SEC Charges Private Equity Manager in First Ever Case Over Allocation of Broken Deal Expenses

The Securities and Exchange Commission recently charged a private equity firm for misallocating more than $17 million of “broken deal” expenses. Broken deal expenses are those associated with identifying, researching and negotiating potential investment opportunities that do not materialize as actual investments. Such expenses can be significant, and typically include research costs, travel costs and professional fees.

Specifically, the SEC found that the firm allocated broken deal expenses to its flagship private equity funds, but did not allocate such expenses to co-investment vehicles that the firm also had established and managed. The co-investors included executives of the private equity firm. As a result of this misallocation, co-investors did not bear these broken deal expenses, and thus benefited because investors in the flagship funds bore these expenses.

By misallocating the broken deal expenses between the flagship funds’ investors and the co-investors, the SEC charged the firm with breaching its fiduciary duty and with failing to adopt and implement a written compliance policy or procedure governing its fund expense allocation practices. The firm agreed to a settlement, and will pay nearly $30 million, including a $10 million penalty.

Andrew Ceresney, Director of the SEC Enforcement Division, remarked, “this is the first SEC case to charge a private equity adviser with misallocating broken deal expense” Mr. Cerseney stated that while the firm “raised billions of dollars of deal capital from co-investors, it unfairly required the funds to shoulder the cost for nearly all of the expenses incurred to explore potential investment opportunities that were pursued but ultimately not completed.”

The SEC noted that the Enforcement Division’s Asset Management Unit has been scrutinizing the private equity industry to make sure that fund managers are not misallocating or unfairly charging fees and expenses to investors.

Our Perspective

The private equity sector continues to be a focus area for the SEC. The Office of Compliance Inspections and Examinations (“OCIE”) recently released a summary of 150 examinations completed over the last two years of private equity firms with a focus on advisers’ collection of fees, allocation of expenses, marketing and valuation. Their findings included, among other things, certain common practices involving expense shifting and hidden fees where disclosure was limited or inadequate.

In this particular case, the firm’s practice to charge all broken deal expenses to its flagship funds was a common practice in 2006 – 2011, which was the period the SEC reviewed. In fact, the limited partnership agreements of the flagship funds at the time required the funds to pay all broken deal expenses. Because the LPAs contained this language, the firm had not previously considered charging any broken deal expenses to co-investors.

However, at some point in 2011, the firm recognized during an internal review that it lacked a written policy governing its broken deal expense allocations. In drafting its fund expense allocation policy, the firm considered whether to allocate broken deal expenses to co-investors and decided at the time to allocate some share of broken deal expenses to several committed capital co-investment vehicles.

Later in 2011, the firm 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.

The firm then revised its broken deal expense allocation methodology in the wake of the third-party consultant’s review of the firm’s fund expense allocation practices. In addition to committed capital co-investment vehicles, the firm’s new allocation methodology began in 2012 to allocate a share of broken deal expenses to other co-investors, including co-investment vehicles for its executives. The firm’s new methodology considered a number of factors, including the amount of committed capital, the amount of invested capital, and the percentage of transactions in which co-investors were eligible to participate given the flagship funds’ minimum investment rights. The new allocation methodology was not part of the SEC sanction in this case.

In light of this case, private equity advisers would be well advised to review their expense allocation policies and procedures to confirm whether they are allocating broken deal expenses to co-investors appropriately. If so, such policies and procedures would help them comply with their fiduciary duties.

We expect the SEC to bring more enforcement actions to deter violations, and to encourage private equity managers to adopt more investor-friendly practices.

SEC3 can assist your firm in creating, implementing and maintaining your policies and procedures. For further information, please contact your SEC3 representative or contact us at