Navigating the SEC's Focus on Private Fund Fees: Understanding the Trends and Mitigating Risk

The following is an edited version of a conversation between Goodwin partners Jonathan Hecht and Isaac Vinyarsh. Before joining Goodwin, Jonathan spent more than a decade in the SEC’s Division of Enforcement, including serving as the Division’s acting co-chief counsel, a key legal and policy advisor to the division’s director and deputy director. Isaac advises private equity sponsors and their portfolio companies on a range of complex transactional, structuring, and corporate matters.

Gurbir Grewal, director of the SEC’s Division of Enforcement, has stated publicly that private funds are a “substantive priority area” for the Division, which is concerned about “fee and expense” issues, in addition to conflicts of interest, in the industry.

The SEC is paying particular attention to the manner in which private fund managers calculate and impose fees, as well as how they disclose information about fees. The focus is on a key, thematic question: Are fund managers doing what they say and saying what they do?

In fact, on June 20, the SEC announced that it had instituted a settled proceeding against a New York–based investment adviser for violations stemming from charging excessive management fees and failing to disclose a conflict of interest to investors regarding its fee calculations. In the settlement, the funds’ manager agreed to pay a penalty of $1.5 million, as well as $864,958 in disgorgement and prejudgment interest, which has already been reimbursed to the affected funds.

According to the SEC’s findings, the funds’ limited partnership agreements allowed the manager to charge management fees based on the funds’ invested capital in individual portfolio investments. The agreements also required a reduction in the basis for these fees if the funds’ manager determined that one of the portfolio investments had suffered a permanent impairment. However, the SEC determined that the manager inaccurately calculated management fees by aggregating invested capital at the portfolio company level instead of at the individual portfolio investment security level, as stipulated in the partnership agreements. Furthermore, the funds’ manager failed to disclose a conflict of interest to investors concerning its criteria for permanent impairment. This lack of disclosure meant that investors were unaware that the criteria used were narrow and subjective, giving the manager significant latitude in determining whether an asset should be considered permanently impaired so as to reduce the basis for calculating management fees.

This action comes on the heels of prior enforcement activity in this space. For instance, at the end of its last fiscal year, the SEC brought a handful of cases involving scrutiny of private fund managers related to the calculation of fees (e.g., failing to adjust management fees for write downs and failure to reduce fees by amounts paid to third parties). Respondents in these cases were ordered to pay penalties ranging from the low six figures to more than $11 million, depending on the nature and severity of the violations.

In addition to meaningful monetary sanctions, enforcement actions in this space can include fraud charges (even when conduct is negligence-based), censures for the adviser, and costly and time-consuming undertakings to change business practices to ensure future compliance with the law.

Proposed Reforms on Private Fund Fee Practices

Activity in this space is not limited to just Enforcement Division investigations and actions. The SEC has proposed a rule introducing comprehensive changes to private fund regulations. The proposed rule would impose specific prohibitions on certain activities or arrangements and would affect the operations of private fund advisors. While the proposed rule is expansive, three elements could have particularly significant effects on fees and fee calculations:

• Quarterly statements: The proposed rule would mandate that SEC-registered advisers provide detailed quarterly statements to each private fund investor.
• Annual audits: The proposal would require SEC-registered advisers to undergo an annual audit that would follow US Generally Accepted Accounting Principles standards and be conducted by an independent public accountant registered with the Public Company Accounting Oversight Board.
• Prohibited activities: The proposed rule would prohibit specific activities that might give advisers incentives to prioritize their interests above their clients, including, among other activities, charging certain fees for services the adviser does not or does not reasonably expect to provide; charging fees and expenses associated with government exams and investigations or certain types of regulatory or compliance fees and expenses; and seeking reimbursement or indemnification for a breach of fiduciary duty, willful malfeasance, bad faith, recklessness, or negligence.

Mitigating Regulatory Risk

Given these regulatory developments, fund managers should consider taking the following steps to mitigate risk:

• Review Fund Documents and Fee Calculations: Ensure the appropriate people review language in fund documents about fees and related issues. Identify and address potential errors in fee calculations by regularly reviewing them with fund documents in mind.
• Assess Fee Calculation Complexity: The more complex, the greater the chance for errors.
• Seek Legal Counsel: If a problem is identified, consult legal counsel for appropriate next steps. If an examination or investigation materializes, these steps could reduce the risk of an enforcement investigation or action or resulting remedies and sanctions.

The proposed rule is not yet final, but the SEC indicated it was aiming for April 2024 in its last published regulatory agenda. However, its potential impact should be considered well in advance to adapt to possible future regulations.