September 16, 2016
Interviewed by: Privcap
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Is the Rise in SEC Scrutiny a Fad?

Pressure from the SEC and limited partners for both compliance and transparency is weighing on general partners. Goodwin’s Paul Verbesey discusses some sticky fee allocation issues, conflicts of interest, and whether the increased scrutiny is here to stay.

Pressure from the SEC and limited partners for both compliance and transparency is weighing on general partners. Goodwin’s Paul Verbesey discusses some sticky fee allocation issues, conflicts of interest, and whether the increased scrutiny is here to stay.

Is the Rise in SEC Scrutiny a Fad?
With Paul Verbesey of Goodwin

Q1: Is the level of SEC scrutiny towards private equity real estate getting more intense?

Paul Verbesey, Goodwin:

Yes, I think it is at the moment. One of the areas they’re really focused on is conflicts of interest, in particular, with respect to fees and expenses. Then, in fact, LPs for years have been looking for further transparency and detail on fees and expenses and ILPA (the Institutional Limited Partners Association), since its founding in 2011, has been focused on this issue. Managers and GPs would be well-served to think about this issue not only from the perspective of the SEC and the other regulators, but from the LPs as well.

Q2: How much does transparency weigh on the reputation of a GP?

Verbesey: They want to be as transparent as possible with respect to fee and expense reporting. LPs are very focused on this issue and I think it’s absolutely reputational for the GP. In particular on expenses, the historical approach in fund partnership agreements was to include a detailed list of the expenses that the general partner or a manager was responsible for and then, basically everything else was a fund expense.

I think what’s changed is the level of detail included in those lists, both on the manager/GP side as well as the fund side. Quite frankly, I’ve seen many of them—what used to be a paragraph is now several pages. So, while I don’t think it’s possible to include everything on the expense side, GPs should be focused on expenses that are clearly anticipated. In particular, expenses that—it’s not always clear whether they should be a GP or a fund expense.

On the fee side, I think it’s still difficult to include everything. But, for the most part, fund sponsors have a pretty good sense of what fees they’re entitled to. One area of focus, though, is at the investment level, whether it’s portfolio company in a private equity context or real estate asset level in a real estate context, the SEC is very focused on fees that are paid at that level, which are then, of course, indirectly borne by the fund and the LPs.

Q3: How can a real estate GP improve disclosure around its use of operating partners?

Verbesey: From the SEC’s perspective and the limited partner’s perspective, operating partners often look very much like GP employees or affiliates. So, obviously, services of GP employees and affiliates are typically a fund expense paid out of the management fee. But often, these operating partners are actually paid by either the portfolio company or the fund directly. So, I think GPs, from a disclosure perspective, need to be very clear from the beginning as to who these people are, what their role is, what their title is, how they’ll be compensated and who will bear the expense. This is one that really is a disclosure issue.

Q4: What are some challenges when it comes to broken deal fees?

Verbesey: That’s another one where disclosure upfront is key. One of the real challenges there comes in the context of when there are parallel entities, co-investment vehicles or multiple affiliated or even unaffiliated entities investing in a single deal. In fact, at the end of last year, there was the KKR enforcement action, which covered just that point.

One of the key issues with all of this disclosure is the timing. Through the broken deal fees, this issue was highlighted by the SEC that the disclosure has to be made at the outset in the initial organizational and offering documents of the fund at the time when the investors are making their investment decision.

Q5: What are some key issues when paying for services provided by independent third-parties?

Verbesey: Property management, construction, leasing management, legal, accounting—these are services that, if provided by an independent third party, in most cases, are clearly a fund expense. The GPs have been saying for years, “We have people who can do this and we can do it more efficiently and more cost effectively than hiring an outside third party.” So, you have to disclose not only that to the extent that you’re going to utilize in-house employees or affiliates to provide these services, I think you have to be clear upfront in your disclosure.

Another key areas is often the GPs will make a commitment that these fees will be charged at or below third-party market rates. The SEC has looked at that very closely recently and is looking for evidence or a record of the GP having actually done the diligence to confirm what third-party market rates are, whether that’s engaging a third party to do a survey or going out and getting three or more quotes from independent service providers.

Q6: Are you seeing pushback from GPs in the allocation of expenses for SEC compliance?

Verbesey: In my experience, the advisor registration costs and expenses are typically a GP manager expense. Funds are very reluctant and investors are very reluctant to bear those expenses. In fact, it’s a clearly negotiated point. It’s one of the first items on the fee expense list for many investors. Where it does get little gray is that there are some expenses that it’s a little unclear whether they are manager expenses, regulatory or fund. For example, with the AIFMD in Europe—the European equivalent of Dodd-Frank—there are some of the requirements and some of the work that fund sponsors have to do over in Europe. Some of it is related specifically to the fund. It’s not an investment manager registration point.

Q7: Is increase in SEC scrutiny a fad or here to stay?

Verbesey: The SEC has focused on conflict-of-interest issues associated with registered investment advisors for years. As I mentioned, that comes up most often and is most pronounced in the fee and expense area. After Dodd-Frank, with more and more advisor registering, the focus on this has just continued to increase and I don’t know if it can continue to increase. We’ve seen, I don’t know what it’s been, eight or even a dozen enforcement actions over the past year or two. I think those are sinking in. So, I don’t think it’s a fad. I don’t think it’s going to go away, but I think the industry is going to adapt.

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