Skin in the Game

Limited partners prefer that a private fund manager have an equity stake in the fund.  In the past, the general partner had to put in equity to make sure the fund qualified as a partnership under tax law. The change in the tax law categorization by the check-the box regulations removed the multipart test to determine if an entity should receive partnership or corporate tax treatment. That effectively ending the tax driven decision that the general partner have a significant ownership interest in the partnership.

A secondary benefit from the general partner’s equity stake was that the fund manager’s economic interest was better aligned with the limited partners’ interests. If the fund took a loss, the general partner also experienced the loss.

A recent SEC case focused on a fund manager’s false claim of having “skin in the game.” Quantek Asset Management represented to prospective investors that its principals had invested their own money in the private funds. Quantek, Bullick Capital, Javier Guerra, and Ralph Patino each settled the charges, but without admitting or denying the findings. I’m treating the findings as true for educational purposes, hoping to find some lessons from this SEC enforcement.

The Alternative Investment Management Association’s standard Illustrative Questionnaire for Due Diligence Review of Hedge Fund Managers asked two questions about “skin in the game”:

  1. What is the total amount invested by the principals/management in the fund and other investment vehicles managed pari passu with the fund?
  2. Has the management reduced its personal investment?

In December 2006, Quantek answered question with $13 million. In later questionnaires that amount was reduced to $10 million, then in June 2007 it went down to $10 million, and in December 2007 fell to $7 million. In each instance the answer to question 2 was “no”.

The SEC says that the correct answer to question 1 was always zero. The principals had not invested any capital in the funds. In their defense, Quantek claims a misunderstanding that they thought some unrelated investments should have been credited as being made pari passu with the funds.  Quantek finally got the amount right in June 2009 when it finally answered no to question 1.  By this point, Quantek had obtained almost $1 billion in assets under management.

In addition to the due diligence questionnaires, Quantek also entered into side letters that limited the ability of the principals to reduce their fund ownership by more than 20%. Such a provision does not make any sense if the principals do not have any fund ownership.

In addition, the SEC found two other areas of failure. Quantek misled investors about certain related-party loans made by the fund to affiliates of Guerra and Bulltick. Second, Quantek  repeatedly failed to follow the robust investment approval process it had described to investors in the fund. Quantek concealed this deficiency by providing investors with backdated and misleading investment approval memoranda signed by Guerra and other Quantek principals.

Quantek and Guerra agreed jointly to pay more than $2.2 million in disgorgement and pre-judgment interest, and to pay financial penalties of $375,000 and $150,000 respectively. Bulltick agreed to pay a penalty of $300,000, and Patino agreed to a penalty of $50,000.Guerra consented to a five-year securities industry bar. Patino consented to a securities industry bar of one year.


Image of the Petronas Towers is by Magnus Manske

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