On September 11, 2017, the SEC charged a registered investment adviser (“the RIA”) and its principal (collectively, “Respondents”) with improperly allocating fees and expenses to two private equity funds (collectively, “the Funds”) managed by Respondents. Respondents performed these improper allocations by:
- Charging $2.2 million in fees to Fund I for services provided to a portfolio company of Fund I;
- Failing to reduce management fees for Fund I as stated in the LPA; and
- Using the Funds’ assets to pay adviser-related expenses.
In addition, the SEC has charged the principal with failing to complete specific capital contributions to the Funds while acting as the controlling person of the respective GPs.
IMPROPER ALLOCATION OF ASSETS AND EXPENSES
The Funds’ LPAs allowed for the RIA to provide services to the Funds’ portfolio companies in exchange for remuneration from the portfolio companies. Between 2012 and 2013, the RIA provided services to a portfolio company of Fund I that amounted to $2.2 million in expenses.
Rather than charging the portfolio company, as agreed upon in the LPA and PPM, Respondents charged Fund I without disclosing the misuse of fund assets to the limited partners.
Although the portfolio company reimbursed the $2.2 million expense, the Respondents continued to charge an incorrect management fee to Fund I. Pursuant to the LPA, the RIA was required to reduce the fee by half of the portfolio company’s remuneration. However, the RIA failed to offset its receipt of $2.2 million against the management fee and thus received an excess of $726,000.
Respondents also utilized fund assets for the following expenses of the RIA that were neither authorized nor disclosed in the Funds’ governing documents:
- Compensation for an employee;
- Operational expenses, including office rent; and
- Costs incurred from an examination with the SEC.
The principal acted as the owner and controlling person of the GPs and the Funds. As required by the LPAs, the principal was thus responsible for making capital calls to the Funds on a timely basis. The principal failed to direct the GPs to contribute actual cash to the Funds. Instead, specific unpaid capital contributions were recorded as receivables without adequate disclosure to the Funds’ limited partners.
CUSTODY RULE VIOLATION
The RIA’s role as an adviser to a pooled investment vehicle and custody of client assets required the RIA to comply with the custody rule. In order to rely on an exception to the rule, the RIA utilized an independent public accountant to audit the Funds’ financial statements. One of the requirements of the custody rule exception is that the RIA provides the Funds’ limited partners with the financial statements that are compliant with Generally Accepted Accounting Principles (“GAAP”) within 120 days of the fiscal year end. Respondents failed to provide these statements within that time frame.
The financial statements that Respondents delivered to the limited partners also did not qualify as GAAP compliant due to the failure to disclose: (1) material related party transactions resulting from the improper expense allocation; and (2) related party relationships arising from the principal’s common control over the RIA and Funds. The Respondents therefore failed to meet the requirements of the exception and consequently violated the custody rule.
WHAT DOES THIS MEAN FOR ME?
The Respondents were censured and fined a civil money penalty in the amount of $300,000 for the above violations. The Respondents were also charged with the failure to adopt and implement written policies and procedures reasonably designed to prevent the violations.
As SEC continues to scrutinize compliance with fund documents, it is imperative that Firms ensure their business practices follow the conditions specified in all applicable governing fund documents. Compliance programs must also be given the tools necessary to identify any potential violations of these terms and adequately address risks. Furthermore, firms should implement written policies and procedures designed to support the compliance program in mitigating these risks.