Expense testing: A not-so-magic trick

Expense testing is a crucial practice for any successful private equity firm.

In December 2018, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations released a risk alert highlighting the most frequent compliance issues related to advisory fees and expenses identified by their staff during examinations.

One of the most frequent issues was misallocation of expenses.

“OCIE staff has observed advisors to private and registered funds that misallocated expenses to the funds,” the risk alert states. “For example, staff observed advisors that allocated distribution and marketing expenses, regulatory filing fees, and travel expenses to clients instead of the advisor, in contravention of the applicable advisory agreements, operating agreements, or other disclosures.”

Keep track or pay the price

Failure to properly handle expenses can lead to costly consequences. There were two noteworthy cases in 2018. The first involved Lightyear Capital, which in December settled with the SEC for $400,000 over claims the private equity firm had overcharged investors.

Lightyear, a Delaware-incorporated partnership with $2.27 billion in assets under management as of the end of 2017, has been managing its Flagship and Employee Funds since 2000. Over a 16-year period through 2016, the Flagship Funds incurred expenses totaling $167,000 that should have been paid by its Employee Funds, the SEC alleged. It also alleged that the firm allowed co-investors to invest in portfolio companies, but their expenses – amounting to $221,000 – were covered by the Flagship Funds as well.

The second case involved a unit of Neuberger Berman settling with the SEC in December for almost $2.7 million. This included a $375,000 civil penalty fee, after the regulator said that the subsidiary had improperly allocated compensation-related expenses to three private equity funds it advised.

NB Alternatives Advisers, which advises certain private equity funds sponsored by Neuberger and has about $49 billion in assets under management, managed three private equity funds known as the Dyal Funds from 2011 to 2016. The funds invested in asset managers in exchange for a percentage of the managers’ profits.

The SEC ruled that NBAA had been charging employees’ compensation expenses to the funds instead of only charging for the time spent providing services to the asset managers. The agency said that of the $28.7 million in expenses paid by the Dyal Funds from 2012 through 2016, about $2 million was paid for time spent on tasks not related to employees’ work for the asset managers.

A necessary process

Since the SEC is clearly cracking down on expense issues, it’s important for firms to have a set process in place to ensure expenses are properly disclosed and accurately charged to the right parties. So what’s the trick to expense testing?

“I don’t think there is any magic to it,” Ken Berman, a partner at Debevoise & Plimpton, tells pfm. “I just think it’s a matter of how complex the allocation methodology is. For example, if the sponsor manages a single fund in its investment period, the process of testing allocations will be far easier than if the manager faces decisions on how to allocate expenses across multiple funds.”

Expense testing simply involves reviewing documents such as financial records, ledgers, financial statements, invoices, and travel and expense reports. Even though it sounds straightforward it can be time consuming, Luke Wilson, a partner and private markets practice leader at ACA Compliance Group, tells pfm.

“It can be a complex area and, despite best intentions and because we are all human, things sometimes go between the cracks,” he says. “It’s challenging to get it 100 percent right all the time. In many cases it is 100 percent accurate, but occasionally processes break, people leave, or practices evolve over time and the relevant policies, procedures, and processes sometimes aren’t updated in a timely manner to reflect such developments.”

Whether or not a firm decides to test expenses as they come in or on a periodic basis depends on the size of the firm. It’s easier for smaller organizations to test expenses more frequently than larger firms, says Bob Plaze, a partner at Proskauer. Many firms also opt to use a third party since handling this process in house can be a tall order.

“We use a third party, but we also do it in-house,” the chief compliance officer of a mid-market private equity firm tells pfm. “We have a schedule where we do various testing throughout the year in connection with our annual review, from checking expense reports to reviewing billings to portfolio companies and funds to make sure everything has been properly charged.  This is similar to what is done in a mock audit by an outside firm or in an exam by the SEC.”

Know your LPA

The key to avoiding misallocation of expenses is to have a good understanding of the limited partnership agreement between those involved and making sure all the expenses charged to funds are disclosed and consistent with the LPA.

“There are no rules saying how they can be allocated between the advisor and the funds and among the funds,” Plaze says. “You can do it in a fair way or you can do it in an unfair way. But you’ve got to disclose it.”

Another key component to a smooth testing process is insuring that the CCO has proper access to all the documents needed.

“In many cases the CCO isn’t the CFO and may not have direct access to financial records and thus will have to request those from somebody on the finance team,” Wilson says.

Along with access, it’s also vital that a CCO is given proper authority to question members of a firm if they come across a questionable expense allocation.

“Expense testing protects the entire firm,” Sanjay Sanghoee, the CFO and CCO of Delos Capital tells pfm. “There shouldn’t be any hesitation for a CCO to go to a deal partner or other member of their own team and say, ‘Hey, this isn’t following best practices.’”