Diligence Lessons from Private Equity - 1 of 3

Castle Hall continues to complete an ever increasing volume of due diligence across the private equity industry - and it's an interesting journey as we encounter diligence issues across both large and small PE managers.

Three recent enforcement actions have caught our eye, which raise topics which should be considered by investors as they conduct diligence on private equity funds. We'll look at each in a short series of Risk Without Reward posts.

The first is the case of Riordan, Lewis & Hayden ("RLH"), a private equity firm based in Los Angeles that reported regulatory assets under management of $1.3 billion as of their latest ADV filed in April 2018.

RLH purchased a portfolio company, "Diabetic Care LX" (which conducted business as "Patient Care America"). Per Justice Department documents (see complaint here) this company allegedly:

"presented, false or fraudulent claims for compounded drugs to TRICARE, the federal health care program for active duty military personnel, retirees, and their families. As part of the scheme, Defendants paid kickbacks to “marketers” to target military members and their families for prescriptions for compounded pain creams, scar creams, and vitamins, regardless of need. While these products were supposed to be compounded specifically for individual patients’ needs, the formulations were in reality manipulated by the Defendants and marketers to ensure the highest possible reimbursement from TRICARE. The marketers paid telemedicine doctors who prescribed the creams and vitamins but never physically examined the patients. The marketers also colluded with the Defendants to pay many patients’ copayments to induce them to accept the compounded drugs. The Defendants and marketers then split the profits, and the scheme generated millions of dollars for them in a matter of months."

Point 1 is that allegedly defrauding TRICARE - the federal health care program for active duty military personnel, retirees and their families - sounds like a particularly bad idea.

Point 2 is directly related to diligence: amongst those indicted were not only the CEO and President for Operations of Patient Care America ("PCA") - but RLA, the PE firm which owned Patient Care as a portfolio company. Per the Justice Department, "At all relevant times, RLH managed and controlled PCA on behalf of the private equity fund through two RLH partners, Michel Glouchevitch and Kenneth Hubbs, who served as officers and/or directors of PCA and of a holding company with an ownership interest in PCA."

In this instance, therefore, the asset manager is facing a lawsuit as a result of events at a portfolio company. We do not have any direct knowledge of RLH or this specific investment: however, in general terms, various questions arise:

• In this case, the government has sued RLH (the investment manager / general partner), not the relevant RLH fund which actually owns the investment. However, was this a deliberate legal strategy - or is there a potential that a future, similar case could ensnare the fund and therefore create liability for investors?
• We would anticipate that the relevant fund documents provide a blanket indemnity for the fund manager - except in the event of wilful default, gross negligence and fraud. However, it is a puzzling question to consider whether the managers' activities at the portfolio company level definitively fall within this liability exclusion.
• Typical indemnification clauses allow for the manager to use fund assets to pay for their legal defence until a final adverse opinion, which cannot be subject to further appeal. Is there a potential for fund investors, in this type of case, to have assets diverted to pay for ongoing legal defence (noting that it can take many years before cases are resolved)
• Are investors fully aware of the degree to which asset manager executives serve as directors of portfolio companies? Are there other areas where actions resulting for appointment of an asset manager executive as a director of a portfolio company could potentially "spill over" to the fund? What would happen, for example, if a portfolio company's directors are found instrumental to the creation and operation of a "Double Dutch Sandwich" tax evasion scheme?
• Given extensive use of "operating partners" and similar consultants, is there any potentially liability if a PE firm essentially controls the activities of the operating partner, even when he / she is not a direct employee of the PE manager?

Traditional operational due diligence has "stopped" at the PE asset manager, with no additional work conducted on the underlying portfolio companies. In discussions with several large investors, however, we are seeing an increase in appetite to "look through" the manager / GP / fund to the assets which are actually owned by the investor.

The phrase "reputational due diligence" comes to mind - do investors actually know what each portfolio company does? As an investor, how can we be sure that there are no companies within our overall portfolios which are potentially engaged in inappropriate activity?