Cross-Investments: The SEC Settles with Lincolnshire Management
One of the problematic areas in private equity or real estate investing is known as cross-investments. The SEC has just settled a case that barely scratches the surface of this issue. A cross-investment occurs when a portfolio company or real estate asset is owned by two or more funds managed by the same manager. The SEC has just reached a settlement with Lincolnshire Management, a relatively small private equity firm with $1.6 billion in assets. According to the SEC, two of Lincolnshire’s funds each owned separate businesses which were eventually merged. As a result, each fund wound up owning a pro rata share of the merged company. The SEC seems to have had two questions. First, were the merger expenses allocated equitably between the LPs of the two funds? Second, did Lincolnshire have policies and procedures for dealing with the equitable distribution of expenses? No and no. As a result, Lincolnshire agreed to pay a $2.6 million penalty without admitting or denying the charges.
This is the first settlement with a private equity manager resulting from the Office of Compliance Inspections and Examinations’ investigation which was summarized in a speech by Andrew Bowden in May. Mr. Bowden, my former colleague at Legg Mason, indicated that his examiners had found a significant number of irregularities. In my experience, the SEC always finds a bunch of irregularities when it begins examining a new area of the investment world. In 1998, the SEC did a sweep of soft dollar practices and found a number of abuses among the 280 money managers they investigated. In short, there’s no surprise that some PE firms have violated SEC rules, and this particular violation, misallocating expenses, doesn’t seem a particularly egregious sin. I suspect that there are cost allocation practices used by some private equity firms that are much more troubling. For an example, see my column in the News & Observer, entitled “Raleigh company’s IPO offers look into world of private equity.”
Nonetheless, lawyers and compliance officers are going to try to figure out if there’s a broader message in the SEC’s settlement with Lincolnshire. However, a single settlement doesn’t really tell us much. At a minimum, the Lincolnshire settlement is a reminder of one standard message that the SEC has followed for decades. No matter the asset class or strategy, the SEC expects to see written procedures, and it expects them to be followed. It doesn’t take a great deal of sophistication or analysis for the SEC to figure out that procedures were inadequate and/or not followed. Thus, I expect that a great many alternative managers will be looking through their procedure manuals to see if they’ve spelled out how they deal with cross-investments.
Obviously I don’t know if the SEC is systematically looking at the practice of cross-investments. The next settlement may be in a totally different area. However, cross-investments are fertile ground because they are rife with conflicts of interest, and require extensive procedures in order to treat the LPs of each fund equitably. The typical cross-investment occurs because a manager wants to acquire an asset that is too large for any one fund. An old fund and newly raised fund both contribute capital to the acquisition. Making the cross-investment is the easy part.
However, cross-investments raise much thornier questions than cost allocation. What happens when the jointly owned company needs more capital or wants to make an acquisition? Will both the old and new fund be able to continue to maintain their pro rata shares in the company? In many cases the old fund will be at the end of its investment period or simply have too little capital. As a result the new fund will start to dilute the new fund’s ownership. What happens if the business isn’t yet ripe for sale, but the old fund is in liquidation mode? Who will buy the old fund’s interest, the new fund or a third-party? The questions go on and on, and require extensive procedures involving advisory committees, third-party valuations, and allocation procedures in order to make sure the LPs in both funds are treated equitably. The demise of the Internet bubble in the early 2000s exposed the perils of cross-investment as portfolio companies and funds scrambled for capital. The credit crisis of 2007 exposed another set of cross-invested deals to a variety of conflicting interests.
Alternative investments are a vast landscape, and the SEC’s resources are limited. I’d bet that if the SEC continues to look at cross-invested deals, it will find situations that are far stickier than Lincolnshire’s misallocation of expenses.