TL;DR
Broken deal expenses are the costs of pursuing an investment that never closes. The LPA decides who bears them, and it commonly names the fund that would have invested. In 2015, the SEC found that a manager misallocated broken deal expenses when it left its co-investors out of them without disclosure.
Broken deal expenses are the costs a fund manager incurs on an investment that it never makes. They include legal work, diligence consultants, accounting reviews and deal-team travel. The limited partnership agreement decides who bears them and whether co-investors who would have joined the deal pay a share.
What counts as a broken deal expense?
A cost counts when it is tied to one specific deal that did not close. Outside counsel drafts the purchase agreement, and the team splits those legal invoices across fund entities by the same rules. Accountants run a quality-of-earnings review. The deal team travels to the target.
The LPA sets the limits of the definition. The ILPA reporting template counts costs "clearly linked to the due diligence of specific investment opportunities." It excludes "the costs of identifying and sourcing potential investment opportunities." The SEC's 2015 order against KKR used a wider definition. It counted KKR's studies of "particular industries or geographic regions" as broken deal expenses too.
A fund accountant at a private equity firm said that this review is very manual. The team flips through long invoices page by page to decide whether a cost is general sourcing or tied to one deal. Size matters too. A finance lead at an early-stage venture firm does not code a meal or a coffee with a founder to a dead deal. That firm's dead deal category holds legal fees and other larger costs.
The SEC charged a manager for leaving co-investors out of broken deal expenses, so the split needs a rule and a record. Ceviche applies the rule your team approved and keeps the vendor invoice, the basis numbers and the approval with every split.
Who pays for broken deal expenses?
The KKR order quotes one LPA that required the fund to pay "all" broken deal expenses "incurred by or on behalf of" the fund. An investment professional at a venture and growth firm said why the fund bears it. In that professional's view, most deals die, so a broken deal expense is a normal cost of investing.
Some managers absorb more. A fund accountant at a large venture firm said that the firm's management company absorbs many costs, especially travel tied to portfolio companies.
"[It's] just very hard to defend in front of the SEC what you're charging through to fund. So we choose to have the management company just absorb it."
At a large private equity firm, the rule depends on the outcome. A closed deal's costs go to the funds that invest. A dead deal's costs become a management company expense.
At a lower-middle-market private equity firm, the closing wires pay a closed deal's costs. A finance lead there builds an expense line of about $50,000 into the closing wires. A dead deal has no closing wire, so that firm charges its costs to the main fund. The same line between fund and management company expenses applies.
Do co-investors have to share broken deal expenses?
If co-investors were in the deal and the documents and disclosures do not say otherwise, the SEC treated leaving them out as a misallocation. From 2006 to 2011, KKR charged broken deal expenses to its flagship funds. Apart from a partial allocation in 2011, it charged none to its co-investors, including its executive vehicles. It did not expressly disclose this in the LPAs or the offering materials. The SEC said that this was "the first SEC case to charge a private equity adviser with misallocating broken deal expenses." KKR agreed to pay nearly $30 million, including a $10 million penalty, without admitting or denying the findings.
In a 2015 speech, the acting head of examinations said "by far the most common deficiencies" in private equity related to expenses and expense allocation. The speech named broken deal expenses moved from side-by-side vehicles onto the main fund as one of the most common practices. The SEC's 2020 risk alert found advisers that split shared expenses such as broken deal expenses among the adviser and its clients. The clients included private fund clients, employee funds and coinvestment vehicles. The split was "inconsistent with disclosures to investors or policies and procedures."
ILPA's Principles 3.0 say that the approach to broken deal expenses for co-investments "should align" with how the GP shares co-investment fees.
Which vehicles were in the deal when it broke?
Decide which vehicles were in the deal as of the date it died, not later. Nobody may have committed yet, so the answer depends on what each vehicle was entitled to or planned to take.
- In the deal. The fund that would have invested. A co-invest vehicle with a contractual right to the deal. An employee or partner vehicle that reserves a percentage of every deal. The KKR order describes vehicles that "invested on a deal-by-deal basis with no specified committed capital."
- Out of the deal. A fund that finished investing.
- Unclear. The window when a predecessor fund and a successor fund may split deals, and a deal too large for one fund.
An investment professional at a venture and growth firm explained the second point.
"[T]hose funds that are done deploying ... shouldn't ever eat the cost of ... a more recent fund. Doing deal work. That would be unfair."
The KKR order did not count co-investors that KKR syndicated deal by deal among the co-investors that should have shared. A finance team at a growth-equity firm argues over this when a deal dies.
"We have a deal on the pipeline that dies. We sort of ping pong around a lot on, hey, which funds would have invested in this deal."
That team's CRM tracks deal status but not which funds were going to invest. Nobody wrote the plan down before the deal died, so the team rebuilds it afterward.
How do you split a dead deal's costs across vehicles?
Use the planned share of each vehicle on the date the deal died. For a vehicle with no commitment, use its reserved percentage or the share of deals it may join. From January 2012, KKR's methodology considered "the amount of committed capital, the amount of invested capital, and the percentage of transactions." That last factor counted the deals in which its co-investors could take part.
Vehicle share = net broken deal cost x (the vehicle's planned share when the deal died / the total planned shares in the deal)
Net broken deal cost = deal-specific costs minus any break-up fee received, where the LPA nets them
The LPA and the co-invest agreements set what counts as deal-specific, whether fees net and whether a vehicle may bear a charge at all. The same allocation methodologies apply, with the death date as the basis date.
Take one illustrative dead deal. The invoices coded to it total $480,000.
| Vendor invoice | Amount | Treatment |
|---|---|---|
| Outside legal for the purchase agreement and structuring | $260,000 | Deal-specific |
| Accounting and quality-of-earnings diligence | $150,000 | Deal-specific |
| Deal-team travel to the target | $40,000 | Deal-specific |
| Sector study ordered before the target was identified | $30,000 | Sourcing under the ILPA template definition |
