Fund Manager SEC Action Offers Cautionary Tale

A recent cease and desist order against Cranshire Capital Advisors, and other actions taken against those in private equity, has highlighted the importance of how expenses are allocated from fund management fees.

It’s no news to those in private equity that the sector has come under increasing scrutiny from the Securities and Exchange Commission. But a recent spate of actions by the SEC has made it clear that things like allocations for fund expenses could bring down a small firm if not done correctly.

One of the most recent cases involved Cranshire Capital Advisors, LLC (CCA), which was the subject of a cease and desist order filed by the SEC on Nov. 23. The allegations, according to the filing, are that Cranshire, as an investment advisor, “negligently charged expenses to fund clients” for its Cranshire Capital Master Fund Ltd., formed on March 21, 2011.

The result of the action by the SEC was “CCA and the fund are both in the process of winding down,” according to the filing, after which the CCA will sell all of the fund’s assets and the net proceeds will be distributed by the fund to the shareholders.

These types of issues involving disclosure of expenses or other items in the limited partner agreement (LPA) is “becoming more common,” according to Julia Corelli, a partner at Pepper Hamilton LLP. “[The SEC] has gone after a number of them,” she adds, citing Blackstone among the most high-profile cases. Other recent actions regarding fees and expenses have been taken against Fenway Partners LLC and Cherokee Investment Partners LLC. On Nov. 3, Fenway Partners and four of its executives agreed to pay more than $10M, which included a $1.525M penalty.

As a reaction to the increase in more thorough regulatory exams and actions by the SEC toward PE firms, new funds have started protecting themselves by reporting “more granularity in fund expenses,” says Corelli. A provision becoming more common in the LPA is that if the LP triggers an investigation, the LP will bear the full expense rather than the fund manager. “I’m sure the SEC won’t like it when they see it [in the LPA],” she says. “It also makes some LPs unhappy. The majority are starting to say any investigation expense beyond the routine is a fund expense.”

In the case of smaller fund managers like Cranshire, they may not be able to absorb the cost of fighting an action by the SEC like larger shops can. The expense of fighting the SEC is “millions of millions of dollars, which the management fee won’t cover,” says Corelli. The fund manager’s LPs may also lose faith in them.

Corelli points out that the cease and desist order from SEC occurs after a whole series of actions from the agency’s Office of Compliance Inspections and Examinations that handles the routine regulatory exam. If the examiner finds something amiss, it will be referred to enforcement, and a back-and-forth occurs between the examiner and enforcement. A fund can settle the matter, as Fenway Partners did, or ultimately be given the cease and desist order, like what happened with Cranshire.

So are there solutions to problems that pop up in the life span of the fund? Short of amending the agreement, probably not, says Corelli.

“A fund that goes through this with the SEC, it could be anywhere in their life. They would have to go back out to their LPs and amend the LPA. Short of an approval by the LPs, there’s not anything you can do. Sticking your head in the sand doesn’t work. Putting it in the ‘other reasonable expenses’ of operating the fund doesn’t work, because it’s not a regular operating expense.”

For those managers looking to go raise a new fund, they would do well to look at Cranshire as a cautionary tale.

“You have to focus on everything that can happen,” Corelli says. “Everything has to be very clearly articulated.”