Navigating SEC Scrutiny: Enhancing The Accuracy of Fee Calculations for Private Funds

In an environment of intense regulatory scrutiny, the SEC is putting private fund managers under the microscope, focusing on fees charged to investors. Management and incentive fees for private funds span a broad spectrum of complexity, both in terms of calculations and the descriptions in the fund's governing documents, and have captured the Commission’s attention. In practical scenarios, however, there is often a disconnect between those drafting the agreements and those responsible for fee calculation.

This disconnect represents a formidable obstacle within the industry, highlighted by recent cease and desist orders issued by the SEC. Inconsistencies and discrepancies in fee calculation often stem from misunderstandings; language that appears straightforward to the legal team may be misconstrued or misunderstood by the accounting staff tasked with implementation. Consequently, the fee calculations, while potentially meeting the expectations of investors, may inadvertently omit or contradict the agreement’s terms.

The complexity inherent in management and incentive fees often stems from multiple layers of calculations and complex terminology. Although many private equity and hedge funds describe their fees as a “2 and 20 fee structure”, where the fund manager or general partner earns a two percent management fee on the assets under management and a 20 percent fee on any profits the fund generates, the reality is more complicated.  For example, the fund documents may require that the fund’s performance exceeds a minimum rate of return, or hurdle rate, before the general partner is entitled to receive the 20 percent performance fee. Some hedge funds may use a high-water mark, meaning the peak of the value of the fund since its inception, as the threshold for earning a performance fee. Conversely, some private fund agreements provide for “clawbacks”, which require the general partner to return any excess performance fees if such fees exceed the share of profits discussed in the fund agreement. To further complicate matters, some fund agreements require that certain fees earned by a general partner, such as monitoring, transaction and other portfolio company related expenses, be set off against any management fees owed to the general partner.

Moreover, the inherent complexity of the performance metrics, which form the basis for such fees, contributes to the overall challenge. The components of performance are defined in the fund agreements, which can differ from fund to fund. For example, 'Gross Asset Value' may be defined differently across different firms and funds, each interpretation having its own unique implications for the fee calculation. These defined terms frequently undergo multiple iterations, and the impacts of these changes are not always fully understood or analyzed. This further escalates the complexity of the calculation process.

To mitigate the risks created by these complexities, it's crucial for firms with complicated fee calculations to establish robust, well-documented procedures. A fundamental first step is ensuring a transparent and clear dialogue between the in-house legal team or external counsel and accounting departments. Defined terms must be thoroughly communicated, vetted, and understood by all parties involved in the process. Additionally, firms should consider implementing regular review sessions to discuss the impacts of any changes, with representatives from both legal and accounting present. Accounting should be empowered to vocalize issues that may complicate their responsibilities or identify components that lead to an error-prone process. Conversely, the in-house legal team or external counsel team should clarify the basis for defined terms and understand how changes to the fee terms may have broader implications.

In conclusion, the challenges inherent in managing complex fee structures are significant but can certainly be overcome, particularly with the right guidance and expertise.

How we help

The specialized knowledge and experience of our Performance Services and Compliance Advisory teams can be particularly beneficial in these scenarios. With a proven track record, we've consistently assisted firms in navigating these complexities.

Our approach involves a thorough review of the fund's governing documents, which not only helps us understand the fee terms clearly but also assesses the implications of the language used elsewhere. Following this, we independently assess the implementation of these terms, identifying any gaps or potential misinterpretations. Importantly, we also recalculate the fees based on our interpretation to further verify the accuracy of the process. This comprehensive evaluation provides firms with a clear roadmap to ensure accurate fee calculations, effectively reducing regulatory risk and bolstering investor confidence.

If you have any questions about this alert or recent SEC activity relating to fee calculations, reach out to your account executive or contact our team here. 

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