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PE Firm Charged with Improper Allocation of Broken Deal Expenses

PE Firm Charged with Improper Allocation of Broken Deal Expenses


On September 21, 2017, the SEC charged a registered investment adviser with improperly allocating broken deal expenses between three private equity funds it manages (collectively, the “Private Equity Funds”) and separate co-investment vehicles (the “Co-Investors”).  From 2004 to 2015, the Private Equity Funds invested $5.3 billion in 85 underperforming portfolio companies while Co-Investors invested an additional $728 million in these same companies.  While developing prospective portfolio investments in underperforming companies, the adviser incurred expenses from negotiating and structuring deals that ultimately did not come to fruition (“broken deal expenses”).  The Private Equity Funds’ LPAs disclosed that the Private Equity Funds were responsible for reimbursing the adviser for broken deal expenses.  However, the governing documents did not state that the Private Equity Funds would be responsible for reimbursing broken deal expenses for the portion of each investment that would have been allocated to Co-Investors had the deal been completed.


The adviser’s improper allocation of broken deal expenses to Private Equity Funds that should have been paid by Co-Investors was a violation of Section 206(2) of the Advisers Act.  Furthermore, the adviser’s failure to adopt and implement written policies and procedures to effectively govern fund expense allocation was a violation of Rule 206(4)-7 of the Advisers Act.  Accordingly, the adviser is required to pay $1,902,132 in disgorgement and prejudgment interest to Private Equity Funds and $1.5 million to the SEC.  In determining the civil penalty, the SEC considered all violations since the Private Equity Funds’ inception in 2004, even though the adviser was not registered with the SEC until 2012.


The SEC’s charges highlight the importance for private equity firms to ensure they have properly allocated expenses based on all governing documents.  Furthermore, private equity firms registered with the SEC should implement written policies and procedures that support the firm in following the provisions of the governing documents.  Fairview® encourages private equity fund advisers to review their expense allocation practices both prior to their registration and afterwards in order to guarantee all necessary reimbursements have been completed.