Platinum Settlement Lesson: Disclose Before Allocating Broken Deal Expenses
Private equity fund advisers would be wise to take note of the SEC’s recent settlement with Beverly Hills-based Platinum Equity Advisors. The large advisory firm, with approximately $13.4 billion in assets under management, paid more than $3.4 million to settle charges that it allocated undisclosed broken deal expenses to three of its private equity fund clients.
During this same period, according to the agency, Platinum allowed co-investors connected with the advisory firm to invest in the same deals. However, "while the co-investors participated in Platinum’s successful transactions and benefited from Platinum’s sourcing of private equity transactions, Platinum did not allocate any of the broken deal expenses to co-investors," the SEC charged. "Instead, it allocated all [emphasis SEC] broken deal expenses to the private equity funds even though the agreements governing the fund did not disclose that funds would be responsible for anything other than their own expenses."
"This case reflects the SEC’s recent focus on fund managers’ expense allocation practices," said Rogers Hardin partner Stephen Councill. "The adviser had some disclosures around broken deal expenses, but apparently no policy addressing them. This serves as a good reminder for compliance officers to review their firms’ expense allocation disclosures and policies to confirm they are fair and appropriate generally, and to make sure they are in fact following those disclosures and practices."
"For anyone harboring hopes that a change in administration and a change in the make-up of the agency would bring about a change in the types of cases the SEC brings against private equity fund advisers, this case suggests those hopes may be misplaced," said Paul Hastings partner Nicolas Morgan. He noted that the case is similar in some ways to the settlement the SEC reached in June 2015 against Kohlberg Kravis Roberts (ACA Insight, 7/13/15).
Broken deal expenses typically occur when a private fund adviser kills a deal after performing due diligence on a potential fund investment. Such expenses may include costs associated with research, travel, professional fees and evaluation of particular industries or regions for buyout opportunities – expenses typical in the due diligence conducted by private equity funds and real estate funds when researching private or other highly illiquid investments.
Making clear in limited partnership agreements and other governing documents just how broken deal expenses will be allocated is critical to not drawing SEC attention. Failure to disclose these details in governing documents is likely to be a red flag to the agency.
In the Platinum case, the advisory firm had two broad categories of investors: those that invested in its private equity funds, and co-investors, who tended to be officers, directors, executives and employees of the adviser.
The private equity funds
Platinum manages private equity funds that focus on investments in underperforming or undermanaged companies that it believes can benefit from its operational expertise. Three of these equity funds were involved in the 2004 through 2015 investments and allocations that drew the SEC’s attention.
The limited partners in the three funds included high net worth individuals and related trusts, as well as institutional investors, including corporate and public pension plans, pooled investment vehicles, school trusts, charitable foundations and endowments, sovereign wealth funds and insurance companies, the agency said in its order instituting the settlement. The minimum capital contribution for limited partners was $10 million.
Platinum would charge these investors an annual management fee for its services. Those fees ranged by fund from 1.5 percent to 2 percent of capital contributions during the funds’ investment periods. The management fees were offset by other fees the advisory firm received, including transaction and monitoring fees, as well as reimbursement of some costs.
The funds’ general partners, who were Platinum Equity affiliates, were eligible to receive carried interest of up to 20 percent of the net profits realized by the limited partners.
Co-investors who took part from 2004 to 2015 typically invested on the same economic terms and conditions as the partnerships, but invested in a percentage of each consummated portfolio investment that was reserved for them. The co-investors made their portfolio investments through a separate Platinum vehicle than that used by the private equity fund investors, according to the administrative order.
"The contracts governing these co-investment vehicles provided that these vehicles paid their pro rata share of expenses related to the investment held by such vehicle, but they did not provide for Platinum to charge these vehicles for broken deal expenses related to the transactions that were never consummated," the SEC said.
Here’s how the agency described the investments from the co-investments compared to those invested by the three funds during the 2004 through 2015 period:
Fund I: Approximately $158 million from co-investors, approximately $518 million from the fund;
Fund II: Approximately $469 million from co-investors, approximately $2.3 billion from the fund; and
Fund III: Approximately $101 million from co-investors, approximately $1.7 billion from the fund.
Broken deal expenses and their allocation
The LPAs for the private equity funds required that each fund be charged for all partnership expenses other than general partner expenses, "including broken deal expenses," the SEC said. "Similarly, the related private placement memoranda stated that each fund would ‘pay all expenses related to its own operations [emphasis SEC] . . . including [b]roken [d]eal [e]xpenses.’ The private equity funds ultimately paid for all of the broken deal expenses incurred."
"From 2004 through 2015, Platinum incurred and the private equity funds reimbursed it for broken deal expenses for potential deals for the private equity funds that, had the deals been successful, would have been partially allocated to co-investment vehicles," the agency said. "The LPAs did not disclose that the private equity funds would pay the broken deal expenses for the portion of each investment that would have been allocated to the co-investors."
Here’s how the SEC said the broken deal expenses were approximately allocated per fund since the second quarter of 2012:
Fund I: $30,000
Fund II: $500,000
Fund III: $42 million
Of these, the portion that Platinum allocated to the private equity funds without disclosure in the LPAs was approximately $1.8 million, the agency said.
The SEC also charged the advisory firm with having deficient compliance policies and procedures, stating that Platinum did not have a written compliance policy or procedure governing broken deal expense allocation policies.
Violations and penalties
Under the settlement, Platinum was found to have violated Advisers Act Section 206(2), which prohibits fraud; and Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule, for failing to adopt and implement written compliance policies and procedures.
Platinum agreed to pay a civil money penalty of $1.5 million, as well as disgorgement of $1.7 million and prejudgment interest of almost $194,000. An attorney representing Platinum did not respond to a voice mail or email seeking comment.