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Recent SEC charges against a registered investment adviser to a private fund and one of its co-founders illustrate recurring themes in SEC enforcement actions against private equity advisers.  The enforcement action includes allegations of improper expense charges, distributions to the general partner contrary to the waterfall in the partnership agreements, misleading statements during the marketing phase, and failure to follow the custody rule.  In general terms, the SEC alleged:

  • The investment adviser misidentified some of its own expenses as “split expenses” that related to both the investment adviser and the funds.  The split expenses were allocated 70% to the advised funds and 30% to the investment adviser.  Misidentified expenses included salaries of the investment adviser’s employees, executive bonuses, health benefits, retirement benefits and rent.  The private placement memorandums, or PPMs, and limited partnership agreements for the funds did not disclose the funds would bear these expenses. Some of the PPMs specifically stated these expenses should not be paid by the funds.
  • The limited partnership agreements for the funds provided that if a fund had distributable cash it would be distributed pursuant to a waterfall provision. While the waterfall provisions varied among the funds, the provisions generally provided for a preferred return to investors, followed by a catch-up provision to the general partner, with the remainder being divided between the investor and the general partner using a disclosed ratio. Among other things, the SEC alleges instead of using catch-up amounts specified in the limited partnership agreement, the investment adviser sometimes used higher catch-up amounts without disclosure to the investors.
  • The co-founder that is charged in the SEC action told an investor he and the other co-founder were both investing $100,000 in a new fund.  However the two co-founders only invested $25,000 each.
  • The investment adviser kept stock certificates for fund investments in its office but did not follow custody rules related to surprise examinations or annual audits.

Of course, some or all of the facts alleged by the SEC may not be true.  But the action clearly demonstrates the SEC’s recent enforcement thrust.


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