Private Equity

On June 20, 2023, the SEC settled^[1] charges against an investment adviser to private funds in connection with the adviser’s (i) charging excess management fees due to inaccurate application of its permanent impairment policy and (ii) failing to disclose a conflict of interest to investors relating to such policy and its fee calculations.  The SEC’s investigation additionally revealed that the adviser did not implement written policies or procedures reasonably designed to prevent violations of the Advisers Act relating to such practices. As part of the settlement, the adviser agreed to pay a $1.5 million penalty and $864,958 in disgorgement and prejudgment interest.   

Specifically, the SEC’s order noted that the limited partnership agreements (“LPAs”) of the adviser’s funds effectively required the adviser to reduce the management fees charged to a fund should the adviser determine that a portfolio investment suffered a “permanent impairment.”  The adviser established criteria to determine whether a permanent impairment had occurred, but these were not disclosed to investors in the LPAs or otherwise. In applying these criteria, the adviser analyzed permanent impairment at the “aggregated portfolio company” level rather than at the “portfolio investment” (i.e., individual security) level, as required by the LPAs, resulting in the inaccurate calculation of the management fees charged to the funds (and therefore investors). 

The order further noted that the adviser failed to inform investors of the impairment criteria, which the SEC described as “narrow and subjective” and granting the adviser significant latitude to determine whether a permanent impairment had occurred. This in turn created an undisclosed conflict of interest because the adviser had an incentive to minimize the existence and size of impairments in order to minimize reductions in its management fees.

The SEC cited the adviser’s actions as violations of Sections 206(2)^[2] and 206(4) of the Advisers Act and Rules 206(4)-7^[3] and 206(4)-8^[4] thereunder.

In response to this enforcement action, advisers should (i) review, and carefully adhere to, (a) any implemented impairment or write-down policies, especially with respect to fee reduction practices, and (b) the relevant provisions set forth in their fund documentation, including any distinctions between “investments” and “portfolio companies” and any interplay with write-downs and, if applicable, (ii) disclose to investors (a) all relevant criteria used in the impairment analysis and (b) the fact that the adviser has a conflict of interest in applying any subjective impairment criteria, as an impairment may reduce management fees and/or impact a fund’s carried interest waterfall.