Private Equity as the Latest Example of SEC Enforcement Cowardice?

One of Teddy’s Roosevelt’s famed sayings was “Speak softly and carry a big stick.” The SEC seems to be hoping that speaking loudly and brandishing a water pistol will be as effective.

As we’ve written, the securities regulator made an impressive initial salvo at the private equity industry. The first was Mary Jo White describing industry abuses in surprisingly specific detail in Congressional testimony. That was followed shortly by SEC official Andrew Bowden giving a simply stunning speech in May. Bowden described more than half the firms in the industry as engaging in what amounted to embezzlement or other serious compliance violations and depicting at length the sort of troubling behavior the SEC was unearthing.

Normally, when the SEC is that pointed in calling out abuses, it means the agency is about to send out Wells notices, which are official warnings that an enforcement action is imminent. But here it is, five months later, and the agency has been walking its tough talk back. What gives?

The agency appears to be hoping that if it makes enough noise, the investors, as in limited partners, will do a better job of negotiating their agreements with and supervising the private equity funds, aka general partners. That is a fantasy. First, the private equity kingpins have a lock on the best law firms in the US. The limited partners are at a negotiating disadvantage even if they did want to stand up for themselves.

Second, the investors are intellectually captured and cowed. They believe they need to be in private equity for its supposedly superior returns (see our post debunking that notion). Thus, if they rock the boat by asking for better terms, they fear they won’t be invited into future deals. Now this is a collective action problem; you’d think enough big public pension funds are in the same boat that this issue would be solvable (as in if a few perceived leaders got together, it would be hard for general partners to say no). But perversely, that hasn’t happened yet.

Third, the employees at public pension funds are personally afraid of challenging the general partners. While some may labor under the delusion that they might land a job at a private equity firm, I’m told that the more common reason for failure to challenge the general partners is that employees are afraid that the funds would interfere with their future job prospects if the staffers were to cross them. That sounds highly unlikely in practice, but it is hardly uncommon for people to be afraid of things that are extremely improbable (start with death from Ebola in the US….).

So if the SEC wants things to change in private equity in a meaningful, as opposed to cosmetic manner, it needs to man up and engage in some enforcement actions. However, its first case is far from encouraging.

Last month, the SEC settled with a firm pretty much no one ever heard of, Lincolnshire Management, which has $1.7 billion under management. The settlement resulted in charges of $2.3 million against Lincolnshire: $1.5 million in disgorgement, roughly $350,000 in interest and $450,000 in fines. Oh, and most important, no admission of wrongdoing.

On the one hand, this settlement isn’t a product of the SEC examination process now underway; the violations took place before Lincolnshire became a registered investment advisor. This case almost certainly came out of a whistleblower filing; the SEC is highly unlikely to find out about portfolio-level accounting issues any other way. That means this case was handed to them somewhere between 50% and 95% done.

The settlement may serve as an early indicator of the posture the SEC is likely to take with the private equity industry, particularly in light of its climbdown even on merely talking tough. And the probable involvement of a whistleblower means that this would have been a lot easier for them than other matters they are investigating. We’ve embedded the SEC’s enforcement action below.

Remember, settlements are similar to plea bargains: the party in the hot lights agrees to lesser charges, which saves the prosecutor/agency the effort of pursuing the case and filing charges (although also note that for certain abuses, the SEC can levy fines and sanctions without going to court).

Let’s look at some media accounts of the conduct cited in the settlement. First, from Fortune’s Dan Primack, arguably the lead reporter dedicated to the private equity beat:

Here are the details: In April 1997, Lincolnshire acquired a hard drive repair company called PCS Inc. through its debut fund. More than four years later, it acquired a complimentary company called Computer Technology Solutions — with the intention of merging it with PCS. But Lincolnshire’s first fund was out of money at that point, so it funded the CTS acquisition via its second fund (raised in 1999).

Such comingled investments can be tricky, particularly given that each fund has at least a slightly different investor base. So Lincolnshire developed expense allocation policies — including annual management fees to be paid directly to Lincolnshire — that were shared verbally with management of both companies. In short, each company’s allocation would be based on the percentage of its contribution to the combined platform’s overall revenue. But the policies somehow never were formalized in writing, thus leading to occasional misallocations. For example, PCS “paid the entire third-party payroll and 401(k) administrative expenses for employees of both companies.”

Each company did undergo regular audits, but it is unclear if the auditors were fully aware of the allocation expectations.

Bracewell & Giulini gets more nitty-gritty about the accounting, um, mishaps:

The SEC cited several instances in which Lincolnshire breached its fiduciary duty to its funds:

In certain instances, Lincolnshire misallocated or failed to document shared expenses, resulting in one portfolio company’s overpayment of expenses that benefitted both companies. For example, a portfolio company of Lincolnshire Equity Fund paid the entire third-party payroll and 401(k) administrative expenses for employees of companies held both by Lincolnshire Equity Fund and Lincolnshire Equity Fund II.

Although Lincolnshire developed an expense allocation policy, the policy was not uniformly implemented. Additionally, Lincolnshire did not provide any written guidance regarding the expense allocation policy, and neither portfolio company entered into any written agreements relating to the allocation of expenses or the companies’ rights and obligations.

Certain employees performed work benefitting both companies, but salaries were not properly allocated as required under Lincoln’s expense allocation policy.

One of the portfolio companies’ foreign subsidiaries performed services and sold supplies to the other portfolio company at cost, but the portfolio company receiving such services and supplies did not contribute to the general overhead costs of running the foreign subsidiary.

As Bracewell & Giuliani points out, the charges are “arguably immaterial” as in a wrist slap. And Lincolnshire can say they admitted to nothing and that all the SEC fined them for was being at worst sloppy.

The problem is that if you read the settlement closely, you’ll see that these bookkeeping errors all operated in the same manner, to shift costs from the company owned by the newer fund, CTS, to the one owned by the older fund, PCS. What are the differences in the financial arrangements between the two companies and the two funds?

First, both companies paid $250,000 a year to Lincolnshire in consulting fees. However, Lincolnshire had agreed to offset half of that amount, or $125,000, in the newer fund, the one that owned CTS. Moreover, prior to the sale of both companies, PCS appears to have owed Lincolnshire $1 million in annual consulting fees for the years 2001 to 2004, when PCS didn’t have enough in income to pay Lincolnshire its annual levy. That would seem to argue for shifting costs the other way, to the company that would pay more net in consulting fees to Lincolnshire, but only if PCS looked likely to come up short on income again. That didn’t happen even with it taking more than its fair share of the freight after they were largely integrated, in 2005.

It is not at all clear how you get to $1.5 million of disgorgment from this picture. The other red flag is this:

When PCS and CTS were sold in January 2013, PCS’s and CTS’s then-existing executives were paid transaction bonuses. LEF, which owned PCS, paid 10% of the transaction
bonuses of two executives who were solely CTS employees.

Query whether either of these CTS employees has been presented to investors as members of the Lincolnshire team but their costs shifted on the portfolio company CTS.

The point is this yet again illustrates the problem of these “no factual admission” settlements. Here we at least get “mistakes were made” details, but the mistakes all going in the same direction creates the strong impression that there was no mistake. And mind you, even though this isn’t a big ticket case, Lincolnshire has gotten into hot water with investors before. From Forbes,

This is not the first time that Lincolnshire has had to deal with accusations of improper expense management. In 2011, Lincolnshire’s investors sued the private equity firm, saying it had avoided paying investor distributions by wrongfully deducting fees, expenses and interest connected to a $99 million legal victory a portfolio company had obtained. The case remains pending.

So if Lincolnshire really was up to something less than kosher with the PCS and CTS “mistakes,” that disclosure would have been helpful to these private plaintiffs.

One can reasonably argue that Lincolnshire was too penny-ante a case for it to be worth it for the SEC to pursue. But one can just as easily point out the reverse: that the SEC has gotten to be in the business of taking cases only so far and settling, and that includes letting its targets off with virtually nothing in the way of admissions.

The fact that even small firms on small matters are getting away with this sort of treatment is a worrisome sign. If the SEC’s posture is that it is not going to chase big guys too hard because they’ve got the agency outgunned, and the SEC won’t pursue small guys aggressively because they are too penny-ante to be worth hounding, then what pray tell are they going to go after? Despite all the private equity saber-rattling, its posture appears to be that it is content to let inmates continue the asylum provided they are willing to play along with occasional exercises in enforcement theater.

Lincolnshire-SEC-settlement
Lincolnshire SEC settlement