Despite consistent warnings from the Securities and Exchange Commission since 2012, alternative investment advisors continue to misallocate expenses in violation of their fund agreements and the Advisors Act of 1940. Last year the commission publicly settled four misallocation enforcement actions totaling nearly $3.5 million in penalties. We’ve summarized the SEC’s 2018 misallocation settlements below.

Fifth Street Management – December 3, 2018

Allegations

Fifth Street’s fund agreements indicated the business development corporations (“BDCs”) that Fifth Street advised would not be responsible for the compensation and overhead costs of Fifth Street’s employees. While Fifth Street shared office space with its BDC clients, it allocated the BDCs “essentially all” rent and overhead expenses. Fifth Street also allocated the BDCs compensation costs of two Fifth Street employees who performed work wholly unrelated to the BDCs. In all, the SEC found Fifth Street improperly allocated its BDC clients over $1,300,000 in expenses. The SEC also noted Fifth Street’s failure to adopt any policies to guide its expense allocation process.

In addition, the SEC found Fifth Street failed to properly review the BDC’s valuation models causing one BDC client’s financial statements to materially misstate its net increase in assets and earnings per share. As a result, the BDC issued overinflated shares to the public.

The SEC found Fifth Street willfully violated the Advisors Act and caused its BDCs to violate three other securities laws.

Outcome

The SEC censured Fifth Street and ordered it to pay $1,999,115 in disgorgement, interest of $334,545, and a penalty of $1,650,000. Fifth Street withdrew its SEC registration in 2017 and later dissolved.

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Yucaipa Master Manager – December 13, 2018

Allegations

The SEC’s settlement with Yucaipa primarily focuses on two instances where Yucaipa failed to disclose conflicts of interest that led or contributed to the misallocation of expenses.

In the first instance, Yucaipa hired a consultant (“Consultant A”) to advise on a portfolio company investment on behalf of its funds. Consultant A also provided unrelated services for Yucaipa. The SEC’s settlement suggests that because Yucaipa didn’t require the consultant to keep records of its time, Yucaipa allocated all Consultant A expenses to its funds. Compounding matters, Yucaipa’s principal personally loaned Consultant A’s principal $215,000 that was secured by money owed to Consultant A by Yucaipa’s funds. Yucaipa then used its fund’s debts to Consultant A to repay the loan.

In the second scenario, Yucaipa used another consultant (“Consultant B”) to simultaneously provide services for its funds and the personal investments of Yucaipa’s principal. Again, the consultant didn’t maintain records of its time and Yucaipa misallocated expenses to its funds that should have been borne by the principal’s personal investments. Compounding matters again, Yucaipa’s principal eventually invested in Consultant B, receiving 25% of its profits. Yucaipa did not, however, disclose this arrangement or offset a portion of this revenue against its advisory fees as required in its LPAs.

In addition, despite correctly allocating a proportional share of its in-house tax specialists who provided services to both Yucaipa and its funds, Yucaipa failed to disclose it was doing so and how.

The SEC found Yucaipa’s conduct negligent and in violation of the Advisers Act.

Outcome

Yucaipa settled with the SEC to pay $1,863,242 in disgorgement, $71,070 in interest, $1,000,000 in penalties, and to undertake independent compliance consulting. The SEC noted Yucaipa’s cooperation in the inquiry and its prompt remedial efforts including, voluntarily reimbursing the funds for misallocated expenses, expansion of its compliance department, and improvements to its policies and procedures.

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Neuberger Berman – December 17, 2018

Allegations

Neuberger manages Dyal Capital Partners, a private equity group that specializes in acquiring minority stakes in alternative investors. The private equity and hedge funds Dyal invests in are known as “Partner Managers.” In exchange for its investment, Dyal receives a portion of the management and incentive fees earned by its Partner Managers. To boost Partner Manager performance, Neuberger created a working group called the Business Services Platform, or “BSP,” that would provide Partner Managers advice and support. Neuberger’s LPAs stated Dyal funds would bear costs related to the Partner Managers’ use of the BSP.

The SEC discovered, however, that Neuberger allocated all BSP employee costs to Dyal despite BSP employees spending time on tasks unrelated to servicing the Partner Managers. As a result, about $2 million, or approximately 7% of BSP employee costs from 2012 to 2016, was misallocated to Dyal funds.

Outcome

Neuberger settled with the SEC for a disgorgement of $2,073,988, interest of $284,620, and $375,000 in penalties. The SEC noted Neuberger’s voluntary remedial efforts and praised its “extremely prompt and responsive” cooperation.

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Lightyear Capital – December 26, 2018

Allegations

Lightyear managed employee funds that invested side-by-side with its investment funds and allowed co-investors to invest in portfolio companies. In both cases, however, Lightyear allocated various shared expenses solely to its investment funds, benefitting the employee funds and co-investors at the investment funds’ expense.

Lightyear also directly advised its portfolio companies for a fee. In its investment fund agreements, Lightyear was required to offset its management fees by any portfolio company advisory fees it received. Lightyear eventually entered into a fee-sharing agreement with its co-investors that split Lightyear’s advisory fees, thereby reducing the management fee offset and increasing the management fees of its investment funds.

In all, the SEC found Lightyear misallocated $221,000 in shared expenses and failed to provide $1 million in management fee offsets.

Outcome

Lightyear settled with the SEC for $400,000 in penalties. In its report, the agency noted Lightyear’s cooperation, particularly how Lightyear proactively reimbursed its investment funds with interest before being contacted by SEC enforcement staff.

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Takeaway

The SEC maintains an unequivocal focus on expense allocation. The commission issued a formal risk alert on the subject last April and, for the second year in a row, restated expense allocation as a compliance priority for 2019.

Why the focus on expense allocation? Simply put, expense allocation is at the core of the SEC’s mission to protect investors. In the commission’s own words, “every dollar an investor pays in fees and expenses is a dollar not invested.” If private advisors aren’t moved by the commission’s words, they should look to the commission’s actions: the average misallocation penalty is now $2,990,000.

As in 2017, the failure to adopt “policies and procedures reasonably designed to prevent [misallocations]” is stated in each misallocation settlement of 2018. To avoid misallocations – and steep penalties – private advisors should review their expense allocation policies and procedures to ensure they meet fund agreement and SEC expectations.

Thinking about improving your expense allocation policies and procedures to prevent misallocations and ensure regulatory compliance? Learn how IntegriDATA EAS can help.

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