Top 5 PE Practices Grabbing SEC Attention - PowerPoint Presentation

1. Top 5 PE Practices Grabbing SEC AttentionWednesday, October 19, 20169:00 a.m. Pacific/12:00 p.m. Eastern

2. 2ModeratorMonique S. BotkinAssociate General CounselInvestment Adviser Association

3. PanelistsHon. Troy ParedesFounder, Paredes Strategies LLCFormer SEC Commissioner Stefano VrancaAdvisory Principal-in-Charge California Region, Marcum, LLPTram NguyenPartner, CorporatePaul HastingsNick MorganPartner, LitigationPaul Hastings

4. Whistleblower bounties: gas on a flameSEC has awarded $111 million to 34 whistleblowersTOP 10Source: SEC

5. Whistleblower bounties: Gas on A FlameSource: SEC

6. What OCIE Identifies, enforcement pursuesOver 50% of examined private equity fund advisers have compliance issues, including allocation of expenses, hidden fees, and issues related to marketing and valuation.Andrew Bowden, then-Director of OCIEMay 4, 2014, “Spreading Sunshine in Private Equity”“The Enforcement Division’s focus on private equity . . . has expanded significantly over the past three years . . .”Andrew Ceresney, SEC Director of EnforcementMay 12, 2016, Securities Enforcement Forum West

7. Overview of VIOLATIONS, RELIEF Case NameDateViolations AllegedMonetary ReliefIn the Matter of WL Ross & Co. LLC 8/24/16Advisers Act, Sections 206(2) & 206(4)SEC Rule 206(4)-8$2.3 million (penalty)$11/8 million (“voluntary reimbursement” & int.)In the Matter of Apollo Management V, L.P., et al. 8/23/16Advisers Act, Sections 206(2) & 206(4)SEC Rule 206(4)-7 & 206(4)-8$40.2 million(disgorgement & prejudgment int.)$12.5 million (penalty)In the Matter of Kohlberg Kravis Roberts & Co., L.P.6/29/15Advisers Act, Sections 206(2) & 206(4)SEC Rule 206(4)-7 $18.7 million(disgorgement & prejudgment int.)$10 million (penalty)In the Matter of Blackstreet Capital Mgmt, LLC, et al. 6/1/16Exchange Act, Section 15(a)Advisers Act, Sections 206(2) & 206(4)SEC Rule 206(4)-7 & 206(4)-8$2.5 million (disgorgement & prejudgment int.)$500,000 (penalty)In the Matter of Cherokee Investment Partners, LLC, et al. 11/5/15Advisers Act, Sections 206(2) & 206(4)SEC Rule 206(4)-7 & 206(4)-8$100,000 (penalty)

8. Top 5 PE Practices Grabbing SEC AttentionTransaction Fee OffsetsAccelerated Monitoring FeesBroken Deal ExpensesTransaction-Based CompensationAllocating Registration Expenses

9. transaction fee offsetsPortfolioCompanyPortfolioCompanyAdviserFundPortfolioCompanyTransactionFeesManagementFeeTransactionFees

10. Transaction Fee offsetsAugust 2016, PE adviser agreed to pay $2.3 million penalty following voluntary reimbursement of nearly $12 million in management fee credits“The Management Fee shall be reduced in any given quarter by an amount equal to fifty percent (50%) of any . . . transaction fees received by the General Partner or any Affiliate thereof during the prior quarter from Portfolio Investments”The adviser retained 60% of such fee from a co-investor for negotiating, advising, and structuring a transaction based on this “ambiguous” language. Co-investor did not receive management fee offsets

11. Transaction Fee offsetsSEC approach: management fee credits were re-allocated only among investors receiving offsetsAdviser allocated the management fee offset that each investment fund received based on each investment fund’s relative ownership interest in the portfolio company, i.e., the same proportion as each investment fund’s relative share of the transaction fee

12. Accelerated monitoring feesPortfolioCompanyPortfolioCompanyAdviserFundPortfolioCompanyMonitoringFeesManagementFeeMonitoringFees

13. Accelerated Monitoring FeeSAugust 2016, four affiliated PE advisers agreed to pay $52.7 million settling allegations that advisers did not properly disclose to investors the practice of taking accelerated feesAllegations: PE firm entered into “monitoring agreements” with portfolio companies allowing firm to charge monitoring fees in exchange for certain consulting/advisory servicesThe agreements allowed the PE firm to terminate the monitoring agreement and accelerate the remaining years of monitoring fees, which it received as “termination payments” when portfolio sold or taken public

14. Accelerated Monitoring FeeSLPAs and PPMs generally provided that advisor was entitled to receive “[a]ny consulting fees, investment banking fees, advisory fees, breakup fees, directors’ fees, closing fees, transaction fees and similar fees . . . in connection with actual or contemplated Portfolio companies”After receipt, PE specifically disclosed actual accelerated monitoring fees in distribution notices, reports to Advisory Board, and, in the case of IPOs, Form S-1 filingsSEC alleged violations based on failure to specifically disclose accelerated fees to LPs prior to commitment of capitalSEC credited advisor with cooperation and remediation…and imposed a $12.5 million penalty

15. Broken Deal expensesAdviserPotentialInvestmentPotentialInvestmentPotentialInvestmentCo-investorCo-investorManagement FeeFundBroken Deal Expenses

16. Broken Deal ExpensesJune 2015, PE adviser paid $29 million in disgorgement and penalties to settle allegations relating to allocation of broken deal expenses (diligence expenses related to unsuccessful buyout opportunities) to the adviser’s PE funds rather than all potential investors eligible to participate in investmentsLPA permitted adviser to be reimbursed by funds for broken deal expenses that are incurred “by or on behalf of” the fundAdviser did not disclose that it do not allocate broken deal expenses to co-investors, even if the co-investors participated in and benefitted from the services giving rise to the expense

17. TRANSACTION-BASED COMPENSATIONLP InvestorPortfolioCompanyAdviserFundTransaction-BasedFeesTransaction-BasedFees

18. TRANSACTION-BASED COMPENSATIONJune 2016, PE adviser agreed to pay over $3.1 million in disgorgement and penalties for receiving transaction-based compensation while not being registered as a broker-dealer Adviser solicited deals, identified buyers and sellers, negotiated and structured transactions, arranged financing, and executed transactions relating to portfolio companiesAdviser received at least $1.8 million in connection with providing these servicesSEC alleged that these were transaction-based fees, requiring registration as a broker-dealer

19. TRANSACTION-BASED COMP/BD RegistrationSEC’s long history of “regulation by enforcement” on issue2013 Enforcement Action against Ranieri Partners2013 SEC/Blass speech suggesting PE BD registration requiredMarch 2013 FundersClub No-Action letterFebruary 2014 “M&A Brokers” No-Action LetterJune 2015 Member of SEC Advisory Committee on Small and Emerging Business Committee submitted commentary that BD registration process too onerous for small intermediariesSeptember 2015, Committee submitted formal recommendation that SEC “take steps to clarify the current ambiguity in broker-dealer regulation”June 2016 action against Blackstreet

20. TRANSACTION-BASED COMP/BD RegistrationDo you participate in important parts of a securities transaction, including solicitation, negotiation, or execution of the transaction?Does your compensation for participation in the transaction depend upon, or is it related to, the outcome or size of the transaction or deal?Are you otherwise engaged in the business of effecting or facilitating securities transactions?Do you handle the securities or funds of others in connection with securities transactions?A "yes" answer to any of these questions indicates that you may need to register as a broker.Source: SEC Guide to Broker-Dealer Registration

21. Allocation of Firm’s Regulatory & compliance ExpensesNovember 2015, PE firm agreed to pay $100,000 to settle action regarding allocation of adviser’s expenses Allegations:PE firm incurred consulting/legal/compliance expenses to prepare for registration as IA, comply with obligations as an IA and respond to investigation requestsThe firm caused the client funds to pay for almost $500,000 of those expensesLPAs disclosed that client funds could be charged for expenses in the “good faith judgment” of the GPNo specific disclosure that the client funds would be charged for the firm’s legal and compliance expenses

22. ConclusionDisclosureHow much is “adequate”?How to anticipate unforeseen expenses?ConsentCurrent PracticeLegacy Practice

23. Q&A

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