US SEC charges investment adviser for undisclosed, disproportionate expenses allocated to private equity fund

After repeated industry-wide warnings concerning the scrutiny of fees in connection with private funds, the US Securities and Exchange Commission (SEC) took action against investment adviser Energy Capital Partners Management (ECP). On June 14, 2022, the SEC settled with ECP for charges relating to allocating "undisclosed, disproportionate" expenses to a private equity fund it advises. In a prior legal update, we discussed SEC Chairman Gary Gensler's statements that the fees paid to private funds will be subject to closer scrutiny as part of a broader effort to boost efficiency, competition and market transparency. His statements were followed by the SEC's proposed rules requiring private equity and hedge funds to provide basic disclosures to their investors and guard against conflicts. This week's settlement demonstrates that more enforcement actions against private funds are likely to come, notwithstanding whether the proposed rules are adopted.

A review of ECP's circumstances helps understand the SEC's focus. According to the SEC's Order, ECP acquired the stock of a publicly traded corporation in a take-private transaction. In connection with that transaction, ECP agreed that third-party co-investors would not have to bear any expenses related to a credit facility used to finance the transaction, resulting in these expenses being allocated disproportionally to an ECP-advised private equity fund that also participated in the transaction. ECP did not disclose to fund investors its ability or plans to make this disproportionate allocation of credit facility expenses even though all investors arguably benefited from the credit facility. Ultimately, the SEC found that the expenses should have been disclosed or not allocated in this manner. The ECP also failed to implement written compliance policies reasonably designed to prevent violations of the Investment Advisers Act of 1940.

Under the settlement, ECP agreed to pay US$1 million penalties to the SEC for violations of the Investment Advisers Act, and SEC rules and to pay back over US$3.3 million to the fund.

In our previous legal update, we recommended that private equity and hedge funds review their disclosure of fees, and this SEC order further emphasizes the need to do so. Indeed, in its press release, the SEC reminded private equity fund advisers to follow their own agreements and ensure investors do not pay more fees than agreed to. In addition to following their agreements, private funds should review their policies regarding fee disclosures to confirm that they are clear, and they should also make sure that their expense and allocation disclosures are accurate. The order signals that the SEC is watching private funds closely and is committed to stopping misconduct in this space. Accordingly, private funds need to be a step ahead.