SEC Examination Priorities for PE Firms Fee and

Expense Practices

Guy F. Talarico, CEO and Founder, Alaric Compliance Services, LLPJeff Blumberg, Partner, Faegre Baker Daniels, LLP

March 31, 2015

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Table of Contents

I. Why is the SEC focused on Private Funds?II. Examples of Problematic PE Fee and Expense PracticesIII. Suggested Corrective ActionsIV. Recommendations to Improve the Compliance ProgramV. Enforcement ActionsVI. What’s Around the Corner from the SEC?VII. What’s next from the NSCP PE Webinar Series?VIII. Resources

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Disclaimer

This information is presented for general informational purposes only. It is not a full analysis of the matters presented and should not be relied upon as legal advice.

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I. Why is the SEC Focused on Private Funds?

“PE firms provide financial security for millions of Americans from all walks of life. The biggest investors in private equity include public and private pension funds, endowments and foundations, which accounted for 64% of all investment in Private Equity in 2012.” Source: Speech by Andrew J. Bowden, Director, OCIE “Spreading Sunshine in Private Equity” delivered in May 2014 at Private Equity International Private Fund Compliance Forum 2014.

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I. Why is the SEC Focused on Private Funds? (con’t)

Certain industry practices that are areas of concern to the exam staff• Limited Partnership Agreements – poor (or missing) fee and expense

allocation disclosures; inadequate information rights for LPs• Lack of Post-Closing Transparency • Industry Trends

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I. Why is the SEC Focused on Private Funds? (con’t)

Certain industry practices that are areas of concern to the exam staff• Limited Partnership Agreements – poor (or missing) fee and expense

allocation disclosures; inadequate information rights for LPs• Lack of Post-Closing Transparency • Industry Trends

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I. Why is the SEC Focused on Private Funds? (con’t)

Limited Partnership Agreements“Many limited partnership agreements are broad in their characterization of the types of fees and expenses that can be charged to portfolio companies, as opposed to the adviser. This has created a gray area, allowing advisers to charge fees and pass along expenses that are not reasonably contemplated by investors. Poor disclosure in this area is a frequent source of exam findings. Source: Speech by Andrew J. Bowden, Director, OCIE. “Spreading Sunshine in Private Equity” delivered in May, 2014.

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I. Why is the SEC Focused on Private Funds? (con’t)

Lack of TransparencyThe exam staff has stated that there is a Lack of transparency as to fees earned by managers and charged to investors and portfolio companies.Some limited partnership agreements have broad, imprecise language that leads to opaqueness when transparency is most needed and do not provide the limited partners with sufficient information rights to be able to adequately monitor not only their investments, but also the operations of their manager.

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I. Why is the SEC Focused on Private Funds? (con’t)

Industry trends • Consolidation, complexity and rapid growth • Structure of the vehicles • Growth coming from separate accounts and side-by-side co-

investments.

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II. Examples of Problematic PE Fee and Expense PracticesThe most common observation made by the examiners has been with the adviser’s collection of undisclosed fees and the misallocation of expenses. Some examples:Fee Issues• Inadequate Fee Disclosures • Monitoring, Transaction and other Fees• Consulting Fees • Break up Fees, Dead Deal Fees

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II. Examples of Problematic PE Fee and Expense Practices (con’t)

• Classification of Deal Fees • Misclassification, misallocation and delay in the application of fees

that should have offset management • Non disclosure of past conflicts of interests and/or potential conflicts

of interest associated with the receipt of fees• Failure to adequately monitor the receipt of fees by employees who

serve as board members of the portfolio companies.

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II. Examples of Problematic PE Fee and Expense Practices (con’t)

• Allocation of fees between Co-Investment and Parallel Vehicles• Lack of detailed compliance policies and procedures compliance

oversight on how fees and expenses are allocated. • Hidden Fees - Charging undisclosed “administrative” or other fees not

contemplated by the limited partnership agreement or properly disclosed to the investors

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II. Examples of Problematic PE Fee and Expense Practices (con’t)

Expense Allocation Issues• Shifting expenses traditionally billed to the adviser in exchange for the

management fee without proper disclosures• Misclassification, misallocation of expenses due to vague disclosure in Fund

governing documents.• Exceeding the limits set in the limited partnership agreement around transaction

fees or charging transaction fees in cases not contemplated by the limited partnership agreement, such as recapitalizations; Charging expenses for items that traditionally are offset to the management fees.

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III. Suggested Corrective ActionsWorking with the CFO • Prepare a list of all the direct and indirect fees that are being collected• Identify all expenses being charged to the fund including allocation of in-

house employee salaries and overhead to the funds and/or portfolio companies

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III. Suggested Corrective Actions (con’t)

Working with the CFO • Determine what fees or expenses should be eliminated given

operative fund organizational and offering documents and/or other pertinent disclosures. • Private equity fund managers may decide to change their policies or

even go so far as to eliminate some expenses– for example, dismissing third party consultants.

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III. Suggested Corrective Actions (con’t)

Working with the Fund’s legal counsel

• Identify and review all the fee disclosures, and determine with the help of the Fund’s legal counsel, if the fees have been accurately and clearly disclosed to investors. In the best case scenario the fees will match what has been disclosed to the investors.• If the fees are not being charged according to what has been

disclosed to investors. Determine along with the Fund’s legal counsel, if any change information on fees needs to be included on the Form ADV. Note: This type of change may trigger an examination.

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IV. Recommendations to Improve the Compliance Program

• Review the existing policies and procedures regarding the calculation, allocation and monitoring of fees and expenses. Periodic sample compliance testing of Fund and Management Company expenses, allocations and payment/wire authorizations including allocations of expenses between Funds, co-investment vehicles and parallel vehicles.

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IV. Recommendations to Improve the Compliance Program (con’t)

• Implementation of a new “Conflicts of Interests Policy” designed to identify, address and document all potential conflicts of interests for Fund transactions and hiring of affiliated and third party service providers and consultants including the fees and expenses prior to such transactions. Consider establishing a Conflicts Committee for the purposes of reviewing all Fund governing documents and Form ADV disclosures and mitigating conflicts of interests where needed, including fees and expenses to be incurred on such transactions.

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IV. Recommendations to Improve the Compliance Program (con’t)

• Implementation of policy requiring third party service provider agreements, engaging of operating partners or senior advisors to be reviewed and approved by compliance and/or legal staff.

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IV. Recommendations to Improve the Compliance Program (con’t)

• Review of Custody policies and procedures to update additional procedures to strengthen internal controls in regards to the authorization and processing of expenses. Consider internal controls placed with accounting/finance to prohibit any wire transactions relating to compensating service providers or consultants until such compensation has been cleared for a conflicts of interest review.

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IV. Recommendations to Improve the Compliance Program (con’t)

• Review Gifts and Entertainment Policy to reflect Chief Compliance Officer (compliance) approval of certain dollar amount thresholds for gifts and entertainment and allocations of such expenses between Funds and Management Company. Periodic compliance testing of time/expense reports for relevant employees.

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V. Enforcement Actions

• Lincolnshire Management, Inc.• Clean Energy Capital, LLC

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VI. What‘s around the corner from the SEC?• Fund managers may assume that the statements in SEC staff speeches

are good predictors of enforcement priorities.• Private equity managers can expect the SEC to scrutinize performance

claims in fund marketing materials. In anticipation of these actions, fund managers should ensure that they review and re-evaluate their performance data and disclosures. We expect the SEC to focus on the transparency of the calculations, valuations and performance data presentations.• Reuters has reported that the SEC Examiners are probing the internal

rate of returns cited in fund marketing materials.

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VII. What’s next from the NSCP PE Webinar Series?In May, we are planning a webinar on Valuations and Performance Disclosures.If you have some topics you would like us to address please email your suggestions to lisa@nscp.org

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VIII. Resources

OCIE Examination Priorities for 2015 www.sec.govBowden, Andrew J., Director, OCIE, “Spreading Sunshine in Private Equity”, speech delivered May 6, 2014 at Private Equity International Private Fund Compliance Forum 2014 www.sec.govHeires, Katherine, “Private Equity’s Risk Management Take-Up, Caught in the net of Dodd-Frank, FATCA and other reforms, yet another category of financial firms is bulking up in governance, risk and compliance”, www.garp.org, August 2014 Alden, William, “After Inspecting Private Equity Funds, S.E.C. Examiners to Broaden Focus”, New York Times, January 22, 2015.