There has for some time been regulatory focus on both the manner in which fees and expenses incurred by investment advisers are allocated and the level of disclosure provided to investors regarding the nature and allocation of such expenses and potential conflicts of interest relating thereto. We have seen the majority of investment advisers pay close attention to this issue and develop detailed policies, procedures and internal controls to review and manage what has become an increasingly complex area. However, it remains a challenge in the industry and one that is not going to get easier to manage without significant infrastructure or external support.
The U.S. Securities and Exchange Commission has brought several cases against US investment advisers for alleged violations of the U.S. Advisers Act and has long expressed its concern regarding the proper allocation of expenses and in particular disclosure of conflicts of interest when entering into arrangements with affiliates that benefit them at the expense of fund clients.
Private equity advisers have also been receiving a lot of attention of late, on the theory that in certain circumstances investors do not have sufficient transparency into how fees and expenses are charged to portfolio companies or the funds. Regulatory actions have concentrated on one or more of the following overlapping areas: undisclosed fees and expenses received by the adviser; shifting or misallocating expenses and failing adequately to disclose conflicts of interests arising from fee and expense issues.
While private fund advisers have been first in the firing line, where the fund itself is regulated (for example by the Cayman Islands Monetary Authority (CIMA), the general partner and/or the directors will have overall responsibility for supervising the affairs of the fund, disclosing and managing conflicts of interest and monitoring the investment manager's activities. Thus, where the fund complex involves both onshore and offshore funds, the issues are relevant to a broader range of 'fund fiduciaries'.
Important considerations
The allocation of fees and expenses is clearly a risk area for fund fiduciaries. Policies should describe how costs are allocated across funds, co-investment vehicles and the extent to which they are borne by affiliates or employees of the manager who participate in investments.
Fund documents and disclosures should regularly be reviewed and updated. It should go without saying that the disclosures in an offering document must be consistent with other materials that are regularly produced or filed such as due diligence questionnaires, Form ADV and the like.
The level of specificity with respect to expenses which may be borne by the fund has dramatically increased in recent times. Some may argue that the sheer length of the disclosures has become a burden not just for managers but for investors attempting to digest the disclosures, often in a short period of time prior to making an investment decision. Mere repetition of information in an offering document, which is already a substantial time, is not the answer. However, detailed disclosure is an important fiduciary matter and can also serve as a protection for the fund's fiduciaries when their practices are scrutinized to determine whether they fell squarely within the disclosures provided to investors.
Even if the documents do not provide a clear roadmap for the allocation of particular fees or expenses, it is important to demonstrate the methodology behind a decision made in any given case. Were the manger's policies and procedures followed? If those too do not sufficiently address the protocol for the situation at hand, what process did the manager adopt at the time? Typical practices include escalating the decision to a senior person within the organization with authority for decision-making, recording the rationale for the decision taken and, in the case of an offshore fund, discussing the matter with the fund's board of directors and if necessary, obtaining board approval. Assuming the board of directors (or at least the majority of the board) is independent from the manager, it can serve as an important check and balance to assist in ensuring that appropriate allocations and disclosures are made to investors. An advisory board or a committee of the board of directors may also be mandated specifically to deal with expense allocation issues.
This issue is not going away. While regulators are constrained by priorities and limited resources, the quantum of an expense improperly allocated or not disclosed may not of itself avoid enquiry or indeed regulatory action. Even if the manager considers the amount to be immaterial compared to overall expenses or the size of the fund, an investor or regulator may not share the same view. Even if no action is brought, why risk the potential loss of trust by investors, not to mention the potential reputational damage?
Originally published by Wells Fargo Prime Services, Business Consulting Group's Industry and Regulatory Update Quarterly, dated July 2017.
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