On August 7, 2020, the SEC issued a Cease-and-Desist Order and imposed sanctions against Rialto Capital Management, LLC (“Rialto”) for violations of the Advisers Act arising out of Rialto’s misallocation of expenses. Rialto serves as the investment adviser to several private funds, as well as two co-investment vehicles. The limited partnership agreements for each of the Fund and both Co-Investment Vehicles provided that Rialto could be reimbursed by the Funds for certain “third party tasks” including, asset-level due diligence, accounting, valuation and other similar services that are typically performed for funds by outside professionals (“Third-Party Tasks”). Each Fund had its own Advisory Committee, which under the Fund’s Limited Partnership Agreement is responsible for approving costs and expenses charged to the Funds, including those related to the Third-Party Tasks. The Third-Party Costs were to be provided by Rialto, “at or below market rate.” Rialto conducted a market rate analysis in 2012, but failed to obtain any updated information between 2013 and 2017. In addition, in its annual report to the Advisory Committees, Rialto did not state that Rialto failed to obtain any updated information or perform any analysis supporting its claim that Rialto’s costs were at or below market rates. In addition, Rialto originally added 11% to the cost of each employee to cover general overhead expenses (the “Overhead Factor”), However, the cost allocation methodology Rialto used from 2012 through 2017 to calculate the costs for Third Party Costs increased the Overhead Factor from 11% to 25%, which increase was not disclosed. The SEC also charged Rialto with a failure to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules.
This SEC action is line with a number of recent actions that the SEC has taken with respect to misallocation of expenses. In this matter, we see two expense approaches which real estate sponsors often request: (1) a provision that certain services will be provided “at or below market rate”; and (2) a methodology of allocating the cost of an employee or employees to the Fund, often with a gross-up for overhead costs.
Both of these can create problems if the Fund manager is not careful. There are a couple of lessons here I think: First, a carefully designed compliance program related to expense allocation is crucial. It should carefully match what is actually said in the PPM. Second, if the sponsor tells investors that these costs will be provided, “at or below market rate,” ensure that you do a market study on a regular basis. (My preference is to avoid this statement entirely and just disclose what the fees will be). Additionally, if a sponsor says it will provide services, “at cost” make sure this is accurate and clearly described if you are grossing up the cost of employees with a portion of overhead expenses. And of course, if you need LPAC approval, don’t hide any information.
The full order can be found here: https://www.sec.gov/litigation/admin/2020/ia-5558.pdf