Failure to Offset Fees May Result in Payments to Both Clients and the SEC
It’s great when fees come in, whether for management, consulting or something else. But check your governing documents – not all fees are meant to be kept by the advisory firm, and keeping such fees may result in a visit from the SEC’s Division of Enforcement staff.
New York City-based exempt reporting adviser Aisling Capital found this out the hard way. The firm, which advises venture capital funds that invest in life science companies, recently settled with the agency over charges that it failed to offset consulting fees it received from two of its funds’ portfolio companies against the management fees it received from the funds. Aisling ultimately had to pay out more than $1 million: $860,515 in voluntary reimbursement to its limited partners, plus a $200,000 civil money penalty to the SEC.
The advisory firm, which reported private fund assets of approximately $639 million as of March 2018, should have known better, according to the settlement order. "The limited partnership agreement and private placement memorandum for each of the funds contemplate[d] that Aisling may receive transaction fees from the funds’ portfolio companies for certain services that Aisling provided, including consulting fees," it said. "The funds’ LPAs and PPMs required Aisling to offset a specified percentage of transaction fees it received against the management fees paid by the funds."
Between July 2013 and September 2013, according to the SEC, Aisling receiving more than $1.2 million in consulting fees from the two portfolio companies, of which the adviser was required to offset $759,870, based on the specified offset percentages in the governing documents. "However, Aisling failed to offset these consulting fees, resulting in the funds and their limited partners overpaying $759,870 in management fees.
"This case is yet another reminder of the SEC’s focus on management fee offsets, even where the conduct relates to venture capital or other exempt reporting advisers," said Paul Hastings partner John Nowak. "It also highlights the agency’s attempt to treat advisers who undertake timely remedial and corrective compliance measures with a relatively lighter touch from an enforcement perspective."
The settlement "demonstrates the SEC’s current focus on protecting retail investors, particularly in relation to payment of management fees," said Paul Hastings partner Thomas Zaccaro.
The advisory firm was charged with violating Sections 206(2) and(4) of the Advisers Act, as well as Rule 206(4)-8, all of which prohibit fraud. In assessing Aisling’s fine, the SEC said that it did consider remedial acts by the adviser, as well as its cooperation during the investigation. An attorney representing Aisling, when reached, chose not to comment.
The firm, the fees and the offsets
The limited partners in the funds managed by Aisling included pensions, public employee retirement systems, charitable organizations and other large institutional investors, as well as high net worth individuals, according to the settlement order. The adviser charged these investors a quarterly advisory fee or management fee of 2 percent of committed capital during the investment period.
The funds’ governing documents made clear that Aisling might provide services to the portfolio companies in which the funds invested, and that the advisory firm might charge transaction fees for those services, including consulting services, the SEC said – and that these transaction fees were in addition to the management fees paid by the funds.
Two funds were involved in this particular settlement. The LPA and PPM for one of them required that Aisling offset 50 percent of the transaction fees it received from that fund’s portfolio companies against the management fees received from the fund. The second fund’s governing documents required that Aisling offset 70 percent of the transaction fees it received from that fund’s portfolio companies against the management fees paid by the fund.
Monies invested and fees paid
Beginning in September 2003, the two funds made investments in a medical research and sales company, and beginning in April 2007, one of the funds invested in a drug development company, according to the agency.
"From July 2, 2012 to May 14, 2013, Aisling received $910,897 from [the medical research and sales company] for the consulting services," the SEC said. "Aisling retained the entire amount of these consulting fees, without offsetting the appropriate percentage of them against the management fees owed by the funds, as required by the funds’ LPAs and PPMs. The funds paid $555,432 more than they should have in management fees due to Aisling’s failure to properly offset consulting fees from [the medical research and sales company]."
The situation with the drug development company was somewhat different. "From July 1, 2012 to October 12, 2012 and [from] August 5, 2014 to October 6, 2014, Aisling received (more than) $1.07 million from [the drug development company] for consulting services, and properly offset 70 percent of the fees by reducing the management fees owed by [that fund], as required by [that fund’s] LPA and PPM," the agency said.
However, this was not the case with monies received from July 16, 2013 to September 16, 2013, when Aisling allegedly received $297,356 from the drug development company for consulting services. "Aisling retained the entire amount of these consulting fees, without offsetting 70 percent of them against the management fees owed by [the fund], as required by [the fund’s] LPA and PPM. [The fund] paid $204,438 more than it should have in management fees due to Aisling’s failure to properly offset consulting fees from [the drug development company]."
The SEC summed its allegations up in its settlement order: "From July 2, 2012 to September 16, 2013, Aisling received a total of $1.21 million from [the medical research and sales company] and [the drug development company] that it did not properly offset against the management fees owed by the funds, resulting in the funds paying a total of $759,870 more than they should have paid."
Enter the investigators
On January 20, 2017, something happened that most advisers hope never happens. The Enforcement Division staff contacted Aisling. The settlement order does not say what prompted the contact, just that it occurred.
The next month, Aisling voluntarily reimbursed the funds’ limited partners $630,319 for excess management fees plus interest, in regard to the fees paid in regard to the medical research and sales company, the SEC said. In June 2017, the agency said, Aisling voluntarily reimbursed limited partners in the fund that invested in the drug development company $204,438 for excess management fees, then later paid interest of $25,758 on that amount.
Grand total: Aisling voluntarily reimbursed limited partners at the funds $860,515, representing $759,870 plus interest of $100,645 for excess management fees,
according to the settlement order.
As for the remedial efforts the adviser undertook, the SEC noted that Aisling voluntarily:
Named a new chief compliance officer "who implemented new controls to verify the accuracy of management fees that Aisling charged and the calculation of offsets for consulting fees;" and
Retained a compliance consulting firm that, among other things, "conducts quarterly testing of existing policies and procedures for expense allocations and ensuring compliance with disclosure obligations."