SEC Sanctions Apollo $52.7 Million for Misleading Expense Disclosures

The SEC sent a message to the private equity industry that it will severely punish managers for expense allocation conflicts of interest by sanctioning Apollo Management $52.7 million for misleading disclosures about portfolio monitoring fees.[1]  The SEC's Order against Apollo is one of several recent cases imposing large fines on private equity titans.  In late - 2015, the SEC imposed $39 million in sanctions against Blackstone Management for similar portfolio monitoring fees issues. In mid - 2015, the SEC imposed $30 million in sanctions against KKR for misallocating broken-deal expenses between Fund investors and co-investors.[2] And the Wall Street Journal has reported that the SEC is investigating private equity titan Silver Lake regarding portfolio monitoring fee acceleration disclosures.[3] The message is clear:  absent express disclosure of expenses raising conflicts of interest, the SEC will impose severe sanctions. Apollo's primary violation was accelerating future portfolio monitoring fees upon the private sale or IPO of a portfolio company, without clearly disclosing this to investors before they committed capital to Apollo. Apollo entered into ten-year monitoring agreements with portfolio companies owned by Apollo-advised private equity funds to provide consulting services in exchange for annual fees. From late-2011 through May 2015, upon the private sale or IPO of a portfolio company, Apollo would terminate the portfolio monitoring agreements, to accelerate the payment of future portfolio monitoring fees in lump-sum "termination payments."

Apollo's acceleration of portfolio monitoring fees raised a serious conflict of interest with its investors. Apollo's portfolio monitoring fees reduced the value of its Funds' assets - and investors' returns - while enriching Apollo itself. This is because the Funds' assets are the portfolio companies, which had to pay out the accelerated monitoring payments to Apollo. The payments would thereby reduce the value available for distribution to the Funds' investors upon the private sale or IPO of a company.

Although Apollo made some disclosures about portfolio monitoring fees, the SEC faulted Apollo for not making it clear before investors committed capital that Apollo may accelerate future monitoring fees by terminating agreements upon a private sale or IPO. Apollo disclosed in offering documents that it may receive monitoring fees from Fund portfolio companies. And Apollo disclosed the amount of accelerated monitoring fees after each acceleration. Apollo also took prompt remedial and cooperative efforts. But Apollo's offering documents did not clearly state up-front - when investors could still choose not to invest - that Apollo would accelerate future monitoring fees upon a private sale or IPO.

In addition to its portfolio management claims, the SEC alleged that Apollo misstated key facts about a loan its affiliate received from its Funds and failed to supervise a former senior partner who improperly charged personal expenses to Apollo's Funds. As to the loan, it was for an amount equal to the carried interest due to Apollo from the Funds. The effect of the loan was to defer taxes that Fund investors would owe on carried interest until the loan was extinguished. Apollo was obligated to pay interest to the Funds for the loan, and the Funds' financial statements identified the amount of accrued interest as part of the Funds' assets. But the financial statements failed to disclose that the interest was allocated solely to Apollo's capital account, and thus was effectively Apollo's asset rather than an asset of the Funds.

The SEC alleged Apollo violated §§ 206(2) and 206(4) of the Investment Advisers Act (the "Act"), which prohibit negligent practices and misstatements that operate to deceive clients. The SEC also alleged a violation of Rule 206(4)-7 for Apollo failing to adopt and implement policies reasonably designed to prevent legal violations relating to expense allocations. And the SEC alleged that Apollo failed to reasonably supervise the former Senior Partner who charged the Funds for personal expenses, in violation of § 203(e)(6) of the act. The SEC's sanctions included over $40 million in disgorgement and interest, plus a $12.5 million civil penalty.

The SEC's order against Apollo shows the severe consequences to private equity and hedge funds in failing to provide clear offering disclosures about portfolio monitoring and similar fees. Where, as in Apollo, such fees have the effect of increasing a fund manager's revenue at the expense of Fund investors, the SEC is penalizing such fees as illegal absent clear up-front disclosures. Accordingly, clients should consult with counsel about drafting or amending their Fund documents to adapt to the SEC's hard-line approach.

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[1]  In the Matter of Apollo Mgmt. V, L.P., et al., Ad. Pro No. 3-17409 (Aug. 23, 2016), available at https://www.sec.gov/litigation/admin/2016/ia-4493.pdf.

[2] In re Blackstone Mgmt. P'rs, Ad. Pro No. 3-16887 (Oct. 7, 2015), available at https://www.sec.gov/litigation/admin/2015/ia-4219.pdf; In re Kohlberg Kravis & Roberts & Co., Ad. Pro. No. 3-16656 (June 29, 2015), available at https://www.sec.gov/litigation/admin/2015/ia-4131.pdf

[3]   D. Michaels & M. Jarzemsky, "S.E.C. Probes Silver Lake Over Fees," (Wall. St. J., Aug. 19, 2016), available at http://www.wsj.com/articles/sec-probes-silver-lake-over-fees-1471646427.

Cheryl Spratt