Recent alleged fraud in the funds finance sector

News broke recently of a private equity fund manager in the US allegedly fraudulently making up investor subscriptions for two investors, and the impact that would have on a capital call facility extended to the fund. Elsewhere a purchaser of copper was surprised to find worthless copper-coloured stone and concrete in its place when the shipment arrived from Turkey. At the end of day, the risk of forgery/fraud will always be present in any commercial transaction. Due diligence will often go some way to mitigate this and of course the age old adage of knowing who you are dealing with.

Due diligence undertaken varies depending on the fund/lender and the relationship between them but may comprise the following: reviewing signed subscription agreements/fund documents, obtaining a list of investors and their commitments from the fund manager/GP, certified true copies or a directors’ certificate confirming any of the foregoing, a legal opinion from fund formation counsel on due establishment of the fund and/or investor letters. Could a determined fraudster magic up any of these? Most definitely – although a legal opinion might be harder to forge. In the absence of investor letters addressed to the lender (which has been the exception rather than the rule for a number of years in the funds finance sector), reference to investor side letters in fund counsel legal opinions may provide an additional source of indirect confirmation of the existence of such relationships.

However, the nature of funds finance may confer an advantage over financing in other sectors, such as trade & commodity financing structures where the secured assets move around and turnover during the life of the financing. In contrast, turnover of investors in private funds is low, and investor commitment documentation is designed as an ongoing contract between investor and fund through the life of the fund. Due diligence will typically be carried out on incoming investors if they are to be included in the borrowing base during the life of a financing. Security documentation is designed to protect lenders from any investor exiting a fund (and cancelling its LP commitments) without prior lender consent. The funds finance sector has also reviewed and evolved its documentation and processes in connection with more unusual circumstances, such as release of investor funding obligations by a general partner in the manner reported to have occurred in connection with the former Abraaj funds. It will be interesting to see if much changes in the funds finance space as a result of this – what more could a lender do?