Infrastructure funds move into SEC spotlight
Infrastructure fund managers should focus on the types of fees they charge their funds and the manner in which fees and conflicts are disclosed to fund investors.
The private equity industry is under increasing scrutiny by the US Securities and Exchange Commission, with particular focus on the conflicts inherent in private equity business models and the manner in which fees and expenses are charged to funds and their portfolio investments.
To date, the SEC’s enforcement actions and guidance have focused primarily on traditional private equity sponsors.
Last year, Marc Wyatt, acting director of the SEC office of compliance inspections and examinations, said the SEC is expanding its focus to private equity real estate advisers that operate more “vertically integrated” platforms, including sponsors that provide a variety of third party services directly to portfolio investments after acquisition.
Fees and Expenses
In a recent speech, Andrew Ceresney, director of the SEC enforcement division, divided private equity enforcement actions to date into three categories.
Some actions have been against advisers who receive undisclosed fees and expenses. For example, a recent SEC action involved a private equity sponsor who failed properly to disclose its monitoring agreements with portfolio companies in which its funds invested. In particular, although the sponsor disclosed in its offering documents the payment of monitoring fees from portfolio companies for board and advisory services, it failed to disclose the fact that the sponsor received accelerated monitoring fees upon termination of the monitoring agreements (for example, upon an initial public offering of shares in a portfolio company).
Another category of actions has been against advisers who impermissibly shift and misallocate expenses. Three examples of such enforcement actions are the following. The first action involved an adviser that allocated broken deal expenses entirely to its flagship fund and not to other managed co-investment funds that typically invested alongside the funds in completed acquisitions. The second action involved an adviser that misallocated portfolio company expenses between two managed funds. The third action involved an adviser that misallocated expenses between the adviser and the fund.
The last category of enforcement actions has been against advisers who fail adequately to disclose conflicts of interest, including conflicts arising from fee and expense issues. Two recent cases involved private equity sponsors who failed to disclose conflicts to (or obtain proper consent from) the limited partner advisory committees of their funds.
In one case, the adviser caused the funds and their portfolio companies to enter into affiliated contracts without properly disclosing them to investors in advance, and without properly disclosing or seeking limited partner approval. In particular, the adviser entered into certain monitoring agreements with its portfolio companies that were not netted against management fees as required under the fund’s operating agreements. The adviser asked fund investors to provide $4 million in connection with an investment in a portfolio company without disclosing that $1 million of the capital call would be used to pay its affiliate. It also paid three former employees of the sponsor $15 million in incentive compensation from the sale of a portfolio company for services that they provided when they were employees of the sponsor without disclosure to the limited partners. Finally, it failed to disclose each of these payments as related-party transactions in the financial statements it provided to investors.
In the second case, the SEC charged the sponsor with failing to disclose and obtain limited partner consent for a series of loans to portfolio companies, resulting in the adviser obtaining interests in portfolio companies that were senior to the interests held by the funds. The sponsor had multiple funds invest in the same portfolio company at differing priority levels, potentially favoring one fund client over another. It also allowed the funds to exceed investment concentration limits in the governing documents of the funds.
Last year, Julie M. Riewe, co-chief of the asset management unit in the SEC enforcement division, emphasized similar themes in a speech on compliance and other issues affecting investment advisers at an IA Watch conference.
She said, “In nearly every ongoing matter in the asset management unit, we are examining, at least in part, whether the adviser in question has discharged its fiduciary obligation to identify its conflicts of interest and either eliminate them, or mitigate them and disclose their existence to boards or investors. Over and over again we see advisers failing properly to identify and then address their conflicts.”
To fulfill their obligations as fiduciaries and avoid enforcement action, fund managers must identify and then address those conflicts. She said each fund manager should “take a step back and rigorously and objectively evaluate its firm, its personnel, its business, its various fee structures, and its affiliates.”
Where conflicts have been identified, she offered a number of important questions to be vetted internally.
For each conflict identified, can the conflict be eliminated? If not, why not? If the adviser cannot, or chooses not to, eliminate the conflict, has the firm mitigated the conflict and disclosed it?
Is there someone — a person, a few individuals or a committee — at the firm responsible for evaluating and deciding how to address conflicts? Is that person, a group of individuals or committee sufficiently objective?
Is the process used to evaluate and address conflicts designed to be objective and consistent?
Does the firm have policies and procedures in place to identify new conflicts and monitor and continually re-evaluate ongoing conflicts?
As to mitigation, are the firm’s policies and procedures reasonably designed to address the conflicts the firm has identified, and are they properly implemented?
As to written disclosure, has the firm reviewed all of the relevant disclosure documents — among others, Forms ADV used by investment advisers, private placement memoranda, limited partnership agreements, client agreements and prospectuses — to ensure that all conflicts are disclosed and disclosed in a manner that allows clients or investors to understand the conflict, its magnitude and the particular risk it presents?
Does the firm review those documents regularly to ensure that new or emerging conflicts are disclosed in a timely way?
Is the adviser keeping the chief compliance officer and any boards of directors informed about conflicts of interest, particularly the adviser’s analysis and decisions on whether to eliminate or mitigate a conflict?
The SEC is broadening its attention to focus on asset classes adjacent to traditional private equity. In particular, the private funds unit at the SEC has undertaken a “thematic review” of private equity real estate advisers based on the observation that real estate managers, especially those executing “opportunistic and value-add strategies,” tend to be much more vertically integrated than traditional private equity fund managers, and often provide property management, construction management and leasing services for additional fees, and potentially charge back the cost of their employees who provide asset management services and their in-house attorneys.
Accordingly, when examining private equity real estate advisers, the SEC can be expected to focus on those ancillary services being provided to managed funds and their projects, and whether the limited partners are being provided with adequate disclosure regarding fees and expenses at both fund level and project level.
Infrastructure fund advisers tend to operate similar vertically integrated platforms. As part of their platforms, they may provide a range of ancillary services and activities to their managed funds and their portfolio companies and project investments.
For example, the infrastructure fund adviser or its affiliates may provide early-stage, pre-construction development services to their project investments, including siting, permitting and negotiating power purchase or other offtake agreements. These activities may be funded by the infrastructure fund in the form of equity contributions or loans to the project company or pursuant to a monitoring agreement with the fund adviser. Infrastructure funds tend to seek compensation for development efforts by negotiating reimbursement of development costs or payment of a developer fee by subsequent equity investors in the project or as loans from the project’s construction lenders.
Another example is construction management services and fees. Some infrastructure funds may cause a project company to enter into a construction management agreement with the fund’s adviser or its affiliate as construction manager, typically on or around financial closing on the construction debt.
The fund manager may also collect fees for acting as a contract operator of a project once the project is in operation.
It might also charge asset management or administrative service fees for doing such things as filing forms, causing tax returns to be prepared, and handling other administrative tasks.
Infrastructure Action Items
Based on recent SEC speeches and actions, infrastructure managers should focus on how they manage and disclose fees and conflicts.
Here is a list of questions to answer while fundraising to make sure the fund will not run afoul of SEC rules.
What are the types of services expected to be provided by affiliates of the sponsor to the fund and the portfolio companies in which the fund invests?
Is the sponsor or its affiliates the exclusive provider of those services or may services be bid out to third parties?
How are fees disclosed to and approved by investors in the fund? Are they set at market rates? How may the rates be altered throughout the life of the fund?
Are there any fee offsets under the fund’s operating agreement? Does the operating agreement expressly provide which services are included within or excluded from the offset?
What is the role of any limited partner board or committee in disclosing or mitigating conflicts and in reviewing affiliate contracts and fees?
For infrastructure fund managers, vetting and disclosing conflicts and fees may pose particular challenges. For example, unlike typical monitoring fees that may be charged by private equity fund managers, it may be difficult to maintain consistency of service fee pricing among project companies in the portfolio, as fee amounts are usually subject to approval by third-party debt or equity providers. Furthermore, debt or equity providers may agree to compensate the infrastructure fund for third-party, out-of-pocket costs, but not for “soft” or “internal” costs such as salaries, travel and overhead costs of the fund adviser. Thus, the infrastructure fund could be asked to cover the fees under the monitoring agreement for certain projects in the portfolio, but not others.
Infrastructure sponsors must balance the desire for flexibility with disclosure obligations. While it may be tempting to “solve” all conflicts by requiring limited partner advisory committee approval for all affiliate services contracts and fees, such a mechanism may be sand in the gears and create uncertainty for the sponsor.
As the SEC focuses more on real estate advisers, its findings and actions will offer guidance.