Alternative Insight – October 2015

Fees and offsets: lessons learnt

Regulators are gunning for fund managers over opaque or dubious fee and expense arrangements. How can managers and investors get ahead of the game?

With most of the new financial regulations on the alternative assets sector having come into effect, regulatory agencies are now devoting more time to scrutinizing the newly-regulated industry’s activities and practices, with America’s Securities and Exchange Commission (SEC) taking the lead on challenging fee and expense arrangements that are questionable or which have not been adequately disclosed to investors.

Over the summer, the SEC agreed settlements with KKR (to the tune of $30m), Blackstone ($39m) and Guggenheim Partners Investment Management ($20m), and it says that several other investigations are in progress.

Following are the key takeaways from the way the SEC has acted:

The past can catch up with you

It’s not just current activity that is under the microscope. Questionable practices that adversely affect investor value will be investigated and punished, even if they are historical or were consonant with industry norms at the time. Some of the recent SEC settlements have involved fees earned and expenses charged several years ago, and the SEC continued with enforcement action even after the manager disclosed the ‘bad’ behaviour and/or adopted new internal policies.

Zero tolerance

Regulators expect disclosures to be more specific and detailed than the industry has previously been accustomed to. In the words of SEC enforcement director Andrew Ceresney, “Hidden or inadequately disclosed fees will not be tolerated regardless of the size of the adviser.”

Better living through lawsuits

None of the fund managers admitted any liability or wrongdoing in their settlements, but they have responded to the scrutiny by improving their fee arrangements and disclosure practices. The regulators appear to be changing industry practice through public enforcement action, rather than in private consultations or by issuing new technical guidance.

Self-deprecation is useful

Managers who identify issues are encouraged to self-report them, as this is one of the factors that regulators will consider when evaluating settlements and a target’s willingness to correct ‘bad’ behaviour.

The SEC action has also highlighted several specific issues which managers will need to address, either because of investor pressure or because the necessary amelioration is already codified in legislation like the EU’s AIFM Directive:

Allocation of expenses

In KKR’s case, the SEC homed in on the way it allocated broken-deal expenses, effectively shifting broken-deal risk on to the main fund for third party investors, and away from co-investment vehicles linked to KKR which were nevertheless able to participate fully in the investment upside. Neither the LPA nor the offering documents had indicated that this would be the outcome, and the lack of disclosure masked a clear conflict of interest.

The SEC also identified, in the Blackstone, another way in which expenses can be misallocated. The SEC charged Blackstone with negotiating big discounts from its legal advisers that were neither disclosed to nor made available for the benefit of its funds. Investors thus ended up footing substantially higher legal bills than would otherwise have been the case.

Portfolio company fees

Management fee offset provisions need good information in order to function properly. Industry research and regulatory inspections have previously shown that many operating partners are compensated directly or indirectly by portfolio companies without those costs being properly captured by the management fee offsets.

Many buyout firms take cash directly out of their portfolio companies in the form of monitoring and other fees. These fees may be “accelerated” at the time the company is exited, which materially reduces the value that the fund receives from the exit. In Blackstone’s case, the firm had made disclosures to its LPAC and also to investors in various routine notices, but the SEC deemed this to be insufficient and particularly emphasized that investors were not given enough information before they subscribed.

Developments in the pipeline

In the UK, the FCA has announced a probe into the factors driving the fees charged to investors and value relative to cost. The FCA also intends to conduct “post authorisation” reviews of funds to examine their compliance with the rules.

Diving in alongside the regulators, some investors are also becoming more assertive on the issue of fee offsets and expenses. The five New York City Retirement Systems (NYCRS) have announced that they will require the fund managers they invest with to make full disclosures on current and historical fees by the end of 2015. NYCRS intends to publish the information gathered on an aggregated basis on the comptroller’s public website and wants to adopt the policy as a prerequisite for any fund that it commits money to in the future. In Europe, PGGM of the Netherlands, is taking a similar approach, albeit to be implemented more gradually.

Meanwhile, an important investor lobby group, the Institutional Limited Partners Association (ILPA), has been reviewing its reporting template and intends to expand and standardise how managers report fees. The new template is due to be issued early in 2016.

Conclusion

Even with the new templates from ILPA and others, there is concern about how (or indeed whether) all the newly disclosed information will be analysed and used. Some of the SEC cases suggest that many investors are quite passive and do not act collectively against managers even when misfeasance is disclosed to them. Smaller firms may also be disproportionately affected by the introduction of more onerous reporting requirements because of regulatory action or investor pressure.

But managers should still err on the side of caution. The recent investigations are likely to be the tip of the iceberg. As scrutiny increases globally, they should be proactive, ensuring that investors understand the fees and costs associated with the fund. The manager and investors may even find it useful to engage an independent monitor to evaluate a fund’s fees and expenses. Conflict and allocation policies should be codified, checked against the relevant regulatory agency’s conflict of interest rules, then disclosed to investors, routinely tested and rigorously enforced.

Early action is a marker of good investor relations and will help to reduce the cost, inconvenience and reputational risks of regulatory enforcement.


 

Alternative Insight is produced by MJ Hudson’s private funds lawyers. We provide expert legal advice to fund managers, other financial sponsors, investors and advisers on the formation, structuring, investment into and regulation of private funds, managed accounts and similar vehicles. Our practice covers the full spectrum of alternative assets, including private equity, venture capital, hedge funds, private debt, real estate and infrastructure. Clients praise our entrepreneurial approach, commercial outlook and dedication to helping them achieve their objectives, regardless of the obstacles.