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Everyone knew the SEC would pursue a marquee-name private equity sponsor for misallocating expenses.  It finally happened, with KKR settling charges for misallocating “broken deal” expenses.  Charges against others are likely to follow over time.

According to the SEC an investigation found that during a six-year period ending in 2011, KKR incurred $338 million in broken deal or diligence expenses related to unsuccessful buyout opportunities and similar expenses.  Broken deal expenses include research costs, travel costs and professional fees, and other expenses incurred in deal sourcing activities related to specific “dead deals” that never materialize. Broken deal expenses also include expenses incurred by KKR to evaluate particular industries or geographic regions for buyout opportunities as opposed to specific potential investments, as well as other similar types of expenses.

The SEC maintains that even though KKR’s co-investors, including KKR executives, participated in the firm’s private equity transactions and benefited from the firm’s deal sourcing efforts, KKR did not allocate any portion of these broken deal expenses to any of them for years. The SEC also maintains KKR did not expressly disclose in its fund limited partnership agreements or related offering materials that it did not allocate broken deal expenses to the co-investors.

The SEC found KKR violated Section 206(2) of the Investment Advisers Act, which prohibits an investment adviser, directly or indirectly, from engaging “in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.” The SEC order states a violation of Section 206(2) may rest on a finding of simple negligence.

In October 2011, KKR engaged a third-party consultant to review the firm’s fund expense allocation practices. At the time, there was public awareness of heightened regulatory scrutiny on the private equity industry.  KKR revised its expense allocation policy as a result of the review, and the new policy was not the subject of the SEC order.

The SEC’s order instituting a settled administrative proceeding also finds that KKR failed to implement a written compliance policy governing its fund expense allocation practices until the end of the six-year period in 2011.

KKR agreed to pay more than $14 million in disgorgement (in addition to $3.26 million that was previously refunded to clients) as well as more than $4.5 million in prejudgment interest and a $10 million penalty.  KKR neither admitted nor denied the SEC’s findings.


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