The Securities and Exchange Commission has been making lots of noise about how its unhappy with how private equity firms are allocating expenses to portfolio companies. And it has finally hit its first target. The SEC charged a a private equity fund manager with breaching its fiduciary duty to a pair of private equity funds by sharing expenses between a company in one fund’s portfolio and a company in the other fund’s portfolio in a manner that improperly benefited one fund over the other.
Lincolnshire’s Fund I bought Peripheral Computer Support, Inc. in 1997. PCS primarily serviced and repaired computer hard disk drives. In 2001, PCS thought an acquisition of Computer Technology Solutions Corp. would be a great strategic acquisition. CTS serviced and repaired laptop computers and handheld devices.
But by 2001 Fund I’s commitment period had expired. So Lincolnshire had Fund II acquire CTS. Lincolnshire integrated PCS and CTS together and sold them together in 2013 to a single buyer.
Commingling investments across different funds is tricky. You need to be concerned about different expectations for investors in the different funds with different investment horizons for the exit. Operationally, you need to be careful how fees and expenses are allocated to treat each fund fairly.
Lincolnshire did set an unwritten policy where it tried to treat each fairly. Generally, shared expenses were allocated based each company’s revenue. So, PCS, the smaller company, paid 18% of the shared expenses. However, PCS and CTS had no written agreements about how to share expenses or the company’s rights and obligations toward each other.
Even though the revenue-basis sharing was the general practice, there were variations. Lincolnshire failed to document why some shared expenses were allocated differently.
Lincolnshire was in a tricky situation and mishandled it.
The SEC based its enforcement action on a violation of Section 206(2) as a “transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.” The SEC is quick to point out that a violation of 206(2) can be based on a finding of simple negligence. The SEC does not need to prove scienter.
The SEC made no charges that Lincolnshire benefited from the misallocation. The SEC makes no charges that either Fund I or Fund II was harmed by the misallocation. Although, presumably, Lincolnshire did benefit and one fund did end paying more than its fair share of expenses.
The SEC merely charges that Lincolnshire was negligent in not having a written policy on the allocation of expenses and not following that policy.
Without any charges that it intended to defraud its investors, Lincolnshire has to pay $2.3 million to the SEC.
Private equity fund managers should take this as a warning to properly document investments combined across more than one fund and to take extra steps to ensure that they are treating each fund fairly.
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