Investment Management Alert: Conflicts Under the Microscope—SEC Charges and Settles with KKR

The recent agreement by Kohlberg Kravis Roberts & Co. LP (KKR) to pay almost $30 million to settle charges with the US Securities and Exchange Commission (SEC) ends the first SEC case to charge a private equity adviser with misallocating broken deal expenses. The settlement total comprises a $10 million penalty, more than $14 million in disgorgement (in addition to $3.26 million that was previously refunded to clients) and more than $4.5 million in prejudgment interest.

While KKR neither admits nor denies the SEC’s findings that it misallocated $17.4 million in so-called “broken deal” expenses among its private equity funds and co-investors during a six-year period between 2006 and 2011, the charges and the settlement reveal several lessons for registered investment advisers about key SEC regulatory interests and conflict resolution approaches.

1. The SEC found that KKR’s expense allocations breached duties to fund investors.
   
   According to the SEC order instituting a settled administrative proceeding, KKR, like many private equity firms, advises and manages private equity funds along with co-investment vehicles and other accounts that invest with the funds in buyout and other transactions. During the six-year period ending in 2011, KKR’s flagship funds invested $30.2 billion in 95 transactions, and KKR co-investors, including the firm’s executives, invested $4.6 billion alongside such funds. During the same period, KKR incurred $338 million in “broken deal” or diligence expenses related to unsuccessful buyout opportunities.
   
   With respect to the expenses incurred by KKR in relation to successful investments, KKR is reimbursed directly from the portfolio companies in which it makes the investments. However, with respect to expenses incurred in relation to unsuccessful investment opportunities (i.e., “broken deal” expenses) KKR is reimbursed through fee sharing arrangements with its funds. Consistent with the fee sharing arrangements in place at the time, KKR typically bore 20 percent of all broken deal expenses. With one partial exception, KKR failed to allocate any of the broken deal expenses to its co-investors, including KKR executives, even though they participated in and benefited from KKR’s sourcing of the private equity transactions. Furthermore, KKR failed to expressly disclose in its limited partnership agreements or related offering materials to investors that it would not be allocating broken deal expenses to its actual or prospective co-investors.
   
   The SEC determined that as a result of the absence of such disclosure, KKR misallocated $17.4 million in broken deal expenses between its funds and its co-investors, thus breaching its fiduciary duty as an investment adviser to its fund investors. Specifically, it found KKR’s conduct during the relevant period violated Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-7 thereunder. Section 206(2) of the Advisers Act prohibits an investment adviser, directly or indirectly, from engaging “in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.”
    
2. The SEC found that KKR failed to adopt and implement a written compliance policy or procedure governing its fund expense allocation practices until 2011.
   
   The SEC also found that KKR failed to adopt and implement, as required under the Advisers Act, a written compliance policy or procedure governing its fund expense allocation practices until June 2011 when it recognized during an internal review that it lacked such a policy. According to the SEC, before 2011, KKR had not considered whether to allocate broken deal expenses to its co-investors because in its view its flagship private equity funds bore all such expenses less the portion borne by KKR pursuant to the fee sharing arrangements in place with the flagship funds. Interestingly, following the engagement of an independent consultant in October 2011, KKR significantly revised its broken deal expense allocation methodology to allocate a greater share of such expenses to all co-investors and others who benefitted from KKR’s sourcing of transactions. The new allocation methodology was not the subject of the settlement with the SEC.
   
   Section 206(4) of the Advisers Act and Rule 206(4)-7 require a registered investment adviser to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules. As a registered investment adviser since October 2008, KKR was subject to this requirement but failed to adopt and implement any written compliance policies or procedures governing its broken deal expense allocations practices until 2011.
   
   “KKR’s failure to adopt policies and procedures governing broken deal expense allocation contributed to its breach of fiduciary duty,” Marshall S. Sprung, Co-Chief of the SEC Enforcement Division’s Asset Management Unit said in an SEC press release. “A robust compliance program helps investment advisers ensure that clients are not disadvantaged and receive full disclosure about how fund expenses are allocated.”
    
3. The SEC is placing a premium on OCIE compliance examinations.
   
   The SEC charges against KKR arose out of a compliance examination and subsequent investigation of the private equity firm by the SEC’s Office of Compliance Inspections and Examinations (OCIE) in 2013. Such activity is indicative of the heightened scrutiny to which the SEC is subjecting investment advisers in the private equity space following the 2010 enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
   
   OCIE has demonstrated increasing familiarity with the private equity and alternative investments business model and practices, and has focused its attention on practices that it regards as potentially problematic. OCIE considers expense allocations and potential expense shifting (such as that outlined with respect to KKR) to be an area of particular concern and focus. In light of the KKR settlement and the heighted scrutiny of, and increased sophistication of the SEC with respect to, the private equity industry, it seems likely that we will see more enforcement activity involving allegations of misallocated fees and expenses by managers of private equity funds.
    

Given the SEC’s emphasis on both robust compliance and duty to disclose in the KKR case and subsequent settlement, registered investment advisers are strongly advised to review their expense allocation policies and related investor disclosures.