The “2-and-20” model has long served as the gravitational center of private fund economics. Yet in today’s fundraising environment – marked by heightened LP sophistication, extended fundraising timelines and fierce competition for institutional capital – the advertised fee structure and the negotiated reality are diverging more sharply, some LPs and GPs would argue, than at any point in recent PE history.

This divergence is not simply a story of fee compression, but is instead a story of strategic economic sharing: GPs deploying management fees, carried interest and co‑investment rights as relationship-building tools while LPs leverage commitment size, early participation and reputational capital to extract bespoke terms. The result is a highly customized fee landscape where nearly every anchor relationship involves some form of economic accommodation and where the long-term consequences of those accommodations are only now coming into focus.

This article examines the current state of GP-LP fee negotiations; the economic dynamics confronted by emerging managers; the impact of co‑investment trends on fee negotiations; and the strategic calculus that GPs and LPs must navigate as fund economics continue to evolve.

See “Survey Finds PE Fundraising Momentum Building Toward 2026 Uptick” (Sep. 18, 2025).

Negotiated Reality: Fee Compression in Practice

Evolving GP‑LP Relationship

On paper, the standard PE fee model remains remarkably stable: a 2% management fee on committed capital during the investment period; 20% carried interest (often above a preferred return, typically 6‑8%); and an American- or European-style waterfall. In practice, however, fewer large or anchor LPs are bound by this standard fee model.

Instead, fee customization has become the norm for many institutional-scale commitments. GPs routinely offer management fee reductions to LPs making outsized commitments relative to total fund size. Early closers – sometimes marketed under labels like “founder LP” or “early adopter” discounts – often receive fee breaks that reward both commitment size and speed of execution. Those concessions reflect a practical reality: in a fundraising environment where a final close can often take 12 months or longer, early capital commitments carry meaningful value for GPs beyond the dollars themselves by reflecting positive momentum and adoption among institutional investors.

The competitive dynamics are straightforward. Sophisticated institutional LPs have more options than at any prior point – more GPs, more strategies and more vehicles competing for finite allocations. That optionality creates negotiating leverage that experienced allocators wield effectively. Smaller investors, or those not perceived as strategically important to GPs, typically continue paying standard rates, but fee customization is now a threshold expectation for institutional-scale capital rather than an exceptional concession.

The implications for a GP’s aggregate fee income are significant. For example, a GP that offers fee reductions to its three largest investors – each representing 15% to 25% of total commitments – may find that 50% or more of its capital base is paying below the stated rate. When combined with management fee offsets for transaction fees, monitoring fees or other portfolio company charges, the effective management fee yield on committed capital can be meaningfully below the headline figure. GPs must model those dynamics carefully to ensure that projected fee income supports their operating budget and talent retention strategy across the full fund life.

Distribution Channel Dynamics

Wealth management registered investment advisor (RIA) networks represent a growing and increasingly important capital source for certain sponsors. RIAs typically charge their end clients approximately 1% in asset management fees, so intermediaries frequently negotiate fund-level fee reductions so the combined cost to the underlying investor remains at or below 2%.

That dynamic highlights a broader trend in private fund economics: the growing importance of distribution channel strategy in fee structuring. A GP raising capital through multiple channels – e.g., direct institutional relationships, placement agents, RIA platforms and funds of funds – may effectively operate with a tiered fee structure even if only one rate appears in the offering documents. The complexity of modeling aggregate fee income across those channels, while ensuring equitable treatment of investors in each, is a meaningful compliance, disclosure and operational challenge that sponsors must address at the structuring stage.

See this two-part series on retail distribution platforms: “Growing Popularity, Numerous Benefits and Operational Obstacles” (Sep. 4, 2025); and “Selection Criteria, Due Diligence Processes and Potential Pitfalls” (Sep. 18, 2025).

Seeding Emerging Managers: The Economics of “But‑For” Capital

For first-time and emerging fund managers, the economics of launching a fund have taken on a distinct character. Before a single dollar of LP capital is committed, a nascent GP must build infrastructure; hire personnel; cover legal and compliance costs; and sustain operations through what is often a 12‑month or longer fundraising process. Those managers often require “walking around money” or “but-for money,” which is seed capital that enables the GP to get up and running.

The typical seeding structure involves a collective commitment of approximately $1 million to $2 million from early backers in exchange for 5‑10% of the fund’s carried interest. Critically, that capital is not structured as a loan; it is spent. Providers of but-for money are accepting real risk – if the fund fails to reach critical mass or underperforms, the carry allocation may yield nothing. Early backers tend to be friends, family members or individuals who want a ground-level stake in a new manager’s enterprise.

As fundraising timelines extend – a trend that shows no sign of reversing – seed capital has become increasingly common and is now viewed as a legitimate component of the emerging manager ecosystem. For GPs, it provides survival capital during an extended gestation period. For seed investors, it represents a leveraged bet on a GP’s long-term success that can generate outsized returns if the manager builds a durable franchise, but that carries genuine downside risk if the fundraise stalls or investment performance disappoints.

See “Planting a Seed or Securing an Anchor: Finding Success As an Emerging Manager” (Nov. 14, 2024); and “A New Role for Seed Investors: Enhancing Evergreen Fund Liquidity Via a Committed Equity Backstop Facility” (Oct. 17, 2024).

The Fine Line: Relationship Building Versus Long‑Term Dilution

Although the strategic sharing of fund economics is a powerful tool for building institutional relationships and differentiating in a crowded fundraising market, it also carries compounding risks that deserve careful consideration by fund sponsors and their counsel.

Downstream Harm of Short‑Term Economic Decisions

MFN Cascade Problem

Most favored nation (MFN) provisions and side letter regimes mean that economic concessions granted to one investor can cascade across the LP base. MFN elections may result in a fee break offered to a single anchor LP becoming available to a broader set of investors, reducing aggregate management fee income well beyond what the GP initially anticipated. Aside from modeling the bilateral cost of a given concession, fund sponsors must assess its potential amplification through the side letter regime. The difference between a targeted accommodation and a fund-wide rate reduction can be a single MFN clause.

Ratchet Effect Across Fund Cycles

Once economics are conceded in a fund (e.g., fund IV), they are exceptionally difficult to recapture in subsequent vintage funds (e.g., fund V, etc.). LPs who receive favorable terms in an earlier fund rarely surrender them voluntarily in later funds. The practical consequence is that earlier-fund fee concessions can become embedded features of the GP-LP relationship across the platform’s lifetime. A GP that offers aggressive economics to close a fund must recognize that those terms are not merely a cost of the current fundraise – they are likely to become a structural baseline that will compound across every subsequent fund cycle. What appears to be a rational near-term decision can produce material long-term economic dilution.

Constraining the Carry Pool

Every percentage point of carried interest allocated to anchor LPs, seed investors or strategic partners is a point unavailable for the management team and investment professionals who generate the fund’s returns. GPs must balance the near-term benefit of closing capital against the long-term imperative of retaining and incentivizing the human capital that drives performance. A carry pool that has been materially reduced through investor accommodations limits the GP’s ability to compete for senior talent, reward exceptional performance and build the bench depth necessary to sustain a multi-fund franchise.

The message for fund sponsors is clear: economic concessions are not merely a cost of the current fundraise. They are a structural decision that shapes the GP’s operating economics and talent strategy for years to come.

See “Structuring Compensation Vehicles and Profits Interests to Optimize Tax Treatment When Forming a PE Firm (Part Two of Two)” (Dec. 1, 2020).

Beyond Fee Breaks: What Anchor LPs Really Get

Many of the most valuable accommodations for sophisticated anchor investors are non-economic in nature and serve to align interests with GPs over the long term. Investment committee observer rights provide visibility into deal flow and decision-making processes. Regular meetings with fund management yield updates on portfolio strategy, pipeline and personnel. Those arrangements, as well as bespoke reporting requirements that are also becoming more common, create informational advantages that allow an LP to evaluate the GP’s performance, team, culture and succession planning from the inside – perspectives that due diligence questionnaires cannot fully replicate.

Notably, those information arrangements are often mutually beneficial as GPs can use them to build deeper relationships with their institutional base and gain market intelligence about LP preferences, allocation trends and competitive positioning that informs future fundraising strategies. For a GP that is establishing or expanding its institutional presence, those regular touchpoints with experienced allocators offer insights about market norms and investor expectations that would otherwise take years to accumulate.

Perhaps the most important benefit that inures to a GP is that a blue-chip anchor investor acts as a powerful signal to the broader market. Other LPs who invest alongside a recognized institutional investor often do so at full fee and carry, making the anchor’s value to the fund far greater than the nominal size of their commitment. A $100‑million anchor investor whose presence helps attract an additional $200 million at full economics has delivered value well in excess of any fee concession provided.

See “Performance Reporting Templates, Standards and Initiatives for PE and Real Estate Funds” (Feb. 5, 2026).

Fees That Stay Home: What GPs Typically Do Not Share

Not all fee income is subject to negotiation. Certain categories of GP revenue remain largely insulated from LP demands for economic sharing due to sound structural reasons.

The base management fee – used to pay investment professionals, fund operations and overhead – is the GP’s primary source of operating capital to, in essence, keep the lights on. Although LPs may negotiate the rate, the fee itself is not typically shared back to the fund. That is particularly true for early vintages of funds, as the management fee may also need to cover the infrastructure buildout costs of a nascent organization that has not yet reached operational scale.

In real estate PE, GPs frequently earn fees at the asset level through development management, property management, construction oversight and leasing commissions. Those fees are generally not shared with the fund’s LP base for a straightforward reason – if the GP were not performing those services, then the fund would pay a third-party provider at comparable rates. LPs typically focus on ensuring adequate disclosure and market-rate pricing rather than demanding that those fees flow back to the fund. The economic logic is sound: the GP’s in-house capabilities represent a genuine value proposition, not a disguised extraction of fund economics.

Co‑Investments: The Defining Economic Shift

If there is a single area where GP-LP economics have been most fundamentally reshaped over the past decade, it is co‑investments. The shift has been dramatic, structural and, at this point, largely irreversible.

Ten years ago, it was common for GPs to charge half-carry and half-management fee on co‑investment capital. Today, the market has moved decisively to a no-fee, no-carry model for LP co‑investors. That represents the single largest form of economic sharing between GPs and their institutional partners – a structural concession that dwarfs most management fee reductions or carry allocations in absolute dollar terms.

Mutual Benefits of No‑Fee, No‑Carry

For LPs, co‑investments offer the ability to average down the blended cost of capital deployed with a given manager, concentrate more capital with fewer GP relationships –a significant operational benefit for institutions with limited internal investment staff – and build deeper, more engaged partnerships with top-performing managers. The economics are compelling: for example, an LP that commits $50 million to a fund at standard terms and participates in $50 million of a no-fee, no-carry co‑investment has effectively halved its blended fee load with that manager.

For GPs, co‑investments provide access to additional capital for larger transactions without the constraints of a new fund vehicle, while deepening LP relationships that support future fundraising efforts. The ability to offer co‑investments at scale have become a differentiating capability – GPs that can efficiently source, underwrite and syndicate co‑investment opportunities have a material competitive advantage in LP retention.

See “Key Drivers, Unique Fund Structures and Alternative Approaches to Co‑Investments (Part One of Two)” (Aug. 22, 2024).

Third‑Party Wrinkle

An emerging negotiation point involves third-party co‑investors – i.e., parties who are not LPs in the main fund, but who participate in co‑investment opportunities sourced through it. Some LPs permit GPs to charge fees or carry to those outside co‑investors but increasingly request that a portion of those economics flow back to the main fund. The rationale is that the sourcing infrastructure, deal team expertise and relationship network that identify and execute transactions are funded by main fund economics. Giving third parties access to those opportunities on a no-fee basis – while the main fund bears the full cost of origination – strikes many LPs as an inequitable distribution of value.

Fund counsel should expect this to remain an active area of negotiation as co‑investment programs continue to scale and as GPs increasingly syndicate deal capacity beyond their existing LP base. The structuring of revenue-sharing mechanisms for third-party co‑investment economics – including the allocation methodology, the treatment of broken-deal expenses and the interplay with existing fee offset provisions – requires careful documentation and clear disclosure to all fund participants.

See this two-part series on negotiating co‑investments: “Relevant Provisions in Main Fund Documents and LP Side Letters” (Sep. 14, 2021); and “Unique Features and Considerations in Co‑Investment Vehicle Documents” (Sep. 21, 2021).

GP‑Led Secondaries: Blurring Traditional Fee Boundaries

GP‑led secondary transactions have introduced additional complexity into the fee landscape by blurring the traditional boundaries between fund-level fees, continuation vehicles, co‑investment economics and liquidity arrangements. In GP‑led secondaries, the GP effectively transitions assets from an existing fund into a new vehicle, creating a liquidity event for existing LPs while retaining management of the portfolio.

The complication with GP‑led secondaries is that they implicate multiple fee dimensions simultaneously. The continuation vehicle may have its own management fee and carried interest structure, raising questions about how those economics relate to the original fund’s terms. LPs evaluating GP‑led secondaries must assess whether the new fee arrangement for the applicable continuation vehicle represents a fresh start or an extension of existing concessions. GPs, for their part, must balance the desire to reset economics against the expectation of continuity among rolling investors.

As GP‑led secondaries become more prevalent, they underscore the broader theme of the current environment: fee negotiations are no longer confined to a single fund’s offering documents but extend across vehicles, transactions and the full lifecycle of the GP-LP relationship.

See “Managing Inherent GP and Counsel Conflicts of Interest in GP‑Led Secondaries” (Apr. 16, 2026).

Strategic Considerations to Ensure Alignment

GPs and Fund Sponsors

The most critical discipline is budgeting forward. Before offering any economic concession – whether a fee reduction, carry share or co‑investment right – the GP must have a clear picture of how much fee income and promote is needed to attract and retain senior investment talent; fund annual compensation and bonus obligations; and sustain fund operations through a full investment cycle. Every economic benefit given away in one fund cycle is extraordinarily difficult to recapture in subsequent funds.

Further, GPs should enter negotiations with a clear floor – i.e., a minimum level of economics below which the fund’s human capital strategy and operational viability are compromised. That floor must account not only for current operating costs but also for the inevitable escalation of those costs as the organization grows, talent markets tighten and operational complexity increases with each successive fund. A sponsor that knows its economic floor before the first LP negotiation can make concessions confidently while using data to resist pressure that would push economics below sustainable levels.

LPs and Institutional Allocators

The ultimate currency is access – not merely to a sponsor’s deal flow, but to information about how its returns are generated; who drives those returns; what the next generation of the sponsor’s leadership looks like; and how its future funds will be structured and incentivized. That level of transparency is far easier to obtain from inside the relationship than through external diligence processes.

Sophisticated LPs recognize that although fee savings are valuable, they are a secondary benefit compared to the strategic advantages of being a meaningful partner in a GP’s ecosystem. The LP that negotiates a 25‑basis‑point management fee reduction has captured a quantifiable, but ultimately modest, economic benefit. Conversely, the LP that secures investment committee observer rights, regular access to senior leadership and early visibility into fund succession planning has positioned itself to make better allocation decisions across multiple fund cycles – the economic value of which far exceeds any fee concessions.

Moreover, savvy allocators understand that the quality of information available from inside a GP relationship – e.g., insights into team dynamics, investment process discipline, pipeline quality and organizational stability – provides early warning signals that external diligence simply cannot replicate. An LP with genuine access can identify leadership transitions, strategy drift or operational stress months before those issues surface in performance data or become visible to the broader market. That informational advantage, deployed across a diversified portfolio of GP relationships, compounds into a material competitive edge in manager selection and re-underwriting decisions.

In addition, thoughtful allocators will calibrate their requests to the GP’s stage and scale. First-time managers may offer more favorable economics to secure anchor commitments, but LPs should consider whether overly aggressive terms risk undermining the GP’s ability to build a sustainable organization capable of delivering the returns that attracted the LP in the first place. The most productive partnerships recognize that a GP operating under economic duress is unlikely to sustain the talent base and operational discipline required to generate superior investment outcomes.

See “ILPA Study Gauges Evolving LP Sentiments Toward PE Allocations and LPA Negotiations” (May 28, 2026).

Looking Ahead

The private fund fee landscape will continue to evolve – driven by LP sophistication, competitive fundraising dynamics and the growing prevalence of institutional co‑investment programs. GPs who approach fee negotiations as purely defensive – conceding terms to close capital without a broader strategic framework – risk structural dilution that compounds across fund generations.

The most effective fund sponsors will treat economic sharing as a deliberate portfolio allocation decision: deploying fee breaks, carry shares and co‑investment rights where they generate the highest return in the form of committed capital, institutional signaling, operational support and long-term partnership value. That approach requires the same rigor that GPs bring to investment underwriting – analyzing not just the immediate cost of a concession, but its net present value across a multi-fund relationship, its cascade risk through MFN provisions and its impact on the carry pool available for talent retention.

Those fund sponsors who get the calculus right will build durable franchises capable of raising capital across market cycles and retaining the investment talent that generates returns. Those who do not may find that the economics they gave away early in their fund cycles define the constraints they face across subsequent fund vintages, and that the relationships built on unsustainable concessions prove more fragile than those built on genuine alignment of interest.

For both GPs and LPs, the path forward requires treating fund economics not as a zero-sum negotiation, but as an exercise in structural alignment. The most productive GP-LP partnerships occur when the GP’s concessions are rationally calibrated to the LP’s contribution of capital, credibility and institutional support. Concurrently, the LP’s demands must be tempered by an understanding of the GP’s need to sustain operational excellence and human capital investment over a multi-decade platform horizon.

 

Stephanie Pindyck Costantino is a partner in the Princeton, N.J., office of Troutman Pepper Locke. She advises venture capital (VC), real estate and PE sponsors on fund formation for both onshore and offshore investments, as well as operations, compliance and assorted transactions including PE investments, VC deals, acquisitions, dispositions, joint ventures and intra-partner negotiations. She also represents domestic and international institutional investors and their advisors across various industry sectors.

Heather M. Stone is counsel in the Boston office of Troutman Pepper Locke. She represents a diverse array of alternative investment funds – including PE, VC and real estate – on structuring, formation, reorganization and regulatory compliance. Her clients include public and private pension funds; educational institutions; insurance companies; corporations; family offices; and endowments. She also acts as GC for growth-oriented companies at various development stages.

Paul A. Steffens is a partner in the Charlotte, N.C., office of Troutman Pepper Locke. He focuses on joint ventures, private funds, private securities offerings, corporate law and M&A. He represents sponsors and investors in connection with the formation of joint ventures, private funds and other capital-raising transactions, as well as buyers and sellers in M&A transactions. He also counsels on economic and governance arrangements among business principals; equity incentive arrangements for managers and employees; corporate governance; disputes among business principals; and ownership succession.

On August 25, 2026, the U.S. Court of Appeals for the Fifth Circuit issued a per curiam ruling (Ruling) denying a petition from Apex Clearing Corporation (Apex) to modify the terms of an earlier settlement order with the SEC. In April 2024, Apex settled with the SEC in connection with the agency’s off-channel communications sweep conducted between 2021 and 2024. Other firms settled similar violations with the SEC in January 2025 with more lenient terms, compelling Apex and others to challenge the Commission to modify their original settlement terms on the basis of inequitable treatment. After the SEC denied the motion to modify the settlement terms in 2025, Apex challenged the matter in the Fifth Circuit.

Despite sympathizing with Apex and other firms as to the inequitable settlement terms they received, the Fifth Circuit ultimately sided with the SEC across various legal grounds. Even amid the current deregulatory zeitgeist, the Ruling affirms the broad discretion afforded to the SEC in administrative proceedings; the finality of judgements and settlements entered into with sophisticated counsel; and the high bar parties face when challenging SEC settlements in court. This article summarizes the Ruling and offers practical takeaways for fund managers, with expert legal commentary.

See “Attorneys in SEC GC’s Office Discuss Pending Challenges to SEC Authority and Significant Litigation” (Apr. 30, 2026).

Background

2024 Settlement

The SEC initiated multiple rounds of enforcement sweeps targeting firms that failed to adopt and enforce policies and procedures reasonably designed to prevent off-channel communications – i.e., firms failing to retain business-related messages sent by employees by text and on social media apps. The SEC’s enforcement actions netted a total of $2 billion in penalties.

Apex submitted an offer of settlement for off-channel communication violations, which the Commission accepted in August 2024. The Ruling briefly recapitulates the underlying violation that led to the SEC’s sweep and its enforcement action against Apex and other entities. Section 17(a)(1) of the Securities Exchange Act of 1934 (Exchange Act) requires regulated entities to “make and keep for the prescribed periods such records, [and] furnish such copies thereof . . . as the Commission, by rule, prescribes as necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of [the Exchange Act].”

As part of the settlement, Apex agreed to comply with undertakings placing the firm under tighter scrutiny from FINRA. From Apex’s point of view, the terms of the settlement were not necessarily problematic when viewed in isolation. The problem, however, is that “in January 2025, the Commission announced settled orders against twelve firms, including three broker-dealers, that were overall less severe than the pre‑2025 settled orders,” according to the Ruling. Specifically, the January 2025 settlement orders did not impose the more onerous FINRA scrutiny that was present in the earlier Apex settlement.

See “SEC Fines 12 Firms $63.1 Million in New Off-Channel Communications Settlements” (Mar. 20, 2025).

Challenging the Settlement

In response to the perceived unfairness of the lighter settlement terms offered in January 2025, Apex and 15 other respondents pursued a modification of their previously settled orders by filing appeals with the SEC. The appeals invoked Federal Rule 60(b)(5), which offers relief from a final judgment in circumstances in which “it is no longer equitable that the judgment should have prospective application. They also cited Rules 200(d)(1), 154 and 100(c) of the Commission’s Rules of Practice.

On April 14, 2025, the Commission issued an order denying the motions to modify or amend the terms of the earlier settlements that were filed by Apex and its co‑respondents. The Commission found the “strong interest in maintaining the finality of settlements” required parties to prove “compelling or extraordinary circumstances” to prompt a modification unless the respondents could prove one or more of the following conditions:

• new circumstances making the settlement terms “substantially more onerous”;
• unforeseen obstacles complicating adherence to the consent decrees;
• detriment to the public interest stemming from enforcement of the order; or
• material changes to the relevant law.

In the absence of any of the above conditions, the Commission rejected the challenge. Notably, Commissioner Hester M. Peirce wrote a dissent citing the serious consequences the original settlements would have for the respondents’ respective FINRA membership.

See “SEC Denies Motion to Amend and Stay Settled Orders Over Off-Channel Communications” (Aug. 21, 2025).

Petition for Review

Apex challenged the Commission’s denial of the motion in the Fifth Circuit under 15 U.S.C. 78y(a)(1), which gives an aggrieved party the right to obtain review of an order by filing a written petition within 60 days after its entry.

Similar Treatment to Similar Parties

The Fifth Circuit deemed that the original settled order imposing undertakings that Apex found hard to comply with – a clear case of “settler’s remorse” – was not up for review. Instead, the Fifth Circuit considered the relevant question to be whether the SEC had treated a party seeking to revisit an order denying a motion to reconsider a settlement the same way as other similar parties, not whether the original settled order was fair in light of later settlements.

In the court’s view, the challenge for Apex was to demonstrate that the denial of the order fit the definition of “arbitrary and capricious” in the Administrative Procedure Act (APA). The APA allows an appellate court to rule in favor of a petitioning responder if it finds an agency’s actions to be “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” To be “arbitrary and capricious,” the agency must have failed to show that it had “reasonably considered the relevant issues and reasonably explained the decision.” To that end, Apex argued that the SEC’s denial of the order to modify the original settlement:

1. violated a basic tenet of administrative law requiring the SEC to treat like cases similarly; and
2. was not the result of reasoned decision-making.

In its Ruling, the Fifth Circuit abruptly dismissed the assertion of the unlike treatment of two different cases, as the matter focused on the SEC’s order denying the motion to amend the settlement terms instead of the original settled order establishing those terms. The Fifth Circuit found the Commission handled Apex’s motion similarly to other similar motions and provided “reasoned explanations” for denying the petition.

No Detriment to Public Interest

As in the cases of other parties seeking modification of a final order, the Commission required Apex to demonstrate why modification was appropriate in the circumstances. The Commission cited legal precedent that modification is called for “only by a significant change either in factual conditions or in law.” It rejected Apex’s view that the 2025 settlements could be said to constitute either type of change, and the Fifth Circuit concurred. Citing the themes of the legal precedent as “unworkability or detrimentality,” the Fifth Circuit found that Apex did not prove “that its undertakings are unworkable or detrimental to the public interest as a result of later settlements.”

Non‑Applicable Precedent

The Fifth Circuit held the Commission had reasonably explained why Apex’s case was different from earlier ones in which modification of settled orders had some basis. The court found the legal precedent that Apex cited when arguing that the Commission had repeatedly modified inequitable undertakings did not present any sort of “overarching principle that settled orders should be modified when they are no longer equitable.”

The Commission argued, and the court agreed, that the legal precedent cited by Apex involved “particular circumstances” supporting modification, namely that the requirements imposed therein were becoming unworkable such that modifying the settlement terms would sunset an obligation that would otherwise have been indefinite. In the Apex matter, however, neither unworkable undertakings nor indefinite obligations were present. For those reasons, “the [order denying the motion to modify the settlement terms] was no deviation from precedent,” the Ruling states.

See “What Remedies and Relief Can Fund Managers Expect in SEC Enforcement Actions?” (Jan. 10, 2019).

Permissible Inequity

With its legal arguments stymied, Apex was left with a situation where its original settlement, albeit admittedly unfair at some level, was not illegal or impermissible. “While the inequity is undisputed, even in an enforcement sweep the Commission is not required to settle on equal terms,” the Ruling states. “We sympathize with Apex’s position; on this record, the [firms in the 2025 settlement] were lucky to be caught in a later wave of the enforcement sweep, enjoying significantly lighter settlement terms,” the Ruling acknowledges. “But . . . that is not enough to say that the Commission’s denial of Apex’s motion to modify was arbitrary and capricious.”

Acknowledging the role of chance or luck in giving other parties more lenient settlement terms might seem to weigh in favor of a court making a concession, but that was not the case here. “They went beyond the legal analysis to specifically sympathize with Apex's position, but then said, ‘Tough luck,’” commented Lowenstein Sandler partner Scott H. Moss. “There is no question that the early SEC sweeps came with more onerous penalties,” added Freshfields partner Andrew Gladstein. “But the Fifth Circuit was hesitant to set a precedent that courts should engage in the minutiae of determining whether or not subsequent settlements are fair.”

Key Takeaways

Fifth Circuit’s Role

It is notable that the Ruling came from the Fifth Circuit, which is not generally known for its heavy-handed treatment of respondents in securities law enforcement cases, asserted Alston & Bird partner Paul N. Monnin. “The Fifth Circuit is currently viewed as being more respondent-friendly in administrative enforcement matters, and has been the home court for favorable ruling on the constitutionality of administrative enforcement.”

In fact, some respondents and their counsel have sought out the Fifth Circuit precisely because it is viewed as a friendlier venue for respondents, Monnin continued. “Many SEC orders are appealed in the U.S. Court of Appeals for the D.C. Circuit or, sometimes, in the Second Circuit. A lot of appeals of SEC rulings have been moving toward the Fifth Circuit in recent years, however, because it was viewed as being more respondent-friendly.”

For coverage of other prominent Fifth Circuit rulings, see “Fifth Circuit Delivers Landmark Victory for Fund Managers in Self‑Employment Tax Dispute” (Mar. 19, 2026); and “Fallout From the Fifth Circuit’s Bombshell Ruling Vacating the Private Fund Adviser Rules” (Jun. 27, 2024).

Finality of Judgments and Settlements

To understand how such an unfavorable judgment was issued by an ostensibly respondent-friendly court, it is helpful to understand the paramount importance of finality of judgment in federal law, Monnin argued. “The Fifth Circuit is a federal court of appeal guided by the principle that if a party voluntarily settles its liability with a regulator while represented by counsel then that type of finality should be respected.”

The finality of judgement principle is critical to keeping the legal system operating properly, which is why it is such a high bar for respondents to overcome, Monnin continued. “If settled orders and judgments with regulators or other administrative bodies could be reopened based on an argument of temporal inequity, a change in administration or a change in the view of the seriousness of underlying violations, then that could strain the system.”

“Further, it is worth noting that Congress has given the SEC a lot of discretion to settle cases where it believes it is in the best interest for the market and required by law,” Gladstein added. “Anything that opens the door to second-guessing settlements that sophisticated parties with counsel have entered into could lead to retreading cases, which is the antithesis of the whole point of settlement,” he reasoned. “Settlement is supposed to give both parties finality, including the SEC.”

“Parties need to be prepared to live with a settlement,” Moss advised. “The appellate court actually used the word ‘hammering’ – that Apex ‘consented to the hammering’ on the remedies and the settlement. But if you’re agreeing to something that’s seemingly harsh, don’t count on it being lifted later. Be prepared to abide by the harsh terms.”

See “SEC Rescinds ‘No Deny’ Policy As a Condition of Settled Enforcement Actions” (Jul. 23, 2026); and “SEC Enforcement Manual Updates Incorporate Changes to Wells Process and Other Protocols” (Apr. 30, 2026).

Per Curiam and the End of Apex’s Road

Underscoring the firmness of the court’s belief in the finality of judgements and settled orders, and its view that Apex’s petition did not really present material legal issues, is the court’s issuance of an unsigned per curiam, or “by the court,” opinion, Monnin observed. “There is no particular judge writing the opinion. It is on behalf of the court. It’s per curiam and it’s unpublished, both of which speak to the finality of administrative settlements that are not deemed to be fundamentally inequitable or punitive,” he explained.

Given the nature of the per curium opinion and the summary order issued by the Fifth Circuit, Apex has limited paths to overturning the Ruling or otherwise modifying the terms of its 2024 settlement. “One option would be to ask the entire Fifth Circuit to sit en banc in review, and the other would be to go to the U.S. Supreme Court,” Gladstein posited. “Both avenues are exceedingly difficult, and the Fifth Circuit was careful to shape its opinion and to distinguish Apex’s authority in a way that doesn’t cry out for further review.”

Lessons for Settlement Negotiations

Firms may be able to avoid Apex’s outcome by negotiating certain terms in future settlements. “If Apex had language in its settlement agreement granting it a right to the benefit of treatment that firms received in later settlements, then they would have been positioned to make the demand,” Gladstein observed. “That’s not to say the SEC will necessarily agree to that demand, but that is one lesson for firms subject to broad future SEC enforcement sweeps.”

A further consideration here is whether the underlying violation lends itself more to litigation in a district court, in which the respondent may have a slightly better chance than when facing an administrative law judge (ALJ) on the SEC’s home turf, Monnin shared. “If the SEC is enforcing a rules-based violation as opposed to a fraud-based violation, then you’re likely to be stuck in the administrative forum, and you’ll be stuck with whatever you settle,” he explained. “If it’s more a capital‑F fraud with investor harm and the SEC is looking at punishment in addition to compliance, then you can go to court.”

What sponsors in that situation have to decide is an issue of gating and framing related to the Commission’s enforcement theory, Monnin continued. “If you can argue that it’s more fraud, abuse and investor harm, then you can use constitutional rulings to say, ‘We’re choosing an Article III district court forum, which is more favorable to respondents,’” he explained. “If it’s a rules-based compliance issue, however, then you’re going to be forced to go in front of an SEC ALJ in an administrative forum.”

See “Recalibrating Securities Enforcement and Risk: What Fund Managers Should Know About the Shifting Legal Landscape” (Apr. 2, 2026).

Proactive Compliance and Anticipation

Rather than looking at ways to challenge court orders when they reach such a stage, sponsors are better advised to tailor their compliance programs in a manner that helps avoid any regulatory trouble. Having effective policies and procedures in place and ensuring employees follow them is likely to prove more effective than challenging orders or settlement terms.

“Every adviser would do well to stay ahead of the Commission’s initiatives and, if there is a broad initiative where people are subject to SEC investigations, to ensure they are well positioned to differentiate themselves from truly bad actors,” Gladstein shared. “With that said, you can’t always predict the SEC’s next priority areas. We can make educated guesses, but the bottom line is, apart from having the best policies and practices, all firms can do is ensure that, as an organization, they operate consistently with the SEC’s rules and guidance.”

See “How Lawyers Can Leverage the Shifting Environment to Enhance Compliance Programs” (Dec. 1, 2022).

After growing to roughly $3 trillion globally in a strong economy, private credit sponsors’ disclosure, valuation and liquidity practices are now facing increased scrutiny from regulators and civil plaintiffs. Securities class actions filed over the past 12‑18 months against business development companies (BDCs) have converged on a narrow set of allegations: that net asset values (NAVs) were stale or overstated; that redemption pressure was known but undisclosed; and that described valuation and diligence processes did not match the actual processes. The SEC has signaled parallel interest in valuations, fiduciary duties, compliance programs and retail-facing products.

Those developments were the subject of a Katten Muchin webinar featuring partners Kevin P. Broughel and Michael J. Diver, as well as associates Zoe Lo and Christopher T. Vazquez. This article analyzes the panelists’ assessments of the redemption, valuation and process-disclosure theories driving private credit litigation; the defenses that have emerged among sponsors; the SEC’s stated priorities regarding the asset class; and the measures that sponsors should consider adopting to mitigate those risks.

See “Private Credit Valuations Under Pressure: Enforcement Trends, Litigation Risks and Mitigation Tactics” (May 14, 2026); and “Evolution of the Private Credit Industry and Ongoing Challenges” (Feb. 19, 2026).

Scrutiny of Valuation Processes

As private credit assets are illiquid and infrequently traded, valuations rely heavily on models, assumptions and internal judgments. Valuations for BDCs are governed by Rule 2a‑5 under the Investment Company Act of 1940 (Investment Company Act), which broadly requires funds to:

• adopt policies and procedures;
• monitor and test valuation methodologies; and
• maintain proper oversight and controls, including board or adviser oversight of fair value determinations.

Valuations are required for portfolio investments for which market quotations are not readily available, and the process by which it is reached has become the focus of litigation. According to Vazquez, there are six primary steps in a valuation process:

• identifying and categorizing investments;
• gathering and verifying inputs;
• valuing the investments;
• reviewing and challenging the valuations;
• making value determinations; and
• applying and reporting the valuations.

Those steps are paired with other related obligations, including:

• a governance framework under Rule 2a‑5 covering valuation committee oversight;
• qualified personnel;
• conflicts of interest management;
• periodic review of valuations and the related process; and
• recordkeeping obligations.

The gap between that theoretical valuation framework and its actual execution is where managers face difficulties. Certain managers have found themselves “in a bind” because of market conditions, without much time to address valuation issues, Diver said. The best way to mitigate – but not eliminate – the civil litigation risk and regulatory scrutiny related to valuation process is for a manager to work closely with external advisers and senior leadership.

See “SBAI Introduces New Standards and Accompanying Guidance on Valuing Illiquid Assets” (Apr. 3, 2025).

Redemption Pressure As a Litigation Trigger

Litigation had ticked up over the past year to 18 months, primarily driven by class action complaints filed by retail investors against BDCs and their officers, Lo reported. Those suits tend to follow a sharp decline in stock value, a quarterly report that misses estimates or a rapid rise in redemptions.

A case pending in the Southern District of New York illustrates how spikes in redemptions can lead to litigation. The complaint alleges that an adviser violated the Securities Exchange Act of 1934 (Exchange Act) by failing to disclose meaningful pressure on redemptions, which rose in the first quarter of 2025, Lo summarized. It further alleges that the adviser did not disclose liquidity issues caused by the high rate of redemptions, that investors had pulled $150 million from the fund and that the fund was contemplating a merger with two BDCs that would have had the effect of halting redemption rights during that period.

In parallel, two different plaintiffs brought derivative lawsuits on behalf of the adviser against current and former officers and members of the board of directors. Those suits assert claims that typically follow a price drop – i.e., breach of fiduciary duty, gross mismanagement, waste of corporate assets and unjust enrichment. The court stayed the derivative suits until the conclusion of the class action.

It is also worth noting that the risk exposure is broader than any single investor complaint. Positive statements about a fund’s business, operations and prospects may later be recast as misleading if redemptions rise or markets worsen. Further, investor claims often turn on how liquidity and redemption constraints were described, even when a fund can manage its liquidity in practice.

NAV, Non‑Accruals and Timeliness

Beyond redemptions, shareholders focus on key financial metrics (e.g., NAV) and whether assets are accounted for in a timely manner, Lo said.

In a class action pending in the Central District of California, the plaintiffs’ primary argument is that a BDC failed to disclose that investments were not being valued in a timely and appropriate manner. The complaint also alleges that portfolio restructuring efforts did not resolve challenged credits or improve portfolio quality, such that realized losses were understated and NAV correspondingly was overstated, Lo explained. The plaintiffs pointed to the number of portfolio companies carrying non-accrual status doubling between 2024 and 2025, and to corrected disclosures showing a 22.44% year-over-year drop in NAV.

Notably, non-accrual trends have attracted the attention of investors who treat them as an early warning signal that “credit stress was obvious” – particularly because those rates are historically known to be sensitive to macro conditions. The allegation is driven by the delta between quarterly valuations of illiquid assets, and any dramatic drop will be characterized as evidence of an inaccurate valuation, Vazquez added. As illiquid assets are very difficult to value, a robust and rigorous valuation process can defeat the allegations.

Delays in markdowns present risks for the same reason. When overstated NAV figures are followed by sharp corrective disclosures, plaintiffs will argue the portfolio was overstated for months beforehand. Further, stale valuations invite allegations of deliberate manipulation and conflicts of interest.

See “SEC Examinations and Enforcement Staff Warn Against Certain Private Credit Practices, Fee and Expense Conflicts (Part Two of Two)” (Feb. 20, 2025).

Disparate Disclosures and Actual Valuation Processes

Another area of scrutiny of private credit from regulators and civil litigants has generally focused on whether funds present clear, specific and non-misleading disclosures, with an emphasis on liquidity and portfolio performance, Vazquez summarized. Generalized disclosures may not be sufficient, particularly when liquidity constraints exist and due to private credit being subject to known stressors, he cautioned.

A case currently pending in the Northern District of California illustrates how, beyond the output of a valuation, investors are focused on a manager’s disclosures about the rigor of the valuation process and whether those match their actual practices. The plaintiffs claimed the defendants violated Section 20(a) and Rule 10b‑5 of the Exchange Act by overstating the due diligence process for a BDC’s deal sourcing, loan originations and portfolio valuations. The complaint also alleges the BDC misclassified its portfolio investments and overstated the robustness of those valuations.

The plaintiffs relied on a report published by a media outlet containing first-hand accounts from two former employees, Lo continued. The report claimed the plaintiff’s valuations team consisted of four people in a single reporting lane, whereas disclosures had described a multi-step valuation process. The report also indicated that the BDC had underrepresented its significant software debt exposure, including exposure to companies that self-describe as software companies. Any inaccurate categorization of portfolio investments will invite scrutiny when a sponsor understates exposure to sectors.

When confronted with those types of claims, typical defenses are that the statements are vague and not intended to be relied upon, and that the defendants lacked intent to deceive. Another prominent defense that carries unique weight is that stock price drops are attributable to market conditions rather than to any alleged misstatement.

Isolated‑Issue Messaging and the Concealment‑and‑Correction Narrative

A class action filed in May 2026 in the Eastern District of Pennsylvania focuses on an alleged concealment-and-correction narrative. According to Broughel, the core allegations are that the defendants failed to disclose that the BDC had overstated:

• the effectiveness of its restructuring efforts for its non-accrual companies;
• the valuation of its portfolio investments;
• the soundness of its valuation processes; and
• the durability of its quarterly distribution strategy.

Certain alleged misstatements appeared in SEC filings, including quarterly filings representing significant progress toward restructuring non-accrual investments. The BDC also gave assurances that its board oversaw valuation processes and that its processes over financial reporting were “effective.”

The corrective disclosures alleged in the complaint began with the second-quarter report in 2025, which reported a NAV decline of 6.2% and declines in other metrics, Broughel explained. Management attributed much of those declines to company-specific issues affecting only four portfolio companies. When NAV continued to decline later in the year, the BDC cut its dividend roughly in half and the chief investment officer acknowledged the underperformance reflected challenges in legacy investments and adviser-originated investments. The four portfolio companies previously identified accounted for only 50% of net realized and unrealized losses.

The complaint highlights the risk that isolated-issue messaging can be seized on by plaintiffs, particularly when later statements show the isolated issues did not account for the majority of losses, Broughel cautioned. The complaint is also notable for framing certain misstatements as affirmatively false rather than merely proven wrong by later events. For example, the plaintiffs alleged that the representation that the BDC had made “significant progress” toward restructuring non-accruing investments had substantially overstated what had been achieved.

It is worth noting that restructuring narratives can backfire the same way. When management presents restructurings as mitigating credit stress, or blames NAV pressure on a handful of portfolio companies, then any later disclosures showing broader markdowns or elevated non-accruals can make those earlier narratives seem misleading.

See “FSB Report Cautions Potential Cascading Market Risks Posed by Private Credit Vulnerabilities” (Aug. 20, 2026).

Institutional Claims in State Court and the Reliance‑Disclaimer Defense

Not every private credit dispute arrives as a federal securities class action. A matter pending in the New York Supreme Court was brought by institutional investors that invested in a private credit fund based on factoring – i.e., the purchase of short-term accounts receivable at a discount, where profit is the spread between the discounted purchase price and the full amount paid by the obligor, Vazquez said. The investors claimed the fund manager represented it would maintain control over the stream of payments such that each obligor would pay the fund directly when, in reality, an intermediary collected the cash before it was deposited with the fund.

The litigation forum matters as discovery in New York state court is typically more liberal, and the common law requirements to satisfy fraud and breach of fiduciary duty claims differ from the statutory securities claims available in federal court, Vazquez explained. The case hinges on a case study the defendants provided showing a typical factoring arrangement; the plaintiffs alleged that is not what happened, making the representation fraudulent or negligent.

The defendants’ motion to dismiss rests on the plaintiffs being sophisticated investors who received a private placement memorandum and a subscription agreement in which:

• they disclaimed reliance on representations made outside the core deal documents;

• were warned that suppliers could make misrepresentations or commit fraud; and
• were informed that the fund could appoint a third party to obtain payments from obligors.

There were, in short, detailed disclaimers of reliance and risk factors describing the very fraud alleged, and in New York, when disclaimers and disclosures match the fraud described, that can result in dismissal at the pleading stage, Vazquez summarized. The dynamic is a rewind of the 2008 global financial crisis, when the common defense was to point to detailed risk disclosures, disclaimers of reliance and offering documents, he added.

See “How Fund Managers Can Use Non‑Reliance Clauses to Protect Themselves From Investor Claims of Misrepresentation” (Sep. 24, 2019).

Fee Claims Under the Investment Company Act

Another core theory in litigation is that inflated valuations have driven excessive fees for advisers under the Investment Company Act, and that an adviser faces a conflict when it receives fees measured by the value it assigns to assets, Broughel noted. Plaintiffs in a number of those cases have highlighted the steep increase in fees over the past five or six years – in one case, fees rose 100% from 2021 to 2025 – and emphasized issues with valuation processes and payment-in-kind assets.

The threshold defense is that the Investment Company Act does not give a private right of action to challenge a fund’s valuation process. Instead, plaintiffs can pursue a claim for breach of fiduciary duty as to adviser compensation, Broughel explained. Plaintiffs are framing the valuation process as part of the compensation structure, and defendants are responding that valuations are regulated by the SEC and carry no private right of action. Defendants are also arguing that complaints lack factual allegations of Rule 2a‑5 violations, and that no basis exists for claims that components of the adviser’s fee, considered in isolation, should have been calculated differently.

Regulatory Backdrop

Borrower collapses have intensified regulatory attention, as reflected in two notable instances:

• Tricolor Holdings: Pledged approximately $2.2 billion in collateral to lenders and investors despite having only about $1.4 billion in actual collateral.
• First Brands Group: Its founder and a former senior executive were charged in the Southern District of New York with wire fraud, bank fraud, money laundering and related conspiracy offenses.

JPMorgan Chase CEO Jamie Dimon warned in October 2025 that those two bankruptcies may reflect loose corporate lending standards across the industry. In a November 2025 interview, U.S. Attorney Jay Clayton shared similar concerns by calling private credit enforcement a priority for his office, stating there are “definitely some areas of concern,” and that “people should know that the financial regulators and the department are looking at those.” Those episodes are a reminder about due diligence processes and what a manager tells investors about its diligence standards, because regulators will examine that record if a portfolio develops a material credit issue, Diver reasoned.

Similarly, the SEC has made its interest in private credit explicit. In its 2026 examination priorities, the SEC’s Division of Examinations signaled continued focus on fiduciary duty, disclosures, valuation, compliance programs and retail-facing products. On March 4, 2026, the SEC hosted a Private Markets Roundtable focused on governance and responsible “retailization,” which showed that the agency had elevated private market valuation issues into an explicit policy discussion. SEC Chair Paul S. Atkins also stated in an April 2026 speech that the agency was monitoring “emerging pressures” in private credit, including elevated redemption requests and rising default-rate projections, and warned that “opacity in this space can be an issue.”

See “SEC Roundtable Examines Valuation, Structuring and Fee Issues for Retailization of Private Markets” (Apr. 2, 2026); and “SEC 2026 Examination Priorities Highlight Classic Compliance Issues, Retailization Efforts and AI Oversight” (Jan. 8, 2026).

Mitigating the Risk

Liquidity and redemption messaging remain two things investors have been very focused on, Lo said. Credit conditions themselves have not yet suggested distress by historical measures. Although non-accrual rates have ticked up, they remain well below the 10‑year average, Vazquez noted.

Managers worried about disclosure and governance can engage accounting and consulting firms to assess whether their controls are effective, Diver suggested. Under-resourced valuation governance limits independent oversight, so managers should engage an independent third party – e.g., an auditor, valuation specialist or consultant – to periodically validate key assumptions and portfolio marks. Disclosed valuation processes should also be adhered to, because deviations can support allegations of oversight failure and misleading disclosure if a fund’s NAV declines.

A further step is to outline exceptions to the manager’s valuation procedures in advance and to disclose to investors that a market downturn could produce a deviation from standard valuation policies, Diver offered. Good faith exceptions create risks that can be mitigated by disclosure, expert consultations and detailed documentation.

An earnouts clause is a provision in an M&A purchase agreement that makes part of the final sale price dependent on how well the company performs after the deal closes. Earnout provisions are common in asset management M&A because of the personal nature of the business and because “assets can just walk right out the door at closing,” explained Debevoise & Plimpton partner Jillian Mulroy Wright during a program on structuring earnouts in asset manager M&A.

Along with Debevoise partners Andrew G. Jamieson and Zachary H. Saltzman, and associate Marisa Demko, Wright explained how earnouts help align the interests of the parties on critical issues, including price, retention of key employees, client consents and the future success of the business. The panelists also discussed common disputes arising out of earnouts and how to mitigate the risk of such disputes. This article synthesizes their remarks.

See our two-part series on asset management M&A transactions: “Negotiating Deal Terms and Addressing the Assignment of Advisory Contracts” (Apr. 27, 2021); and “Role of Target and Buyer Diligence and Tips for Areas to Scrutinize” (May 4, 2021).

How Earnouts Are Used

Bridging Valuation Differences

Parties to acquisitions use earnouts to bridge differences in valuations. “An earnout is an agreement under which a payment is made by the buyer to a seller after closing if specified milestones are achieved,” Wright said. “Rather than agreeing on a fixed purchase price today, the parties defer part of the consideration until they have greater certainty about how the business performs post-closing and whether the value predicates that were set at signing have been met.”

In the context of asset management M&A, valuations are often tied to assets under management (AUM), client retention, fundraising success and retention of investment professionals. In particular, an earnout is an effective retention tool for buyers because, in many asset management deals, sellers are typically the target firm’s key investment professionals, Jamieson noted. The earnout gives the sellers an incentive to remain engaged after the closing.

An earnout shifts some risk back to the seller because the extra consideration is paid only if the specified performance is achieved, Wright clarified. At the same time, it can facilitate negotiations by providing a higher overall deal price to the seller and giving the seller the opportunity to participate in the future success of the business. It helps the seller receive the full value of the business instead of a potentially discounted price reflecting uncertainty over future performance.

Obtaining Client Consents

The Investment Advisers Act of 1940 prohibits assignment of an advisory contract without the client’s consent – and change of control of an adviser is deemed an assignment, Wright explained. Consequently, many deal terms – e.g., closing conditions and purchase price adjustments – revolve around the client consent process. An earnout can help with the client consent process by showing that current management and investment professionals will have skin in the game after closing and, therefore, an incentive to support the business.

Satisfying Indemnification Obligations

An earnout can serve as a source of funds for satisfying a seller’s indemnification obligations, especially when there are several sellers or the sellers are individuals, according to Wright.

See “Considerations When Using Earn‑Outs to Consummate Secondary Transactions During a Downturn” (Jun. 16, 2020).

Common Issues and Concerns

Although earnouts are intended to improve buyer-seller alignment, “that alignment is often imperfect and can create new conflicts that require careful planning,” Wright cautioned.

Earnout Milestones

When used to bridge a price gap, an earnout can be a source of future disputes because determining whether an earnout has been achieved in whole or in part and the cause of underperformance can be subjective, Jamieson said. Earnouts are often “bespoke and highly negotiated, which leads to a higher chance of dispute – especially when the earnout is a significant portion of the deal consideration.”

Business Integration, Plans and Efforts

A poorly designed earnout can create “tension between integration of the target business and the buyer’s broader business goals when acquiring that business,” Jamieson warned. For example, the deal may require the buyer to maintain some separation of the seller’s business from the buyer’s business to facilitate determining whether the earnout has been achieved. Additionally, if a buyer invests in the acquired business to improve its performance, it could create a windfall for the sellers who did not necessarily contribute to that improved performance.

Further, a seller might take exception with a buyer’s decision to de-emphasize the acquired business if that was not addressed as part of the deal negotiations. For example, if the earnout is tied to increasing AUM, but the buyer’s strategy is to sell high-fee or high-margin products, a dispute could arise if the seller employees who remain with the acquired firm seek to accumulate low-fee AUM during the earnout period.

Along that vein, a seller might claim the buyer’s actions improperly frustrated the seller’s ability to achieve the earnout, Jamieson continued. Alternatively, a buyer might claim that the seller’s short-term actions to achieve the earnout were not in the long-term interest of the buyer.

Employee Compensation and Retention

When an earnout is used as a retention tool, it could cause key employees to depart if it appears the earnout will not be achieved and the buyer does not offer additional compensation, Jamieson advised. A buyer in that situation might feel it is paying twice to acquire the business.

Additionally, compensation arrangements for the seller’s employees could be problematic for the buyer if they are not commensurate with their contributions to the business, Jamieson added. That could be a source of frustration for other employees.

See our two-part series on internal compensation arrangements for investment professionals: “Carried Interest and Deferred Compensation” (Mar. 15, 2018); and “Private Fund Compensation and Non-Competes” (Mar. 22, 2018).

Subsequent Sale of the Business

An earnout could make it harder for the buyer to sell itself during the earnout period, Jamieson noted. The earnout obligation could be a significant contingent liability, so the resale price could be reduced if potential buyers value the business as though the earnout were fully achieved. Additionally, litigation risk from the earnout could discourage potential buyers. The earnout might also give rise to business integration concerns for the subsequent buyer.

Mitigating Earnout Risks

Clearly Define Post‑Closing Duties

To mitigate the risk that a party may act to tilt an earnout in their favor, the parties should clearly define who has discretion to operate the company – especially as to operations that affect the earnout, Demko advised. There are several ways to structure the buyer’s post-closing duties, including:

• giving the buyer full discretion to operate the business, regardless of the impact on the earnout;
• giving the buyer discretion over operations, but prohibiting the buyer from taking steps intended to reduce the earnout; or
• requiring the buyer to use commercially reasonable efforts or best efforts to maximize the earnout payment.

The latter two options could lead to facts-driven litigation, Demko cautioned. Still, it is advisable to specify the buyer’s obligations. If the agreement is silent, a court might determine the buyer was subject to a common law duty of good faith and fair dealing – which could be a higher standard than the parties would have agreed to.

Ensure Appropriate and Precise Definitions and Formulas

“Selecting the appropriate metric for the particular business and defining it clearly is one of the most important aspects of drafting an effective earnout,” Wright opined. Typical earnout milestones in asset management are tied to AUM growth, revenues, fee income and/or fund closings.

A common source of dispute is whether an earnout milestone has been achieved and, if so, the amount of the payment due, according to Wright. To avoid that scenario, the earnout terms should be drafted and defined as precisely as possible – especially for benchmarks used to measure performance. It also helps to include a sample calculation and to ensure the contractual language matches the sample.

Another area where precision is critical is a deal where the earnout is tied to AUM or fund closings, Wright continued. For example, the parties should consider whether accounts of friends and family, or funds outside the agreed investment strategy, should be included when determining AUM. It is also advisable to use “performance metrics that are less susceptible to manipulation,” such as revenue instead of earnings, she suggested. Finally, the earnout period should be defined carefully; the shorter the period, the less likely there are to be issues over changes in key personnel or business operations.

Recent Litigation

Buyer’s Duty to Use Commercially Reasonable Efforts

Fortis Advisors, LLC v. Johnson & Johnson, a 2024 Delaware Court of Chancery case, is instructive for the multiple issues it raises regarding the standard that should apply to buyers and their commercially reasonable efforts to support an earnout.

Impeding Earnout Milestones

In Fortis v. Johnson & Johnson, the merger agreement in question required Johnson & Johnson (J&J), the buyer, to use “commercially reasonable efforts” to sell the two robotic devices it was acquiring, which were deemed “priority medical devices,” Saltzman described. The agreement included 10 factors to determine whether J&J had used commercially reasonable efforts. It also prohibited J&J from acting with the intent to frustrate the earnout.

The parties ended up in litigation over whether the seller was entitled to the earnout payments and whether J&J had used commercially reasonable efforts, Saltzman explained. J&J had put an acquired product head-to-head against an existing product, which it claimed was a “commercially reasonable” approach to improving the profitability of its robotics program.

Although J&J claimed it should be held solely to the “commercially reasonable” standard, the Chancery Court determined the appropriate standard for reaching the earnout milestones was “commercially reasonable efforts befitting a ‘priority medical device,’” he recounted. The court determined that J&J had repeatedly impeded development of the seller’s products and awarded the seller $1 billion in damages.

Standard for Commercially Reasonable Efforts

In the J&J litigation, one milestone – worth $400 million – depended on seeking approval from the U.S. Food and Drug Administration (FDA) for a certain product through the FDA’s “510(k)” approval pathway. After the merger agreement was signed, however, the FDA concluded that pathway could not be used for the product.

The Chancery Court concluded that J&J should have, but did not, use reasonable efforts to secure FDA approval through another pathway, Saltzman recounted. The Delaware Supreme Court reversed, holding that the merger agreement only contemplated use of the 510(k) process to secure approval. When that was no longer available, the Delaware Supreme Court deemed that J&J was not obligated to pursue a different approval pathway.

The litigation shows that, even when a contract is clear, when enough is at stake, the parties may see value in litigating, Saltzman noted. “Unfortunately, an earnout can be “a purchase of future litigation, even when you do it right.”

Promises During Negotiations

In Fortis v. Johnson & Johnson, Fortis’ complaint against J&J included a fraud claim based on J&J’s statements during negotiations to the effect that one earnout milestone was almost certain to be met, even though J&J knew that was not the case. “Over-promising can actually get you into trouble. You might think you’re just negotiating, but those words can come back and be the basis of a lawsuit,” Saltzman warned.

Importance of Technical Clarity

In Fortis Advisors, LLC v. Dematic Corp., which was decided by the Delaware Superior Court in 2022, the parties sought to define the earnout carefully, Saltzman said. The merger agreement provided for an earnout payment based on “Order Intake Amount,” which was tied to “Company Products,” which, in turn, referenced a schedule. However, the schedule described the products only in “extremely general terms,” according to the decision. Based on extrinsic evidence, the Delaware Superior Court determined that Company Products included buyer products that incorporated the seller’s source code, which resulted in the seller meeting the relevant earnout threshold.

Even when a contract seems clear to the parties and their counsel, they should consider whether it will also be clear to a judge or another third party trying to figure out what they meant, Saltzman advised. “Fortis v. Dematic highlights the importance of making sure the lawyers and the deal team are talking with the people who understand the underlying science or the underlying product or issue.”

Primacy of Control Provisions

In Delaware, control provisions have teeth and are enforceable through an expedited trial process, said Saltzman. For example, in Fortis Advisors, LLC v. Krafton, Inc., which was decided by the Delaware Court of Chancery in March 2026, the deal included an earnout and contemplated that seller’s management would remain in place. The buyer, however, replaced the management. The court, determining the buyer had improperly terminated key employees, rectified the issue by reinstating the seller’s CEO.

Good Faith Dealings

In Fortis v. Krafton, Krafton’s CEO allegedly used ChatGPT to develop a strategy to avoid paying the earnout and then executed that strategy, Saltzman recounted. The ploy came to light in discovery because ChatGPT searches are not privileged. “If you covenant to agree to pay an earnout, live by your covenant. But if you’re not going to live by it, don’t create a paper trail of all your efforts to avoid paying the earnout because courts are not going to like that,” Saltzman said. The three Fortis cases also suggest that courts approach earnout disputes assuming that the buyer is going to try to avoid paying the earnout, he added.

Alternative Dispute Resolution

Disputes over earnouts may be resolved through litigation, but the proceedings are costly, occur largely in public and are decided by courts that may not have relevant expertise, Demko noted. Alternatively, a contract may provide for arbitration, which is less public than litigation but may also be costly and call for the arbitrator to decide issues outside the arbitrator’s expertise. A third option is to use an accounting or other expert for complex valuations and other specified issues. Such experts, however, cannot resolve legal issues. It is also possible to bifurcate dispute resolution, with an expert addressing accounting issues and a court resolving legal issues.

See “What Fund Managers Need to Know About Arbitration of Disputes” (Aug. 30, 2022).

Tax Treatment

Earnouts are typically treated as an adjustment to the purchase price, which provides advantageous tax treatment. There are special considerations, however, when an earnout is conditioned on the continued employment of the seller’s management team, Jamieson noted. If the earnout is intended to incentivize management to contribute to the growth of the business, then buyers often argue they should not share in the earnout if they leave. Sellers typically resist that approach because payments conditioned on continued employment are treated as ordinary income rather than capital gains.

Alternatives to Earnouts

There are certain alternatives to earnouts that can help align buyers’ and sellers’ interests, Jamieson noted. For example, a buyer could purchase a majority – but less than 100 percent – of the seller’s equity, with an option to purchase the remainder based on a specified formula. The deal could also give the sellers a corresponding put right. Although that structure creates significant alignment, there are significant potential drawbacks:

• the seller’s retained share could slow integration of the two businesses;
• concerns around maximizing or minimizing the subsequent payment are similar to those for an earnout;
• negotiating put/call formulas and governance arrangements takes additional time and effort; and
• the purchase option may create an accounting liability for the buyer.

Alternatively, a deal may have a fixed purchase price and use employee compensation arrangements to address retention and alignment of interests. It may be difficult, however, for the parties to agree on a fixed price.

Although it may seem that artificial intelligence (AI) is being deployed and embedded across the entire economy, uptake by financial services firms has been modest. “While most firms have begun to engage with AI, relatively few have translated that engagement into structured, scalable deployment,” according to ACA Group’s new report, State of AI in Compliance and Operations (Report), which is based on a study it conducted in March 2026. Most firms in the study are using AI to some extent, more often in compliance workflows than in operations. This article synthesizes the key findings from the Report and the insights from a related presentation by ACA Group on agentic AI, AI-related risks and developing robust AI governance.

See our two-part series “Safeguarding Proprietary Fund Data and Intellectual Property When Using Generative AI”: Part One (Oct. 19, 2023); and Part Two (Nov. 2, 2023).

Survey Methodology

ACA Group surveyed 201 investment management firms, including asset managers (31%), private market firms (31%), wealth managers (20%), hedge funds (16%) and broker-dealers (2%). More than three-quarters of respondents were CCOs. The rest included GCs (11%), operations heads (9%) and chief risk officers (3%).

It assessed respondents’ current and anticipated adoption of AI in the following 20 compliance and operations workflows.

Compliance Workflows

1. compliance program administration;
2. compliance testing;
3. electronic communications surveillance (eComm surveillance);
4. employee compliance monitoring;
5. expert network chaperoning;
6. know your customer/investor lifecycle (KYC);
7. market abuse surveillance;
8. marketing material reviews;
9. material nonpublic information (MNPI) monitoring;
10. regulatory filings; and
11. representative management.

Operations Functions

1. cash reconciliation;
2. market data quality control;
3. net asset value validation/publication;
4. performance composite maintenance;
5. position reconciliation;
6. pricing quality control;
7. trade confirmation;
8. trade notification; and
9. trade reconciliation.

The survey distinguished AI that is embedded in a firm’s internal systems or a third-party application from what it terms “desktop AI” such as Claude or ChatGPT, explained Joseph Kochansky, head of product and engineering at ACA Group.

For another AI report from ACA Group, see “Benchmarking AI Uptake by Compliance Functions” (Feb. 19, 2026).

Wide, but Limited, Use

AI adoption “has moved beyond experimentation, but not yet into broad operational integration,” notes the Report. Adoption is “a mile wide, but an inch deep,” according to Kochansky. More than four-fifths of respondents’ firms use AI in some capacity. Additionally, nearly two-thirds use it in at least one of the 20 compliance or operations workflows covered by the study. The flip side is that more than one-third still have not deployed any function-specific AI. On average, firms deploy AI in just 1.8 of the 20 workflows. Most say they use AI in either one, two or three compliance functions.

Just a handful of respondents said their firms deploy AI across multiple compliance workflows and at least one operations workflow. Such firms are “establishing governance frameworks to support scale and moving beyond isolated use cases toward more integrated, enterprise-level capability,” the Report explains. “Success in using AI is less about technology selection and more about operating discipline. Firms making measurable progress are focused on high-impact workflows, disciplined governance, and incremental execution,” according to the Report.

Adoption Corresponds to Firm Size

The proportion of respondents that have adopted AI generally correlates to their assets under management (AUM) and headcount. At the high end of the spectrum, more than four-fifths of respondents with at least $50 billion in AUM or 1,000 employees are using AI. At the other end, just 45% and 52%, respectively, of respondents whose firms have less than $1 billion in AUM or 10 employees are using it.

Widespread Use of Desktop AI

“Many firms remain in a hybrid state where AI usage is personal rather than institutional,” which limits the potential benefits of AI to individual productivity gains, notes the Report. In that regard, a majority of respondents use desktop AI, including 32% that use it exclusively and 29% that use it along with either third-party software (20%) or internal software (9%). The most common desktop tools are ChatGPT and Copilot, which are used by more than half of respondents. Fewer use Claude (38%) or Gemini (16%).

The remaining respondents exclusively use either third-party software (30%) or internal software (9%). Notably, more than two-thirds of respondents using desktop tools also use AI in one of their compliance or operations workflows, versus just one-third of those that do not use any desktop tools. “Governance, system integration, data readiness, and workflow prioritization remain the primary barriers to scaling AI beyond isolated use cases,” said ACA Group.

See “Benchmarking Fund Managers’ Adoption and Governance of Generative AI” (Jan. 8, 2026).

AI in Compliance Workflows

Respondents have deployed AI primarily in “documentation-heavy, text-driven, or review-oriented” workflows, according to the Report. In that regard, half use it for compliance program administration. More than one-third use it for eComm surveillance and/or marketing material reviews, while 30% use it for compliance testing. Additionally, roughly one-quarter of respondents said they are planning to deploy AI in those areas. Roughly one-fifth said they use AI for employee compliance monitoring, market abuse surveillance, KYC and/or regulatory filings. On average, just 18% of respondents presently use AI in at least one of the 11 compliance functions, and an additional 15% plan to deploy it in the coming year, noted Kochansky.

See our two-part series on AI in private funds: “Emerging AI Technology and Valuable Legal- and Compliance‑Related Applications” (Nov. 16, 2023); and “Challenges, Best Practices for Implementation and the Road Ahead” (Nov. 30, 2023).

AI in Operations Workflows

There was significantly lower uptake of AI in the nine operations workflows covered by the study. At the high end, just 14% of respondents’ firms are using AI for market data quality control. About 10% are using it for cash reconciliation and/or position reconciliation. In each case, just over one-tenth of respondents are planning to deploy AI in those workflows. At the low end, just 4% and 5%, respectively, use AI for trade notification and/or pricing quality control. One explanation for the lower uptake of AI in operations is the significant cost and risk of integrating AI with existing order and portfolio management systems, accounting systems and data infrastructure, according to the Report.

AI Most Needed for Compliance Processes

Asked for their “AI wish list,” just over half of respondents said they want to deploy AI for compliance testing, which reflects its “high manual burden and its perceived suitability for AI-assisted analysis,” notes the Report. Roughly one-fifth also desire to deploy AI for eComm surveillance and/or marketing material review, which could “improve coverage and consistency without increasing headcount” or disrupting core systems, states the Report.

Other wish list items cited by at least one-tenth of respondents include:

• tools for data analytics and reporting (17%);
• automation of repetitive and/or manual tasks (17%);
• document review and policy drafting (13%); and
• due diligence and research (11%).

See “Limited AI and Alternative Data Adoption for Legal and Compliance Efforts, According to Survey” (May 1, 2025).

Navigating the Rapid Adoption of AI

Agentic AI

AI was first seen as a replacement for Google, noted Kochansky. Soon, it was being used as an assistant for drafting documents, translating and other tasks. In the last six months, AI has increasingly been embedded directly into everyday business applications.

Agentic AI inverts the model of using AI to take the first crack at a task, explained Kochansky. The AI agent itself is not actually AI. It is more of a loop. It takes a request, sends it to the user’s AI system and asks, “What’s the next step?” When the AI responds to the agent, the agent takes the action; collects the output; and sends the output to AI and asks what to do next. The loop continues until the AI deems the task completed. So-called “connectors” or “model context protocols” enable AI assistants to connect to various systems and data sources. For example, a connector could give an AI model access to surveillance systems, eComm archives and trading data for purposes of compliance reviews.

A desktop agent could create information security and compliance risks, noted Kochansky. It is difficult to control what people use them for and how they use them. For example, the agent may have access to the internet, or the user might download so-called “skills” for the agent that are of unknown origin.

Agentic AI may also be embedded in an organization’s systems, which gives the organization greater control over it, continued Kochansky. A system can provide a list of agents that can be created by the system provider or the system user. It can enable the organization to create permissions for users who are authorized to manage the agents. It can also maintain an audit trail of when each agent operated and the actions the system took.

AI agents are not just “running around everywhere,” remarked Kochansky. They have a user ID, just as humans do, and are subject to each application’s permissions and access controls. In addition to setting permissions, the organization can control the connectors to which the agent has access. Each agent is tailored for a specific task and triggered by specified events within the system. The agent will complete the assigned task and exit the relevant application. An agent may also have a “chaperoning” mode, in which the user can watch how the agent is approaching the task; correct and redirect it, if necessary; and then fine-tune the prompt.

Six Key Risk Areas

Firms must address the following unique AI-related risks, according to Joshua Broaded, co-head of global regulatory compliance at ACA Group.

1) Overreliance on AI

A firm may use AI for sensitive tasks – such as fee calculations – without validating the results. Consequently, sensitive functions should have a “human in the loop” and extensive human oversight.

2) Shadow AI

Employees may be using AI without their firms’ knowledge or in ways the firms did not contemplate. For example, employees may upload sensitive documents into AI tools, creating the risk of data leakage.

3) AI Note Takers

AI-driven note takers are ubiquitous. They create concerns about preserving attorney-client privilege; capturing and storing personal information; managing MNPI; and consent requirements for recording conversations.

4) Vendor Risk

Many vendors are embedding AI into existing tools. Such applications give rise to risks from data handling, model changes, hallucinations and incident response protocols.

See “Contracting With Vendors to Mitigate Third-Party AI Risk” (Jul. 9, 2026).

5) Data Governance

The current data control environment was set up for humans and is good at protecting against the most egregious violations. However, an organization may hold sensitive information in remote or overlooked places that AI could find. Consequently, tightly controlled data governance is critical.

6) Disclosure

Organizations must be careful to avoid overstating their use of AI – so-called “AI washing” – and failing to disclose material facts about how they are using it. AI is moving so fast that organizations should review their disclosures frequently. An annual review is no longer sufficient.

See “SEC Enforcement Actions Targeting ‘AI Washing’ Follow Familiar ESG Playbook for Emerging Areas of Concern” (May 16, 2024).

A Framework for Developing AI Governance

Regulators worldwide “are paying attention” to AI, cautioned Broaded. If a regulator asks about AI use, a firm must be prepared to respond. “I think the strongest response is going to center around culture, which is to say the CCO is at the table and shaping governance,” he said. Organizations can use the following framework to establish AI-related governance processes over a 90-day period, he suggested.

First 30 Days

Use AI

A CCO must understand what AI can do. Consequently, the CCO must use AI and learn how it functions.

Create an Inventory

An organization should create an inventory of AI uses and tools. This involves, for example, talking to people, conducting surveys and reviewing IT and procurement records.

Identify Risk Areas

An organization should identify AI “hot spots,” especially applications involving both agentic AI and sensitive data. Hot spots may include, for example, AI-generated client communications, note-taking in meetings involving MNPI, creation of marketing materials and tools that make decisions without human review.

See “CCOs Discuss the Challenges of AI Implementation and Ongoing Vigilance in a Deregulatory Environment” (Apr. 30, 2026).

Next 30 Days

Establish a Governance Team

An organization should establish a cross-functional governance team, which should probably include the CCO, the chief information security officer, the chief technology officer, the GC, HR, a data analytics leader and a senior business leader. Using the AI inventory, the organization should determine who owns what hot spot, who can make AI decisions independently and when an AI committee or team must make an AI-related decision.

Conduct Vendor Due Diligence

Organizations should ensure thorough vendor due diligence. For example, they should ask about data handling; training opt-outs; output provenance, including citations for outputs; model change notifications; transparency about hallucination error rates; and incident response plans.

See “The Importance of Exercising Due Diligence When Hiring Auditors and Other Vendors” (Jun. 21, 2018).

Create a Note‑Taking Policy

Note-taking is the most common shadow AI use. Consequently, organizations should establish a clear note-taking policy.

Last 30 Days

Track Metrics and Fine-Tune Policies

Organizations should track key metrics, including adoption trends; rates of errors and overrides; and vendor performance. They should also ensure policies and procedures are up to date and develop written processes for approving new tools and reviewing tools when there are model changes.

Conduct Training

Training is critical. “Policies and procedures are not much good if nobody knows about them,” said Broaded.

See our two-part series on compliance training: “SEC Expectations and Substantive Traps to Avoid” (Mar. 15, 2022); and “Who Conducts the Training and Five Traps to Avoid When Providing Training” (Mar. 22, 2022).

Help the Business

A CCO should try to position compliance as an “AI enabler” and “the department that helps your firm be ready for AI tools as they become available,” said Broaded. One approach is to hold “AI office hours” to make it easy for people to ask questions about AI issues – and, when appropriate, get answers on the spot.

Zhiyan Cao and Stephanie Epstein Srulowitz have joined Simpson Thacher as partners in its New York office. Cao’s expertise is centered in secondaries transactions, while Srulowitz’s practice focuses on fund formation and fundraising.

For commentary from Srulowitz, see our two-part series: “Practical Issues GPs Need to Consider Before Offering Co‑Investments” (Apr. 12, 2022); and “Potential Conflicts of Interest From Entering, Holding and Exiting Co‑Investments” (Apr. 26, 2022).

Cao advises on all types of secondaries transactions, including GP‑led transactions, continuation funds, tender offers and other bespoke liquidity solutions. She also has experience advising PE firms and corporations in M&A, joint ventures and other strategic transactions, including PE buyouts, preferred equity investments and strategic minority investments. Most recently, she served as counsel at Debevoise & Plimpton.

Srulowitz represents sponsors in the formation, structuring and negotiation of private funds, as well as in secondaries transactions, carried interest arrangements, governance structuring and fundraising-related matters. In addition, she counsels PE clients on co‑investment structures and terms. She also has experience advising institutional investors as to their investments in PE, real estate and other closed-end funds. She joins the firm after serving as a partner at Weil.

For insights from Simpson Thacher, see “SEC Reg Flex Agenda Hints at Atkins’ Deregulatory Rulemaking Priorities” (Aug. 20, 2026); and “SEC Proposes Amendments to Small Entity Definitions for Investment Advisers” (Feb. 19, 2026).