Private Fund Managers Must Prepare For Greater Scrutiny and Transparency Regarding Affiliated Service Provider Arrangements
Proposed SEC Rule and Examination Priorities Target “Problematic Compensation Schemes” and “Opaque Reporting Practices”
Private fund managers – especially managers of real estate, private equity, and private credit funds – have increasingly used affiliated service providers to perform various tasks for their funds or portfolio companies. Such tasks include asset-level due diligence, loan servicing, property management, accounting, in-house legal, fund administration, and other similar services typically performed by outside professionals. The reasons for the use of affiliated service providers may be to reduce total costs for investors or to secure additional revenues for the managers, especially at times where management fee and incentive compensation levels for private funds are under pressure.
The Securities and Exchange Commission (the “SEC”) views these arrangements as generally suspect, and as these arrangements continue to proliferate, the SEC has voiced its concerns by way of enforcement actions, examination priorities, and proposed disclosure rules. Those concerns primarily focus on the inherent conflict of interest with respect to compensation – namely, the exact terms of how these affiliated service providers are compensated, and the sufficiency of disclosures and reporting to investors and portfolio companies regarding such compensation.
The SEC’s enforcement actions against managers generally charge errors involving conflicts of interest that amount to violations of the anti-fraud and associated provisions of the Investment Advisers Act of 1940 (the “Advisers Act”). Two of the more recent examples are explored further below. In addition to enforcement actions, the SEC’s Division of Examinations (the “Division”) 2023 Examination Priorities1 and the SEC’s proposed new private fund adviser rules2 under the Advisers Act (which are expected to be soon adopted substantially in this form) (the “Proposed Rule”) signal that managers will need to be more transparent in their quarterly reporting regarding affiliated service providers.
Collectively, these actions and priorities underscore the need for managers to understand and appreciate the issues involved with using affiliated service providers, and to prepare to provide more granular details regarding fees and compensation.
More Detail and Transparency In Reporting
Released on February 7, 2023, the Division’s Examination Priorities for the year include greater scrutiny of private fund managers’ use of affiliated service providers, conflicts of interest with these providers, and how managers establish and disclose fee arrangements involving them – a repeated priority for the Division. The Division will also focus on private funds that have specific risk characteristics, including “private equity funds that use affiliated companies and advisory personnel to provide services to their fund clients and underlying portfolio companies.”
The Division’s scrutiny of fees and expenses billed by, or paid to, affiliated service providers aligns with the Proposed Rule that would, among other things, establish more detailed reporting requirements regarding these costs.
The Proposed Rule would require registered investment advisers to distribute quarterly statements that contain, among other information, “a detailed accounting of all compensation, fees, and other amounts allocated or paid to the adviser or any of its related persons by the private fund.” The Proposed Rule specifically notes that such reporting would include forms of compensation (with a separate line item for each category of allocation or payment) paid to the manager or its “related persons”3 (other than the traditional management fee and incentive compensation), including administration fees or servicing fees. The SEC’s proposed “related person” definition is designed to capture the various entities and personnel, including affiliated service providers, an investment adviser may use to provide advisory services to, and receive compensation from, private fund clients.
Enforcement Actions Also Focus on the Lack of Transparency Regarding Affiliated Service Providers
The Proposed Rule’s reporting requirement is an extension of perennial SEC enforcement efforts that have also focused on how a lack of transparency goes hand-in-hand with an increased risk of prohibited conflicts of interest. As the Release discusses:
“Opaque reporting practices make it difficult for investors to measure and evaluate performance accurately and to make informed investment decisions. Moreover, such reporting practices may prevent private fund investors from assessing whether the type and amount of fees and expenses borne by the private fund comply with the fund’s governing agreements and can lead to problematic compensation schemes and sales practices with investors bearing excess or improper fees and expenses.”4
Two enforcement actions in recent years are illustrative of the kind of “problematic compensation schemes” and “opaque reporting practices” that draw the SEC’s scrutiny and serve as cautionary tales for private fund managers when crafting and reporting their arrangements with affiliated service providers.5
Monomoy Capital Management
On April 22, 2020, the SEC entered an order6 against private equity fund manager Monomoy Capital Management, L.P. (“Monomoy”) for its failure to disclose certain fees charged to its fund’s portfolio companies for the services of Monomoy’s in-house operations group (“Operations Group”) and related conflicts of interest.
For years, Monomoy had provided its fund portfolio companies with the services of its Operations Group, which included operationally focused services related to making business improvements for a portfolio company’s operations. Monomoy heavily marketed this aspect of fund management to potential investors, and its fund’s offering documents generally referenced the Operations Group concept.
The SEC found that Monomoy had established a practice, without adequate disclosure, of billing its fund’s portfolio companies for Monomoy’s costs of providing the Operations Group services rather than covering the costs out of its management fee. Monomoy did so by charging the portfolio companies an hourly rate designed to recoup most of the costs of maintaining its Operations Group. Between 2012 and 2016, such reimbursements accounted for approximately 13.3% of all revenue Monomoy received from the fund.
While Monomoy did refer to the Operations Group in the fund’s offering documents and a due diligence questionnaire, it did not disclose the particulars of its billing practices, such as the fact that Monomoy would receive compensation-related fees for its Operations Group from portfolio companies.
Moreover, the SEC concluded that the disclosures in Monomoy’s 2014 Form ADV were inadequate as they “did not fully and fairly disclose the fact that Monomoy did, in fact, routinely provide such services, that it did, in fact, receive reimbursements from portfolio companies and that the reimbursement rates were designed to recoup most (but not all) of Monomoy’s costs of maintaining its Operations Group.”7 The SEC ordered Monomoy to pay $1.9 million in disgorgements and a $200,000 civil penalty.
Rialto Capital Management
A few months after the Monomoy Order, the SEC issued an order8 imposing sanctions against private equity real estate firm Rialto Capital Management, LLC (“Rialto”). The sanctions were based on, among other things, misconstruing, and failing to disclose, certain calculations of the costs and expenses tied to various third-party tasks performed by Rialto affiliates, which included asset-level due diligence, accounting, and valuation (“Third-Party Tasks”).
Rialto advertised its ability to perform Third-Party Tasks in-house (where other advisers may have caused their funds to outsource them) and that it would be entitled to reimbursement for the costs and expenses incurred providing those tasks. In two of its real estate funds’ operating agreements, Rialto disclosed that it would include an allocable portion of the time its employees spent performing the Third-Party Tasks as part of the costs and expenses charged to clients, and charge each of the clients a pro-rata share of such expenses. Moreover, Rialto represented that the fees and costs for Third-Party Tasks performed would be “at or below market rates,” the evidence of which would be reported annually to the funds’ advisory committees.
The SEC found significant issues with Rialto’s calculation of, and analysis behind, such costs and expenses, as well as the adequacy of its disclosures regarding them. In the funds’ operating agreements, Rialto stated that before seeking reimbursement for Third-Party Tasks, it would provide the respective advisory committee a breakdown of the costs of those tasks as well as a memorandum evidencing that the fees were at or below market rates.
While Rialto conducted such a market rate analysis in 2012, it did not do so over the next five years. From 2013 to 2017, Rialto did not obtain any updated information or perform any analysis supporting its claim that Rialto’s costs for performing Third-Party Tasks were at or below market rates and failed to disclose this fact. Moreover, in 2011, Rialto disclosed that the costs for the Third-Party Tasks added 11% to the total cost for each employee to cover general overhead expenses. But between 2012 and 2017, Rialto failed to disclose that the cost allocation methodology Rialto used to calculate these same costs resulted in an increase from 11% to 25%.
Furthermore, Rialto failed to adopt and implement written policies and procedures reasonably designed to prevent the misallocation and miscalculations of costs and expenses related to Third-Party Tasks.
For these failures, Rialto was ordered to pay a $350,000 civil penalty.
Possible Mitigating Techniques and Solutions For Private Fund Managers
Both the Monomoy and Rialto actions, among others, reflect the common pitfalls private fund managers can face when dealing with affiliated service providers. Those actions, together with the repeated examination priorities around these matters, as well as the related requirements contained in the Proposed Rule, make clear that transparency and detail are paramount. If an affiliated service provider receives fees from the manager’s clients, the manager’s first step should be to correctly disclose the exact nature of the relationship in the appropriate fund documents. In particular, any compensation arrangement between affiliates (that are not fully offset against management fees) needs to be disclosed with details on the amount and payment terms, even if the total amount of compensation may not be material when compared to fund size and fund expenses generally. Legal and compliance personnel involved in the preparation of such fund documentation need to ask targeted questions to identify any such practices and/or relationships. But even with adequate disclosure, it is still imperative that the manager’s actual practices are consistent with the disclosures (as Rialto failed to do).
With the above in mind, a manager may be inclined to use broad and flexible language when disclosing its conflict management techniques, as doing so will enable it to evolve its practices over time. But it should be prepared that such flexibility may garner pushback. Investors may resist, and the SEC may scrutinize, broad provisions relating to conflict mitigation, and demand more precise formulas from managers with respect to how they will secure the best deal for investors in connection with the use of affiliated service providers. For example, it may behoove managers to deliver certain service provider agreement forms to investors, potentially with a top rate fee included, so that investors can adequately consent to certain more conflicted and/or costly arrangements.
Managers must likewise understand that given the increasingly complex and evolving standards relating to the use of affiliated service providers, they must effectively communicate to their compliance personnel those aspects of the investment management or fund finance side of the business that may affect third-party tasks.9 Compliance personnel will need to understand any process changes or data adjustments so that they can determine whether there are any related regulatory implications. Keeping compliance personnel apprised of these business practices can prove critical in ensuring that no pertinent affiliated and/or third-party arrangements slip through the cracks and are inadequately disclosed.
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If you have questions or would like to discuss your concerns regarding affiliated service provider arrangements, please contact any member of Kleinberg Kaplan’s Private Funds and Investment Management Practice Group.
1 See 2023 Examination Priorities, SEC Division of Examinations (Feb. 7, 2023) available here.
2 See Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Investment Advisers Act Rel. No. 5955 (Feb 9, 2022) available here (the “Release”).
3 The SEC’s proposed definition of “related persons” includes:
- all officers, partners, or directors (or any person performing similar functions) of the adviser;
- all persons directly or indirectly controlling or controlled by the adviser;
- all current employees (other than employees performing only clerical, administrative, support, or similar functions) of the adviser; and
- any person under common control with the adviser.
4 Release at page 26.
5 In addition to the two enforcement actions for private fund managers discussed herein, the SEC also brought enforcement actions against registered investment advisers along similar lines for failure to adequately disclose transactions or arrangements entered into with affiliates of the registered adviser. See, e.g., In the Matter of Kahn Brothers Advisors, LLC and Thomas Kahn, Securities Exchange Act of 1934 Release No. 95045 and the Advisers Act Release No.6043 (June 6, 2022) available here (“Specifically, KIA and Kahn (a) failed to fully and fairly disclose to advisory clients all material facts related to the conflict that arose from KIA’s use of an affiliated broker-dealer to execute client transactions; and (b) made misleading statements to clients and prospective clients that KIA would aggregate client transactions to reduce commissions. KIA and Kahn also failed to seek best execution for advisory clients, failed to conduct a best execution review of KBD, and failed to adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and its rules”.); and In the Matter of Huntleigh Advisors, Inc. and Datatex Investment Services, Inc., Advisers Act Release No. 6251 (February 27, 2023) available here (“breached their fiduciary duty to advisory clients in connection with compensation that Huntleigh and Respondents’ affiliated broker-dealer received as a result of the advisory clients’ investments. […] failed to provide full and fair disclosure regarding their conflicts of interest associated with: (a) compensation Huntleigh received based on client transaction fees; (b) revenue Huntleigh and Respondents’ affiliated broker-dealer Huntleigh Securities Corp. (“HSC”) received in connection with advisory client cash sweep accounts; and (c) HSC’s receipt of fees pursuant to Rule 12b-1 under the Investment Company Act of 1940 (“12b-1 fees”) from clients’ investments in certain mutual fund share classes, including when lower-cost, non fee-paying share classes were also available.”)
6 In the Matter of Monomoy Capital Management, L.P., Advisers Act Release No, 5485 (April 22, 2020) available here (“Monomoy Order”).
7 Monomoy Order at page 3.
8 In the Matter of Rialto Capital Management, LLC, Advisers Act Release No, 5558 (August 7, 2020) available here.
9 In addition to releasing the Proposed Rule, the SEC continues to propose additional rules that have implications on registered investment advisers’ use of affiliated service providers. Specifically, the SEC’s proposed rule Outsourcing by Investment Advisers (Advisers Act Rel. No. 6176 (October 26, 2022) available here) concerning outsourcing by investment advisers contemplates requiring registered investment advisers to conduct “due diligence prior to engaging a service provider to performance certain services or functions” and does not “make a distinction between third-party providers and affiliated service providers.”