The private equity industry should carefully consider the implications of a recent Securities and Exchange Commission ("SEC") enforcement action. In it, the SEC, for the first time, sanctioned an SEC-registered private equity advisory firm for failing to register also with the SEC as a broker for receiving transaction-based fees when the funds it managed purchased or sold their portfolio companies.1 It is common industry practice for private equity advisory firms to perform investment banking services for their pooled investment funds and to receive an investment banking fee based on a percentage of the value of the completed transaction. In addition to $800,000 in penalties and interest, the advisory firm and the individual owning the advisory firm, without admitting or denying the SEC’s allegations, agreed to pay $2.3 million, of which $1.9 million represented transaction-based fees.

Blackstreet Management, LLC, a registered investment adviser under the Investment Advisers Act of 1940 ("Advisers Act"), manages $150 million for two private equity funds that acquire, in leveraged buyouts, controlling interests in underperforming or distressed businesses that have annual revenues between $20 million and $100 million. In addition to receiving the traditional 2% annual management fee on assets under management and 20-25% carried interest on the funds’ profits, Blackstreet also received transaction or "brokerage" fees for providing investment banking services in connection with the purchase or sale of portfolio companies. The various ways in which Blackstreet was to be compensated had been "fully disclosed"2 to the funds’ investors in the documents provided to them before they made their capital commitments to the funds.

The SEC Order identified numerous ways in which Blackstreet failed to follow the requirements of the funds’ governing documents or took actions not authorized by the funds’ documents, including making political and charitable contributions with fund assets over a seven-year period, and self-dealing in connection with its purchase of fund interests from its investors. However, the SEC focused its findings on Blackstreet’s receipt of previously-disclosed transaction-based compensation, because while Blackstreet was registered with the SEC under the Advisers Act as an investment adviser and thereby subject to regular SEC reporting and oversight, it was not registered with the SEC as a broker. Significantly, this was not a case of "double dipping" in which an advisory firm retains a registered broker-dealer to perform investment banking services for transaction-based compensation and the advisory firm also collects a transaction-based fee, thereby resulting in the fund investors paying twice for investment banking services. The SEC found that Blackstreet performed the transaction services internally, including soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, and arranging financing and executing transactions, also common private equity industry practices.

Federal securities law provides that it is unlawful for a broker to "effect any transactions in … any security"3 unless such broker is registered with the SEC in accordance with Section 15(b) of the Exchange Act of 1934 ("Exchange Act"). The term "broker" is defined in the Exchange Act as "any person engaged in the business of effecting transactions in securities for the account of others."4 Unlike a broker registered under the Exchange Act who acts as an investment banking intermediary in connection with an acquisition or disposition, an SEC-registered private equity advisory firm does not offer its investment banking services to unrelated third parties but acts solely for the pooled investment funds it created and in which it has a substantial economic interest. Significantly, the decision whether to buy or sell a portfolio company of a private equity fund is made by the SEC-registered private equity advisory firm, not the fund investors. As such, it would seem that in performing investment banking services, the SEC-registered private equity advisory firm is not acting for the account of others.5

For more than a decade the SEC has taken the position that, in connection with the purchase or sale of a company, if a business adviser is to receive transaction-based compensation, it is then a broker required to be registered with the SEC or associated with an SEC-registered broker.6 This position changed somewhat in 2014 when the SEC provided broad-based relief in a "no action" letter allowing business advisers to receive transaction-based compensation in the purchase or sale of ownership and control of private companies ("M&A Brokers") without registering as a broker with the SEC. See McCarter & English Alert, Business Brokers Get "No-Action" Relief from SEC (February 2014). Unfortunately, SEC-registered private equity advisers do not qualify as M&A Brokers because they possess the power to bind their funds and possess control of their funds’ capital resources. However, unlike M&A Brokers, an SEC-registered private equity advisory firm maintains a significant ongoing economic relationship with its fund investors and, more importantly, its ongoing relationship with its fund investors is already regulated by the SEC.

An SEC-registered private equity advisory firm must comply with an expansive set of disclosure and substantive rules that essentially govern all aspects of its operations, including advertising, conflicts of interest, valuation, custody of client assets, reporting, and maintenance of books and records. Most fundamentally, an SEC-registered investment adviser is a fiduciary to its investors, a higher standard than that to which the SEC holds a broker. While a broker must merely recommend "suitable" investments to its clients, an investment adviser must act solely in its clients’ best interests. An SEC-registered adviser must put its clients’ interests ahead of its own. While requiring an SEC-registered investment adviser to register also as a broker would involve additional ongoing reporting and associated expense, it is difficult to see what additional substantive protections, if any, would be provided to fund investors.

Key Takeaways

1. A private equity advisory firm that is to receive transaction-based fees upon the purchase or sale of a portfolio company should consider returning all or a portion of those fees to its investors in the form of offsets to the annual management fee and other fees that may be due the advisory firm from its funds or its funds’ portfolio companies. It has been suggested in speeches by SEC personnel that such offsets may "cleanse" the broker issue.7 However, such fee offsets have been viewed in other contexts as an indication that an investment fund was "engaged in a trade or business" with significant negative implications.8
2. A private equity advisory firm should consider whether it should be compensated for the investment banking services it provides for its funds on some basis other than a percentage of the transaction value of a successful acquisition or disposition. A fixed dollar amount or an amount based on the hours devoted to a transaction may be more appropriate.
3. If transaction-based fees are to be paid to a private equity advisory firm or its affiliates by either its private equity fund or its portfolio company, those fees should be reasonable in relation to the services performed; the performance of the services should be accurately documented; and the advisory firm may wish to limit those services to consulting services such as due diligence, accounting, financial modeling and analysis, and other professional services.
4. A private equity advisory firm that is to receive transaction-based fees should consider whether to establish an SEC-registered-broker affiliate or otherwise associate with an SEC-registered broker.
5. The placement memorandum, the limited partnership agreement and other disclosure documents distributed to potential investors in a private equity fund should clearly, concisely and comprehensively disclose how the advisory firm and its affiliates are to be compensated, not only by the funds themselves, but also by the portfolio companies the advisory firm controls through the funds. A private equity advisory firm should make sure that it and its affiliates strictly adhere to those disclosures in the operation of the funds and the related portfolio companies. 　

* The author would like to thank Evan X. Bakhet, a summer law clerk, for his assistance with this client alert.

1 Blackstreet Capital Mgmt., LLC, Exchange Act Release No. 77959, Advisers Act Release No. 4411 (June 1, 2016).

2 June 1, 2016, SEC Press Release “SEC Private Equity Fund Adviser Acted as Unregistered Broker.”

3 Section 15(a)(1) of the Exchange Act.

4 Section 3(a)(4) of the Exchange Act (emphasis added).

5 Following the SEC’s logic, it could be argued that even an SEC-registered investment adviser who does not receive an investment banking fee in connection with the purchase and sale of portfolio companies, should nevertheless register as a “broker” under the Exchange Act because the adviser is “effecting a transaction in a security for the account of another” and is receiving a portion of a fund’s profits from the transaction in the form of a carried interest.

6 As a result, the continued validity of the long-standing SEC-created “finder’s exception” to broker registration in which a person provides only the names and contact information of potential investors and receives a transaction-based fee if the potential investor actually makes the investment has been called into question. See Paul Anka, SEC No-Action Letter (July 24, 1991). While not expressly saying that the finder’s exception will no longer apply, the SEC almost always finds that the finder did more than provide names and contact information.

7 See A Few Observations in the Private Fund Space, Speech to the ABA, Trading and Markets Subcommittee, David W. Blass, Chief Counsel, SEC Division of Trading and Markets (April 5, 2013).

8 See Sun Capital Partners III, LP v. New Eng. Teamsters & Trucking Pension Fund, 724 F.3d 129, 143 (1st Cir. 2013) (in which a fee offset was a key factor in finding that a private equity fund is “engaged in a trade or business” and liable for portfolio companies’ unfunded pension obligations under the Multiemployer Pension Plan Amendments Act of 1980). See also McCarter & English Client Alert “Private Equity Funds Liable for Portfolio Company’s Pension Obligations” (April 6, 2016).