SEC Enforcement Case Highlights Pitfalls Of Private Fund Advisory Fees

On June 20, 2023, the U.S. Securities and Exchange Commission (“SEC”) issued an order against Insight Venture Management LLC (“Insight”). The SEC and Insight settled the matter to resolve allegations that the adviser charged excessive management fees caused by the adviser’s inaccurate application of its “permanent impairment” policy and that the adviser failed to disclose a conflict of interest related to these fee calculations.

Insight is an adviser that advises private equity funds. Limited partnership agreements (“agreements”) associated with some of these private equity funds stated that Insight charged management fees during the funds’ post-commitment period—the period during which a fund manager manages and looks to exit funds’ investments—based on the investor’s pro rata share of the funds’ invested capital. The agreements further stated that if Insight determined an investment suffered a “permanent impairment” in value, the adviser would remove an amount equal to the difference between the acquisition cost and the impaired value of the investment. This amount would be paid from the funds’ invested capital, which would in turn reduce the basis used to calculate fees paid by the fund to Insight. The agreements allotted Insight discretion to reverse the “permanent impairment” determination if the investment increased in value thereafter.

The excessive management fee calculations were due to an improper application of the terms of the funds’ agreements. In order to determine whether an investment was “permanently impaired,” Insight analyzed certain criteria, including permanent impairment at the portfolio company level instead of at the portfolio investment level. To the contrary, the funds’ agreements required that the calculation be completed at the portfolio investment level. In application, there could be multiple portfolio investments in a portfolio company. Accordingly, the agreements were improperly applied which resulted in inaccurately calculated management fees.

The adviser then failed to disclose a conflict of interest associated with the “permanent impairment” criteria to investors. Based on this failure, investors did not know these criteria were difficult to satisfy and allowed the adviser significant freedom to make the “permanent impairment” determination based on subjective factors, such as whether they may need to raise additional capital in the next twelve months. The adviser further failed to adopt policies and procedures reasonably designed to prevent violations of the Investment Advisers Act of 1940 (“Advisers Act”).

During the SEC’s examination of Insight, the adviser took some remedial steps, such as adopting more objective criteria for calculating a “permanent impairment” and waiving its ability to reverse the “permanent impairment” determination. Insight applied these new criteria to four portfolio companies identified by SEC staff and reimbursed fees and interest of approximately $3.8 million. Thereafter, the SEC conducted an investigation of Insight and the adviser applied the updated “permanent criteria” calculation, resulting in approximately $865,000 more in reimbursed fees and interest.

The SEC ultimately found that Insight willfully violated the Advisers Act based on these actions and ordered the firm pay disgorgement and prejudgment interest of the approximately $865,000, previously satisfied by payments made during the SEC’s investigation into Insight, and a civil penalty of $1.5 million.

Investment advisers that advise private equity funds should take note of this order and ensure they have sufficiently objective management fee calculations, that any related conflicts of interest are disclosed to clients, and that they have policies and procedures in place reasonably designed to prevent violations such as those committed by Insight.

Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.

Contact Information