A Familiar Theme in Unfamiliar Times
Recently, the SEC settled with a private equity adviser for failing to adequately disclose and obtain consent for conflicts of interest associated with portfolio compensation. The Administrative Order reminds us of familiar tenets to regulatory disclosure, and perhaps this familiarity is reassuring to us in these unfamiliar, pandemic times.
However familiar the theme, this case is a healthy reminder of the need for specific disclosure. Apparently, according to the Order (findings were neither admitted nor denied), since 2007, the adviser had provided portfolio companies of one its funds with “operationally-focused services” to drive business improvements and add value. More specifically, an in-house “Operations Group,” comprised at least at certain times of two lead “operating partners” supervising five portfolio company employees and 12 contractors, provided these services. As you may guess, the adviser billed the portfolio companies at an hourly rate to cover most of the costs of providing the services and did not cover these costs with the management fee. The payments represented 33.3% of all revenue received regarding the fund during the relevant period.
The crux of the violations is, as said, familiar: the adviser did not provide full and fair, timely disclosure to all of the fund’s investors that was sufficiently specific so that the investors could understand the conflicts of interest and have the knowledge to consent or reject to the practice. Among other undertakings, the adviser now has to pay disgorgement, prejudgment interest, and civil monetary penalties totaling $1,926,579.
Here, interestingly, is what the adviser did do.
- The adviser disclosed in the fund’s LPA that portfolio companies are responsible for fees paid to the adviser including “monitoring fees, consulting fees, directors’ fees and other similar fees.”
- The adviser disclosed, at least at times, in the Form ADV Part 2A, that “under specific circumstances, [adviser] operating professionals may provide services to portfolio companies that typically would otherwise be performed by third parties” and that the adviser “may be reimbursed” for costs related to such services.
The SEC was not impressed with these disclosure attempts. The Order states that:
- The adviser did not sufficiently disclose that “it did, in fact, routinely provide such services, that it did, in fact, receive reimbursements from portfolio companies for such services and that the reimbursement rates were designed to recoup most (but not all) of [the adviser’s] costs of maintaining the Operations Group.”
- The adviser did not mention the facts in its Form ADV Part 2A, Item 2, Summary of Material Changes when it first disclosed the practice in the 2A.
The relevant period for the violations was April 2012 through December 2016—and it is not clear from the Order what facts absolved or prevented the wrongfulness prior to and after that time, if we assume similar facts spanned from before 2012 (at least starting from 2007) and after 2016. But we do know this:
- You must scrub your disclosures for the use of the word ‘may.’ Regulators have been saying every which way that ‘may’ is an inappropriate word when making a regulatory disclosure. Consider the various ways to change it, as there are several. For example, “The adviser has the authority to and with one fund has …”
- Offsets to management fees are important. If you do not offset, the regulators may see double-billing for the same set of services. The amount of offset also is important. (Remember the transaction fee compensation issue; likely that needs to be at 100% even if other portfolio company derived compensation can hover around 80% or some other negotiated rate.)
- The SEC, although now understanding the industry uses “operating professionals,” scrutinizes these relationships, including compensation to and disclosures around them.
- You must disclose conflicts of interests to fund investors, and the disclosure must be specific and timely.
- You cannot provide consent for conflicts of interest when you are conflicted.
It is comforting to really know something in these unprecedented times. And we know the SEC demands specific, timely disclosures around portfolio compensation. Most of you have carefully considered and applied these regulatory disclosure tenets, particularly around compensation. If you have not, now is the time. Even if you have previously reviewed your disclosures around portfolio compensation, operating professionals, and offsets, and you have scrubbed your 2A for ‘may,’ how about testing: for example, make a chart of all forms of compensation; connect the compensation to authority in the fund documents; and connect the authority and practice to specific Form ADV disclosure. Ask yourself if there are any undisclosed material facts. When was the last time you used your limited partner advisory committee to discuss a conflict of interest? Let’s get these basic concepts covered, so that you can go on and run your business during these difficult times and beyond. We are here to help you. Please email our CSS regulatory experts at [email protected].