Tuesday, June 30, 2015

KKR to Pay $30 Million to Settle ‘Broken Deal’ Misallocation Charges

By Amanda Maine, J.D.

Private equity firm Kohlberg Kravis Roberts & Co. (KKR) has agreed to settle SEC charges that it breached its fiduciary duty by misallocating diligence expenses related to unsuccessful deals and by not disclosing how these expenses were allocated. KKR agreed to pay nearly $30 million in disgorgement, prejudgment interest, and penalties to settle the matter with the SEC, which had alleged that KKR’s conduct violated Investment Advisers Act Sections 206(2) and 206(4) and Rule 206(4)-7 (In the Matter of Kohlberg Kravis Roberts & Co. L.P., Release No. IA-4131, June 29, 2015).

According to Enforcement Director Andrew J. Ceresney, the KKR proceeding “is the first SEC case to charge a private equity adviser with misallocating broken deal expenses.”

2006 Fund. KKR, which is registered with the SEC as an investment adviser, advises and manages its main private equity funds (Flagship PE Funds) and other co-investment vehicles. Between 2006 and 2011, the KKR 2006 Fund LP (2006 Fund) was KKR’s largest private equity fund, investing over $16.5 billion.

Limited partners in KKR’s private equity funds include large institutional investors such as pension funds and university endowments. KKR also establishes co-investment vehicles for its executives, certain consultants, and others to make co-investments. Under the 2006 Fund’s limited partnership agreement (LPA), up to 5 percent of every portfolio investment is reserved for these co-investors.

Broken deal expenses. KKR’s “broken deal” expenses include research costs, travel costs, professional fees, and other expenses incurred in deal sourcing activities for deals that never materialize. The 2006 Fund LPA required the fund to pay all broken deal expenses incurred by, or on behalf of, the fund.

According to the SEC, KKR bore 20 percent of the broken deal expenses of the 2006 Fund but did not allocate broken deal expenses to KKR co-investors, even though the co-investment vehicles participated in and benefited from KKR’s general sourcing of transactions. KKR also failed to disclose in the LPA and offering materials that it did not allocate broken deal expenses to the KKR co-investors. This resulted in the misallocation of $17.4 million in broken deal expenses between its Flagship PE Funds and the co-investors and was a breach of its fiduciary duty as an investment adviser, the SEC alleged.

Revision of allocation methodology. Following an internal review and a later review by a third-party consultant, KKR revised its broken deal expense allocation methodology in 2012. The SEC’s Office of Compliance Inspections and Examinations (OCIE) conducted an examination of KKR’s fund expense allocation practices in 2013. During this time, KKR refunded some of the misallocated expenses to the Flagship PE Funds.

Charges and settlement. The SEC’s order instituting administrative proceedings alleged that KKR’s broken deal expenses conduct violated Advisers Act Section 206(2). In addition, the order charged KKR with violating Section 206(4) and Rule 206(4)-7 for not adopting and implementing written policies and procedures designed to prevent violations of the Advisers Act. To settle the charges, KKR agreed to pay disgorgement and prejudgment interest of $18.7 million and a civil penalty of $10 million. KKR also agreed to cease and desist from committing further violations.

The release is No. IA-4131.

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