Expense allocation comes under the regulatory spotlight

If you run an investment firm, expense and vendor management might not be high on your list of priorities, but that could be a costly mistake. Regulators, in particular the Securities and Exchange Commission (SEC), are shining a much brighter light into the books of asset managers, and particularly alternative funds. Firms will now have to demonstrate that they are following the stated agreements of the Offering Documents and Investor Agreements and those that do not will face disciplinary measure including large fines.

Let’s face it, this issue is not new. Fees and expenses were brought under the SEC remit by Dodd Frank. General partners are obliged to disclose how fees and expenses are spent, and compliance teams are much more circumspect, but enforcement was often seen as lax. This has changed over the past two to three years as the screws have been noticeably tightened.

In fact, in early 2021, the SEC Enforcement Division said it is increasing its focus on disclosures of fees and expenses as well as investment risks and conflicts of interest, liquidity, valuation of assets and protecting material non-public information.

The US watchdog has already handed out several sanctions over the past three years to private equity firms for misallocating fund expenses. The most high-profile cases include the almost $2M fine levied against a private equity firm for failing to fully reveal or obtain consent to its practice of charging private fund portfolio companies for the costs of certain services. More specifically, the SEC claimed the manager breached Section 206(2) of the Advisers Act, which prohibits investment advisers from directly or indirectly engaging “…in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.”

The $350,000 fine against another PE firm for misallocating certain costs and expenses relating to two real estate private equity funds also grabbed the headlines. The SEC claimed the firm failed to adopt and implement written compliance policies and procedures designed to prevent violations of the Advisers Act and its rules.

Beyond manual processes

Although behemoth financial firms have the resources to either invest or upgrade systems, many of their medium to smaller-sized counterparts lack the same deep pockets. Their critical back-office processes, including accounts payable, vendor management, and expense allocation tend to rely on manually intensive Excel-driven and paper-based processes, often handled by junior staff members. This leads to human errors, key person risk, and a lack of oversight and transparency, particularly in the case of audits.

Manual procedures are also the bane of vendor management. The accounts payable process is often ad hoc, complicated, and fragmented, resulting in duplicated service costs, missed renewal discounts and cancellation deadlines. This method increases the potential for errors or misappropriation, which in turn can trigger regulatory and investor concerns about transparency, particularly for complex constructions and partnerships.

In the past, solutions have not been easy to find. This was due to the dearth of purpose-built, Enterprise Resource Planning (ERP)-style platforms that catered to the requirements of asset managers and particularly alternative investment firms such as private equity and hedge funds, which are some of the world’s most complicated businesses.

7 steps to strengthen your expense allocation compliance

While every firm’s expense and vendor management situation is different, most would benefit from a digitally driven approach based on best practice and underpinned by a platform that automates and streamlines inefficient processes while creating a single source of truth, enhanced preventive controls and clear audit trails.

If this is an area where you need to up your game, here are 7 steps to consider:

Step 1 – Digitize the expense management process to increase transparency and bolster controls with clear audit trails.

Step 2 – Create templates for expense allocations based on guidance from your Chief Compliance Officer (CCO) and relevant documents such as the Private Placement Memorandum (PPM).

Step 3 – Use application controls to embed the template, restrict access and audit all changes and application of the expense methodology.

Step 4 – Document how expenses should be judged between manager/investor and educate all stakeholders on the correct approach.

Step 5 – Create and implement a strict maker/checker process which segregates the responsibility of the review of the expenses and the allocation to the funds.

Step 6 – Capture the workflow and the associated approvals in a database structure for transparency and ease of proof in case of a regulatory or financial audit.

Step 7 – Conduct periodic reviews and keep up to date with current regulations with professional advice from legal and public accounting teams.

This approach will give you greater internal visibility and control based on cost-effective and operationally resilient digital processes. Equally as important, you will create a much-needed single source of truth to make regulators happy while increasing client satisfaction through enhanced transparency around fees and expenses.

About the author, Jonathan Hinkley

Jonathan Hinkley, is the SVP, Middle and Back Office Services at Linedata. He is a financial services leader with 20+ years’ experience in Investment Management Middle/Back Office operations and Public Accounting. Jonathan leads the Middle and Back Office Co-Sourcing business for Linedata Global Services in New York, where he leads multiple cross-functional teams enabling multi-strategy, credit, and private equity firms to maximize operating leverage. Jonathan is a trusted advisor and valuable resource to CFO and COOs, with an extensive background in creating scale servicing funds across the capital structure with a particular focus on complex Credit Funds. Jonathan holds a Bachelor of Science in Accountancy from Bentley University and has held a Certified Public Accountant license (MA) since 2001.