Debevoise partner Robert Kaplan, now KKR’s outside counsel. Neither Karpati nor Kaplan replied to attempts to reach them.
KKR did issue an official statement. "This resolution, which relates to historical expense allocation disclosures and policies and not to any current practices, allows us to focus on delivering value for those who invest with us," the firm said. "We take our fiduciary responsibilities seriously and have strived to adapt our policies and practices to the changing nature of the industry, market and our business. KKR is firmly committed to upholding the highest governance and transparency standards, and we remain dedicated to continually enhancing our practices on behalf of our fund investors."
The firm, the fund and expenses
New York City-based KKR is one of the country’s best-know private equity firms, and specializes in buyout and other transactions. It advises and manages its own flagship private equity funds, as well as other co-investment vehicles and accounts that invest alongside the funds. As of the end of 2014, KKR had more than $51 billion in assets under management from its private equity line of business alone.
From 2006 through 2011, the KKR 2006 Fund, referred to in the SEC’s administrative order as the "2006 Fund," was the adviser’s largest private equity fund, with $16.6 billion in committed capital. Limited partners in KKR’s private equity funds include many large pension funds, university endowments and other large institutional investors, and high net worth individuals. The adviser charged investors a management fee, typically from 1 percent to 2 percent of committed capital during a fund’s investment period, and received a carried interest of up to 20 percent of the net profits realized by the limited partners.
Broken-deal expenses include research costs, travel costs and professional fees, as well as other expenses incurred when sourcing deals that do not ultimately materialize. They also include expenses related to the evaluation of particular industries or geographic regions for buyout opportunities.
The limited partnership agreement for the 2006 Fund permitted KKR to allocate to or be reimbursed by the 2006 Fund for all broken-deal expenses that were incurred by or on behalf of the fund, the administrative order said. The method by which KKR was reimbursed was through fee-sharing arrangements it had with its funds. Pursuant to its LPAs and management agreement, KKR shared a portion of its monitoring, transaction and break-up fees with the fund. For the 2006 Fund, KKR reduced its management fee by 80 percent of the fund’s proportional share of those fees after deducting broken-deal expenses, the SEC said. "Accordingly, KKR received 20 percent of those fees, and economically bore 20 percent of broken-deal expenses. The 2006 Fund in turn received 80 percent of those fees, and economically bore 80 percent of the broken-deal expenses."
However, both for the 2006 Fund and its other private equity funds, KKR did not "expressly disclose in the (limited partnership agreement) or related offering materials that it did not allocate broken-deal expenses to KKR co-investors … even though these co-investors participated in and benefitted from KKR’s sourcing of private equity transactions," the agency said. "As a result of the absence of such disclosure, KKR misallocated $17.4 million in broken-deal expenses between its flagship PE funds and KKR co-investors during the relevant period and, thus, breached its fiduciary duty."
Interestingly, noted Morgan, "the SEC does not appear to challenge the accuracy of the limited partnership agreement’s representation that KKR allocated broken-deal expenses to the fund that were incurred by or on behalf of the fund. Rather, the SEC argues that the limited partnership agreement required an additional explicit representation that KKR did not allocate broken-deal expenses to other investors who benefitted from those expenses."
But just how explicit does a limited partnership agreement have to be for the SEC to consider it explicit? Frumento noted that, in its administrative order, the agency said that the limited partnership agreement states that "’all’ broken deal expenses that were
‘incurred by or on behalf of’ the 2006 Fund" could be allocated to the fund.
"If ‘all’ expenses were allowed to be allocated to the 2006 Fund, that would mean that none would be allocated to the friends and family investors," he said. Perhaps the SEC wanted that logical conclusion written out in the limited partnership agreement, but since most of the 2006 Fund investors were pensions funds, endowments and other high net worth investors, they were sophisticated enough to realize that saying "all" expenses would be allocated to the fund would mean that none would be allocated elsewhere, Frumento said.
"This apparent favoring of some investment clients over others in the allocation of expenses raised another issue common to many SEC Asset Management Unit cases: breach of fiduciary duty," Morgan said. "Because KKR was in the position of deciding which of its adviser clients would bear broken-deal expenses, it had a fiduciary duty not to favor one client’s interests over another. While this may be a novel application in the context of broken-deal expenses, the principle is not new with the SEC."
KKR discovers its problem
In June 2011, KKR conducted an internal review and realized that it lacked a written policy for broken-deal expense allocations. "Before June 2011, KKR had not considered whether to allocate or attribute broken-deal expenses to KKR co-investors because in its view the flagship PE funds bore all broken-deal expenses less the portion of those expenses that KKR bore pursuant to its fee-sharing provisions with the applicable funds," the SEC said.
KKR drafted a fund expense allocation policy in October 2011, and decided to allocate some share of broken-deal expenses to several of its co-investment vehicles. During the same month, the adviser engaged a third-party consultant to review its fund expense allocation practices. Based on the review, KKR revised its broken-deal expense allocation methodology in January 2012, increasing the allocation of such expenses to more partners and co-investors. The new practice considered a number of factors before allocating broken-deal expenses, including the amount of committed capital, the amount of invested capital, and the percentage of transactions in which a KKR co-investor was eligible to participate given the fund’s investment rights. The SEC took a pass as to whether it found the new allocation methodology sufficient, saying that it was not a subject of this administrative order.
Violations and penalties
While KKR did not admit or deny guilt in the settlement, the SEC charged the firm with violating Sections 206(2) of the Advisers Act, which prohibits fraud. It also charged the firm with violating Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule, for not having adopted and implemented written compliance policies and procedures.
While the administrative order does note KKR’s remedial efforts taken and cooperation with the Commission staff during the examination and subsequent investigation, the SEC nonetheless ordered the advisory firm to pay $18.7 million in disgorgement and interest to compensate the 2006 Fund and other funds that invested in private equity transactions from 2006 to 2011. KKR previously refunded $3.3 million in broken-deal expenses to clients.