Those involved in the private equity industry will have seen the recent reports of an alleged fraud on a U.S. bank by a Florida-based private equity fund manager, the accusation being that subscription agreements with LPs, as well as an audit letter, were forged by an officer of the fund. A subscription line provided by the bank on the back of the forged documents was then drawn down and reportedly $80m of the $95m drawn is missing.
As lawyers acting for a wide range of banks and borrowers on subscription line financings (also known outside the U.S. as capital call facilities or commitment bridge facilities), we are very familiar with harnessing the very best cross-border legal skills to devise and document practical and robust structures to provide lenders with a security route to the undrawn LP commitments that support the lenders’ risk exposure. But even if legal risk is eliminated there is of course the credit risk that the LP cannot fund its commitment when called upon. And then, as the Florida case illustrates, there is the fraud risk - that the supposed LP commitment does not actually exist.
What will be the reaction to this case?
- Some lenders may reappraise private equity fund fraud risk. In our view, this is unlikely to reduce the appetite to lend. However:
- There is an increased chance that, at least in some cases, lenders will require their due diligence to involve more direct contact between the lender and LPs
- Generally, the less long-established funds in particular may find that due diligence carried out on them is slower and consumes more of their time
- The Florida case will give lenders, investors, and auditors, among others, food for thought about appropriate due diligence
Fraud, like death and taxes, will always be with us, and no industry is immune. In the long run, the occasional sharp reminder of this truth is a healthy thing.