Introduction

As we previously wrote, the Securities and Exchange Commission (the “SEC”) proposed several rules that would impose additional requirements on private fund managers (“Managers”), many of which relate to various types of disclosure and associated conflict mitigation and other practices. Given the SEC’s evergreen focus on management fee offsets and step-downs and the new proposed rules, Managers should expect to see the SEC examine Managers’ management fee offset and step-down disclosure policies and procedures. Therefore, this article will specifically highlight the SEC’s focus on management fee offsets and step-downs and examine certain related SEC enforcement actions and related guidance.

Background

The SEC’s focus on management fee offsets and other calculations is not new. In its 2022 Enforcement Results, the SEC specifically referenced a management fee offset-related SEC enforcement action. Furthermore, in its 2020 Examination Findings Risk Alert, one focus of the SEC was management fee offsets, and the alert summarized certain common management fee offset-related issues with respect to Managers, such as those related to calculations and disclosures. Furthermore, in both 2018 and 2021, the SEC released risk alerts focused on advisory fee and expense compliance issues.

Even in 2012, the SEC was asking, “How clear are investor disclosures around . . . management fee offsets . . . ? How robust are the processes to ensure compliance with those disclosures?”

Enforcement Actions

As previewed, below we examine several management fee offset-related SEC enforcement actions (a topic we have previously written about). Although the summaries also highlight certain remedial actions that the SEC viewed favorably, Managers should focus on building a robust and tailored compliance program, an issue that in and of itself is on the SEC’s radar. For example, in a 2017 Risk Alert, the SEC noted that “certain compliance programs did not take into account important individualized business practices such as the adviser’s particular investment strategies . . . and advisory fees.” This compliance program should include, among other things, disclosures, policies, and procedures related to the calculation of fees, allocation of expenses, management fee offsets, and management fee step-downs to help avoid the expense and reputational damage of an enforcement action in the first place.

Example

Findings/Takeaways

Example #1 (2022)
  • The SEC fined a Manager for failure to properly offset advisory fees in connection with commissions received by an affiliated broker-dealer, despite an advisory brochure stating such commissions would offset advisory fees.

Example #2 (2022)
  • The SEC fined a Manager for failure to properly repay the Manager’s loans via an offset to management fees and failure to disclose the lack of such “repayment,” despite fund offering documents disclosing that the Manager would make a prompt repayment of such loans via a management fee offset.
  • Note, however, that the SEC explicitly recognized certain of the Manager’s remedial efforts, which included:
    • Fully repaying the loan with interest
    • Hiring a new chief compliance officer (CCO)
    • Engaging an outside compliance consultant
    • Creating a management committee that would have oversight of the compliance program

Example #3 (2021)
  • The SEC fined the Manager for failure to properly offset management fees with respect to, among other things, portfolio company and director fees, despite the fund offering documents disclosing that the Manager would offset such fees against the management fees.
  • Furthermore, the “[Manager] failed to have written policies and procedures in place to confirm the calculations were being made in a manner consistent with the [offering documents], including in this instance the provisions on management fee offsets against portfolio company advisory fees and director fees.”
  • Note, however, that the SEC explicitly recognized certain of the Manager’s remedial efforts, which included:
    • The voluntary remediation of the relevant advisory fees
    • Enhanced fund disclosures
    • Improved procedures and controls for the calculation of fee offsets

Example #4 (2018)
  • The SEC fined the Manager for failure to properly offset management fees in line with what was disclosed in the fund offering documents.
  • Note, however, that the SEC explicitly recognized certain of the Manager’s remedial efforts, which included:
    • Installing a new CCO, who implemented controls to help verify the accuracy of management fees charged and the calculation of corresponding management fee offsets
    • Retaining a compliance consultant who, among other actions, tested expense allocation policies and procedures and helped otherwise ensure compliance with its disclosure obligations

Example #5 (2016)
  • Although offering documents noted that the Manager would offset management fees in connection with transaction fees received from portfolio companies (and did so, in a sense), the Manager’s methodology allocated an outsized portion to itself. In that vein, it received certain fees that should have offset fund management fees, without disclosing such practice.
  • In 2014, prior to the enforcement action, the SEC investigated the Manager, which then and thereafter took several remedial actions, which included:
    • Revising its transaction fee allocation methodology
    • Hiring a new CCO
    • Engaging an independent accounting firm that performed an “internal controls review” of its back-office functions
    • Enhancing its processes and internal controls with respect to, among other actions, the tracking and monitoring of transaction fees

Management Fee Step-Down Enforcement Actions

In addition to management fee offsets, certain Managers may include management fee step-down provisions in their offering documents, which, in short, typically means that management fees paid by investors will be lowered after a certain event and/or duration (such as stepping down once a post-commitment period commences). As with management fee offsets, it is crucial that Managers are aware of their management fee step-down provisions and obligations, make full and fair disclosure surrounding such practices, and have policies and procedures in place to help ensure that their actions match their disclosures. As previewed, Managers’ disclosures, policies, procedures, and actions related to management fee step-downs are certainly on the SEC’s radar. For example, in both their 2022 and 2023 examination priorities, they specifically noted that they would continue to examine “the calculation and allocation of fees and expenses, including the calculation of post-commitment period management fees . . . .” We have highlighted just two of several SEC enforcement actions related to improper management fee step-down calculations.

Example

Findings/Takeaways

Example #1 (2022)
  • Fund offering documents noted that starting at the post-commitment period, the Manager would reduce management fees in connection with “dispositions” (which included, among other things, any write-down in value of individual portfolio company securities).
  • The SEC fined the Manager for, among others:
    • Failure to adjust its management fee calculations to account for portfolio company securities subject to certain dispositions
    • Calculating its management fee based on aggregated invested capital at the portfolio company level instead of at the individual portfolio company security level
    • Incorrectly including accrued but unpaid interest as part of the basis of the management fee calculation
    • Failure to begin calculating the funds’ post-commitment period management fees on the date the post-commitment period actually started  

Example #2 (2021)
  • Fund offering documents noted that management fees would “be reduced as a result of certain triggering events, including, but not limited to, write downs of portfolio securities.”
  • The SEC fined the Manager for failure to reduce management fees charged based on certain write-downs of fund portfolio securities.

Takeaways

As highlighted by this risk alert, the SEC has examined and will continue to examine Managers’ practices and associated disclosures with respect to management fee offsets, step-downs, and calculations. In that vein, the common themes with respect to these enforcement actions include, among others, (a) a failure to disclose fee arrangements and other conflicts, (b) a failure to properly follow disclosures, and (c) failure to have written policies and procedures in place to help avoid and/or mitigate (a) and (b). Managers should pay careful attention to these trends and should continue to take every effort to examine their business and other practices with respect to management fee offsets, step-downs, and calculations. More specifically, Managers should ensure that they provide their investors with full and fair disclosure with respect to their management fee offset, step-down, and calculation practices and compensation to advisors or related persons and expense allocations; they have policies and procedures in place to help ensure that disclosures are actually being followed; and the relevant parties (both internal and external) are aware of the disclosures, policies, and procedures as applicable. That said, these items should be only one piece of a more robust and specifically tailored compliance program. In addition to being disclosed in offering documents and the Manager’s Form ADV, there should be policies and procedures in a Manager’s compliance manual. Furthermore, Managers should consider including review of the associated policies and procedures and ensuring management fee offsets and step-downs are calculated properly as part of their annual compliance review, mock exams, and conflict and risk assessments.

However, this is not a “one-and-done” approach. Managers should continuously monitor these programs and constantly strive to improve them. As new funds launch and as operations, personnel, and business strategies, among other things, continue to change, Managers should conduct ongoing compliance reviews and continuously update disclosures, policies, and procedures as appropriate.

Next Steps

For further information, guidance, and clarity on how Managers can approach and tailor their management fee offset and step-down disclosures and associated policies and procedures, and/or factor the foregoing into their annual compliance review and periodic risk/conflict assessment, please reach out to the authors, Scott Moss, partner in Lowenstein Sandler’s Investment Management Group and Chair of the firm’s Fund Regulatory & Compliance Group, Jeremy Cantor, associate in the firm’s Investment Management Group; or reach out directly to your regular Lowenstein Sandler contact.