For years, the Securities and Exchange Commission has been focused on fees and expenses allocated by a private fund managers to their sponsored funds. The latest to be caught improperly allocating fees and expenses is Potomac Asset Management.
First, Potomac improperly charged $2.2 million in fees to the fund for services provided by Potomac to a portfolio company of Fund I. After the portfolio company subsequently reimbursed the cost of the fees, Potomac failed to offset those fees against the management fees it charged to Fund as required by the fund documents. That meant Potomac earned a larger advisory fee that was in violation of the fund documents and was failed to be disclosed on Form ADV.
Second, Potomac improperly used the Funds’ assets to pay some expenses that should have been paid by Potomac. An individual with the title of “Principal”, who was required to perform at least 35 hours of “consulting” per week, and who was treated internally as a Potomac employee was billed to the fund improperly. Potomac also billed office rent to the fund.
The fund documents provided:
In general, [Potomac] shall bear compensation and expenses of its employees and fees and expenses for administrative, clerical and related support services, maintenance of books and records for the Fund, office space and facilities, utilities, and telephone insofar as they relate to the investment activities of the Fund. All other expenses will be borne by the Fund.
Third, Potomac used fund assets to pay costs associated with the Potomac’s regulatory obligations. Potomac charged some of the costs associated with the SEC exam and enforcement investigation to the fund. [That is always a big mistake.]
Fourth, the Funds’ audited financial statements failed to disclose these payments as related party transactions. Because the financial statements did not reflect the related party relationships and material transactions, they were not prepared in accordance with Generally Accepted Accounting Principles . Therefore, Potomac did not have a good audit under the Custody Rule. That left Potomac outside the audit exception for private funds and in custody of client assets in violation of the Custody Rule.
Fifth, the general partners of the Funds, failed to timely make certain capital contributions to the Funds as required by the terms of the Fund documents.
I don’t see any novel items in this list of mistakes and misdeeds. The SEC has been speaking about these concerns and bringing actions against firms who have done similar things. The first three items are only wrong to the extent it’s in contravention of the fund documents. Many fund managers are getting more explicit in the fund documents about what expenses can be charged to the fund. Although, I don’t think many fund investors would accept fund documents that allocated those expenses to the fund.
It has been a few months since I have seen a private equity fees and expenses case. It’s a good reminder to make sure funds are following the fund documents.