The SEC recently settled its latest enforcement action around the practice of PE fund managers receiving so-called “accelerated” monitoring fees from portfolio companies without adequate disclosure to their funds’ LP.
The attention on this issue has been part of the SEC’s overall focus on PE fund managers’ disclosure practices. The actual practice of earning accelerated monitoring fees—that is, charging portfolio companies fees for performing consulting, advisory, or similar services, and then upon “early” exit (i.e. before the end of the term of the management agreement), earning a lump sum of all the fees the fund manager would have received if the companies had not been exited early—has not been the focus of enforcement by itself. Rather, the SEC has brought actions where this practice was not adequately disclosed to a fund’s LPs in its offering materials. As management services agreements often have long terms, an accelerated fee provision can result in a significant payment to the fund manager that the SEC has indicated requires adequate disclosure pre-commitment.
There are some nuances on this issue around whether the fund in question has a management fee “offset” provision. The practice of charging accelerated fees clearly reduces the value of the applicable portfolio company upon exit. However, many PE funds provide for a management fee offset, where the fund-level management fee is reduced by any portfolio company fees earned by the fund manager and its partners and employees. To the extent that accelerated monitoring fees are fully offset against fund-level management fees, LP investment returns would not be affected. However, while there has been a trend in the industry recently to move toward more 100% offset provisions, many PE funds still have management fee offsets of 75%-80% (or lower in a few cases). Furthermore, even funds with a 100% offset provision do not necessarily insulate themselves from scrutiny if there are excess fees retained by the fund manager where no further fee offset can be applied upon fund liquidation.
The regulatory focus on accelerated management fees has also put more emphasis on the issue from a commercial perspective, and a number of firms are no longer charging these fees in order to avoid being perceived in the marketplace as earning fees for services they did not ultimately provide. However, there can be circumstances where the facts and circumstances around charging an accelerated monitoring fee can be justified. A portfolio company going up for sale earlier than originally anticipated could require the fund manager to spend more time advising management through a sale process earlier than originally planned, for example.
With regulators zeroing in on this issue, transparency with investors will continue to be key. Prior to entering into a management service or similar agreement that will include a provision for accelerated monitoring fees, it is best practice to consider whether the possibility of a fund manager earning accelerated fees was adequately disclosed in the fund’s private placement memorandum and other offering documents.
Brad Mandel is a partner at Winston & Strawn, LLP, focusing on PE and other US and non-US alternative investment fund sponsors and managers in fund formation, maintenance, and regulatory matters. Brad can be contacted at Bmandel@ winston.com or 312-558-7218.