Highlighting its focus on private equity fees and expenses, the SEC announced on September 22 that Lincolnshire Management, Inc. (Lincolnshire) has agreed to pay more than $2.3 million to settle charges that it breached 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 benefitted one fund over another. The $2.3 million that Lincolnshire has agreed to pay to the SEC consists of a disgorgement of $1.5 million, prejudgment interest of $358,000 and a civil penalty of $450,000.
Lincolnshire Equity Fund, L.P. (Fund I) acquired Peripheral Computer Support, Inc. (PCS), in 1997, and Lincolnshire Equity Fund II, L.P. (Fund II) acquired Computer Technology Solutions Corp. (CTS) in 2001. Upon the acquisition of CTS, Lincolnshire disclosed to limited partners of both funds that it intended to integrate certain business and administrative functions of PCS and CTS (or, as the SEC put it, to “comingle assets”). After integrating the companies, Lincolnshire sold them together in 2013 to a single buyer.
In accordance with an unwritten policy, Lincolnshire allocated any shared expenses between the companies based on each company’s proportional revenue. Although Lincolnshire generally followed this unwritten policy, the SEC found that “there were times when the shared expenses were misallocated and went undocumented.” According to the SEC, these misallocated expenses included:
- 401(k) administrative expenses for employees of both companies,
- salaries of shared employees,
- costs of shared services provided by a PCS subsidiary, and
- bonuses to executives who were solely employed by CTS.
Based on these deviations from Lincolnshire’s policy, and its failure to document any basis for the deviations, the SEC claimed violations of Section 206(2) of the Investment Advisers Act of 1940. The SEC alleged that Lincolnshire, a registered investment adviser, caused PCS to pay “more than its share of certain expenses that benefitted both companies.” According to the SEC, this misallocation constituted a breach of Lincolnshire’s fiduciary duty to Fund I and Fund II, and therefore Lincolnshire engaged in a “transaction or course of business which operates as a fraud or deceit upon any client or prospective client.”
In addition to Lincolnshire’s misallocation of expenses, the SEC complained that Lincolnshire had no written policies or procedures in place to address the integration of PCS and CTS (citing Section 206(4) and Rule 206(4)-7 thereunder, which require registered investment advisers to adopt and implement “written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules”).
The SEC recently has increased scrutiny of private equity firms’ collection of fees and allocation of expenses. Andrew J. Bowden, director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), said in a May 2014 speech that when OCIE examined how fees and expenses were handled by private equity fund managers, OCIE identified what it believed to be “violations of law or material weaknesses in controls” more than 50 percent of the time. The violations included fees and expenses directly levied on fund investors and those charged by private equity firms to the companies they owned, Bowden said.
This case should serve as warning to registered investment advisers who have integrated portfolio companies across two or more private equity funds (or who may so integrate in the future) to:
- have in place prepared written policies and procedures that specifically address the integration of portfolio companies;
- carefully allocate expenses pursuant to those policies and procedures; and
- carefully document any deviation from such policies, including a detailed description of how the deviation is in the best interest of the relevant private equity funds.
Note also that Lincolnshire was not registered until 2012, and the misallocations took place from 2005 to 2013. Advisers should address actions that implicate fiduciary duties regardless of the adviser’s registration status at the time, and take affirmative corrective or remedial measures as appropriate.