Private Equity + Conflict of Interest + Failure to Disclose = SEC Enforcement
Here’s a recipe sure to draw the SEC’s attention, direct from the Division of Enforcement’s cookbook: Take one private equity firm, add a tablespoon of conflict of interest, mix, and then bake. When done, divide among selected colleagues and enjoy the finished product in private. Be sure not to share the recipe with clients, investors or board members.
Warning: This recipe may prove significantly more expensive than expected, and you may not be doing much more baking after agency charges lead to a costly settlement.
That’s what at least some key players at New York City-based private equity fund adviser Fenway Partners may be thinking, now that the adviser and four of its executives agreed to pay more than $10 million to settle with the SEC. The agency alleged that the adviser and its executives "failed to disclose conflicts of interest to a fund client and investors when fund and portfolio company assets were used for payments to former firm employees and an affiliated entity."
According to the SEC, Fenway Partners, two of its principals, a former principal and its chief financial officer failed to fully disclose to the client and investors information about transactions involving more than $20 million in payments from fund assets or portfolio companies. The payments allegedly went to an affiliated entity for consulting services, as well as to the Fenway Partners’ former principal and other former employees for services that were mostly provided while they still worked for the adviser.
"Fenway Partners and its principals failed to tell their fund client that they re-routed portfolio company fees to an affiliate, and avoided providing the benefits of those fees to the fund client in the form of management fee offsets," said Division of Enforcement director Andrew Ceresney when the November 3 settlement was announced. "Private equity advisers must be particularly vigilant about conflicts of interest and disclosure when entering into arrangements with affiliates that benefit them at the expense of their fund clients or when receiving payments from portfolio companies."
The Enforcement Division’s Asset Management Unit co-chief Marshall Sprung added that Fenway Partners and its principals "breached their fiduciary obligation to fully and fairly disclose conflicted arrangements to a fund client, and compounded the breach by omitting material facts about the arrangements when communicating with fund investors."
SEC hot buttons
"This case features a trifecta of current enforcement issues for the SEC: 1) conflicts of interest, which is a perennial enforcement priority, 2) private equity, which has come under increased scrutiny in recent years, and 3) individual accountability, in terms of actions against firm principals and CCOs," said Foley Hoag partner Daniel Marx.
"The SEC staff has repeatedly warned investment advisers that they must adequately and timely disclose conflicts of interest relating to the collection of fees and expenses," said Mayer Brown partner Matthew Rossi.
Consider that in the past two years, the SEC has brought enforcement actions against private equity fund advisers for, among other things, misallocating expenses among funds, misallocating broken deal expenses (ACA Insight, 7/13/15), charging funds for the adviser’s own expenses (ACA Insight, 6/15/15), accelerating monitoring fees, and taking service provider discounts that should have gone to the funds they managed (ACA Insight, 10/20/14), all of which relate to not providing adequate disclosure to limited partners or authorization from offering documents.
Monitoring fees and advisory fees
Fenway Partners, like many private equity fund advisers, was required by the Dodd-Frank Act to register with the Commission, which it did in March 2012, when it had $756 million in assets under management, according to the SEC administrative order instituting the settlement. Its assets under management dropped to $445 million as of April 2015, the SEC said.
The adviser had management service agreements with a number of portfolio companies, under which Fenway Partners received periodic monitoring fees for providing management and other services, the agency said. The monitoring fees were offset by 80 percent against the advisory fee paid by one of the funds it managed. For example, the SEC said, when Fenway Partners received $1 million in monitoring fees from a portfolio company in 2010, it reduced the advisory fees payable by its fund by $800,000.
Beginning in December 2011, according to the SEC administrative order, the firm and its executives "caused certain portfolio companies to terminate their payment obligations to Fenway Partners under their management service agreements and enter into agreements … with Fenway Consulting Partners, an entity affiliated with Fenway Partners" and principally owned and operated by three of the adviser’s executives.
Fee arrangements were different under the new agreements, in a way that greatly benefitted Fenway Partners, the SEC alleged: the monitoring fees were not offset against the fund’s advisory fee, "resulting in a larger advisory fee to Fenway Partners." For instance, using the example mentioned above involving $1 million in monitoring fees received by the adviser, under the new agreements, there was no reduction in the advisory fees payable by the fund.
Fenway Consulting received $5.74 million under these agreements from January 2011 through December 2013, the SEC said, "none of which was offset against Fenway Partners’ advisory fee."
In addition to the monitoring fees/advisory fees situation, Fenway Partners and its executives allegedly asked investors to provide $4 million in connection with an investment in a portfolio company without disclosing that $1 million from that sum would be used to pay Fenway Consulting. Finally, the SEC said, Fenway Partners enabled one of the executives and two advisory firm employees to receive $15 million in incentive compensation from the sale of a portfolio company "for services that they had almost entirely provided when they were Fenway Partners employees."
Advisory firm lessons
Creation and use of an affiliate to avoid paying fees is "exactly the kind of conduct the SEC is focused on right now," said Rossi. "Advisers must be very careful to ensure that any changes to fee arrangements and conflicts of interest arising from those arrangements are fully disclosed to fund investors as well as authorized by fund organizational documents.
The action against Fenway Partners "is an example of the close attention that the SEC is now paying – and the skepticism it often has – about many fee arrangements in the private equity industry," said Marx. "This is a major risk area, and advisers must carefully consider whether they have conflicts that must be eliminated or, alternatively, mitigated and disclosed to their advisory boards and investors.
"Moreover," he said, "it is not enough to analyze conflicts of interest once and then move on. Dealing with conflicts is not a one-and-done proposition. For example, anytime business models change, including how fees are charged and allocated, advisers must re-assess potential conflicts. And if those changes result in investors or portfolio companies paying more fees for essentially the same services, which is what the SEC alleged happened here, that is a red flag."
There were multiple failures to disclose, according to the SEC. For instance, Fenway Partners and its principals allegedly failed to disclose:
The conflict of interest presented by the management service agreements between the portfolio companies and Fenway Consulting, the Fenway Partners affiliate that was owned by the adviser’s principals, to the fund’s advisory board, as required by the fund’s organizational documents.
The conflict of interest "presented by the fact that the portfolio companies had terminated their payment obligations under the management service agreements and replaced them with consulting agreements – and that, as a result, the limited partners would not receive the benefit of an advisory fee offset for such portfolio company payments" to the advisory board, again as required by the fund’s organizational documents.
The "inherent conflict of interest" associated with the payments to Fenway Consulting, and that they were not authorized by the organizational documents. "Fenway Partners could not effectively consent to these payments on behalf of [the fund] because it was conflicted, as the recipient of the fees was an affiliate of Fenway Partners, and Fenway Partners received the benefit of the decision not to offset the portfolio company fees paid," the agency said.
The cash incentive plan that allegedly enabled the firm’s principals to receive $15 million, which the SEC said was "not disclosed in or otherwise authorized by the organizational documents."
Violations and penalties
Fenway Partners and its executives were charged with violating Section 206(2) of the Advisers Act, which prohibits an adviser from engaging in fraud. In addition, the firm and its executives were charged with violating Section 206(4) and its Rule 206(4)-8, which also prohibits fraud. The firm and its executives agreed to pay more than $8.7 million in disgorgement and interest, as well as approximately $1.53 million in a civil money penalty. An attorney representing the firm did not respond to an email or a voice message seeking comment.