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Expense Allocation: SEC Warns, Private Equity Should Listen

In February, the SEC once again listed expense allocation as a compliance exam priority. Three months later, it reiterated its warning in a Risk Alert highlighting expense allocation as one of the most frequent issues uncovered by compliance exams given over the past two years.

The SEC’s focus on expense allocation should surprise no one. The agency has been warning about expense allocation since 2012 and has backed up its warnings with 11 public misallocation charges averaging penalties of $3.7 million. All private advisors should take these latest warnings seriously, but private equity, which accounts for 98% of all expense allocation penalties, should be particularly concerned.

Expense allocation is the process of allocating operating costs across funds while making sure each fund pays its fair share only for the expenses defined in its fund agreements. The SEC considers misallocations a breach of fiduciary duty under the Investment Advisors Act Sections 206(2) and 206(4), which prohibit fraudulent or deceptive practices. In 2003, the SEC adopted Rule 206(4)-7 requiring investment managers to “implement written policies and procedures reasonably designed to prevent violation of the federal securities laws,” in other words, policies to prevent misallocations.

Before 2010, private advisors, then exempt from SEC registration, saw expense allocation as an obscure back office chore with mistakes of little to no consequence. Dodd-Frank’s passage in 2010 repealed the private advisor exemption and radically changed the regulatory landscape. Private advisors, now subject to SEC registration and Rule 206(4)-7, suddenly found immaculate allocation policy and procedures a regulatory requirement.

Allocation policy codifies the expenses each fund has agreed to pay for and takes the form of a complicated hierarchy of allocation rules. Allocation procedures guide the execution of policy. The problem is that most private advisors allocate manually in Excel and the repetitious complicated steps required by allocation procedures are highly susceptible to human error. This renders manual expense allocation effectively incompatible with Rule 206(4)-7.

The nuances of private equity further complicate allocation policy and exacerbate misallocation risk. Hedge funds typically only allocate invoices, but private equity deals often involve extensive travel, requiring the allocation of T&E. Whereas invoiced expenses are allocated shortly after an expense is incurred, deal related T&E is frequently incurred long before investors and investment vehicles are firmly in place. Consequently, PE firms may not know how to allocate T&E until after a deal closes, yet still must account for the incurred expenses beforehand. This means T&E is allocated and reallocated, often multiple times, throughout a deal’s life cycle.

The need to manage T&E throughout a deal’s life cycle bloats private equity allocation policy and procedures with intricacies not required by other private advisors. Yet private equity, like the rest of the industry, is largely performing expense allocation manually. The more complex a manual task, the greater the chance for error. It makes sense, then, that nine out of eleven public misallocation charges have been brought against private equity firms. All private advisors allocate manually, but private equity’s added complexity means they are more likely to have misallocations.

The SEC continually notes the “failure to adopt [adequate] policies and procedures governing expense allocation” as a major contributing factor in each misallocation charge. Manual allocation is too error-prone to meet the standards of Rule 206(4)-7. Private advisors would be wise to automate their allocation procedures to prevent misallocations and ensure compliance – none more so than private equity. After all, the SEC’s latest Risk Alert underscores the risk of misallocations and no one is more at risk for a misallocation than private equity.

Nicholas Molina is Head of Business Development and Marketing at IntegriDATA