Recent comments by Andrew Bowden, Director of the Office of Compliance Inspections and Examinations for the Securities and Exchange Commission (SEC), highlight the growing tension between Dodd-Frank compliance and fund manager bottom lines. During comments yesterday, Mr. Bowden related the findings of his office's Presence Exam Initiative, which was launched post-Dodd-Frank in October 2012 to examine the operations and risks of private equity advisers. He noted that more than one half of the 150 investment fund manager examinations under the study disclosed compliance violations or material weaknesses around the assessment of fees and expenses against managed funds. Examples include shifting staff onto portfolio companies or to third party contractors, undisclosed fee arrangements with operating partners, fee-shifting during the fund lifecycle, and the use of accelerated monitoring fees charged to portfolio companies.
While clearly there are cases where departures from best practices have been egregious, the SEC's study also highlights the growing pressures on fund managers and the industry generally. On the one hand, fund managers, notably small and medium-size managers, face increased costs relating to, among others, Dodd-Frank, cybersecurity, environmental compliance, and, in the case of international funds, compliance with the U.S. Foreign Corrupt Practices Act (FCPA) and Foreign Account Tax Compliance Act (FATCA), as well as foreign equivalent laws. On the other hand, such fund managers are also facing downward pressure on their traditional fee structures from investors, which seek to minimize current asset-based fees, such as management fees, and re-weight compensation based on fund performance (carry). In many cases, in the absence of satisfactory fee arrangements and a fair allocation of costs between the fund manager and the fund itself, small and medium-size fund managers are dropping out of the industry altogether, thereby reducing healthy competition within the industry for the benefit of investors and portfolio companies alike.
When negotiating fund documentation, private equity fund managers should pay particular attention not only to the size of their asset-based fees, carry, and projected operating budgets, but also to how operational expenses are allocated between the fund manager and the fund, as well as how services rendered directly or through related party entities to the fund and portfolio companies are disclosed. In all cases, fund managers should err on the side of full disclosure of fee arrangements and ensure that fee allocations and structures are adhered to consistently throughout the life of the fund or renegotiated with investors.