SEC Charges Private Equity Firm with Misallocating Expenses
The SEC has charged a private equity firm and its principal with securities fraud for charging management company expenses to the fund and as well as entering into illegal principal transactions, misleading clients, violating the custody rule, and having an inadequate compliance program. According to the SEC, the respondents designated certain management company expenses as “split expenses” subject to a 70/30 expense sharing between the funds and the management company. The SEC asserts that at least $3 Million of these expenses should not have been charged to the funds. These expenses included salaries, bonuses, health benefits, recruiting costs, phones, and other miscellaneous office expenses. Also, the SEC argues that any expense allocation should reflect real expenses and not an arbitrary split ratio. The SEC says that the firm also arranged loans at high interest rates (payable to the management company) to allow the funds to pay the expenses because the funds didn’t have sufficient cash. The SEC also charges that the firm misled a potential investor about the extent of management co-investing, an incident that prompted the Chief Compliance Officer to resign. The SEC also charges the firm with failing to deliver audited financial statements and a bevy of other violations.
OUR TAKE: As a fiduciary, private equity firms cannot treat the funds they manage as their own piggy banks. Any compensation received should be disclosed (clearly) in the PPM, the LPA, and the ADV. Also, newly registered advisers must be cognizant of substantive Advisers Act regulations that apply including the requirements of the custody rule, the limits on principal transactions, and the marketing restrictions.