The subscription credit line market is taking stock after Silicon Valley Bank disclosed it was the victim of an alleged fraud perpetrated by one of its clients, Miami-based private equity fund manager JES Global Capital, in late February.
The case, the first in which a borrower is alleged to have fabricated commitments, underscores a weak point in the market’s due diligence processes. Lenders rely on information provided by managers to underwrite their subscription lines and to monitor their performance, but it is LPs that are ultimately on the hook, since their commitments form the collateral. “The bottom line is that there is no direct contact by the bank with investors in the vast majority of these transactions,” said one market participant.
In this instance, which market players are saying is the first case of fraud in the US sub line business, Elliot Smerling, of Florida-based mid-market private equity manager JES Global Capital, is accused of forging subscription agreements totaling $85 million from two institutions, as well as an audit letter attesting to the audited financials of the fund, and falsifying bank records attesting to a $4.5 million wire transfer from one of the institutions to JES’s private equity fund.
That fund was identified by its subscription credit lender, Silicon Valley Bank, in its regulatory filings as JES Global Capital III.
The subscription market isn’t used to credit losses of significance. There have been only a very small handful of reported institutional defaults on capital calls, and sub line lending has become a business built heavily on relationships.
“The market has definitely moved to a position where there is a little bit more of a trust factor involved,” said one sub line banker. “You’re not validating individual investor commitments, which used to be part of more standard operating procedure.”
In an increasingly relationship business, banks often rely heavily on the quality of the manager, and of its compliance and operational structure, with some banks not checking individual LP commitments at all, and others doing so only for smaller and newer managers, the banker said.
But, as the first market player said: “There’s no reason why this couldn’t happen with a larger, well-known manager.”
SVB, which some fund managers call “the bank for private equity”, stated in a regulatory filing that it had $70 million in credit exposure, net of taxes, to the client via a capital call line. A complaint lodged by prosecutors says JES took out a $95 million line with SVB for the $500 million fund in December.
The two institutions whose commitments were allegedly forged remain unidentified. One is the endowment fund of a Manhattan-based university, and the other is the investment management division of a Manhattan-based banking and financial services firm. Smerling allegedly forged the signatures of the CIO of the endowment fund and the chief executive of the of the investment manager.
It isn’t clear if any of the other fund assets were fabricated. JES Global Capital III’s most recent Form ADV shows it had a gross asset value of $561,833,988 as of 20 March 2020.
Should it come to light that other investors commitments in the fund weren’t fabricated, the remaining LPs would potentially be on the hook for any missing commitments. Standard documentation in sub lines holds remaining LPs liable for stepping in if other LPs default on their capital calls.
Approximately $80 million of the $95 million in loan proceeds from SVB are currently unaccounted for, according to the complaint. Smerling agreed at his 3 March hearing to pay the $80 million to SVB by end-April, and court records state he already repaid the bank $15 million.
The credit line was meant to refinance one taken out from Sumitomo Mitsui Banking Corporation. While SVB wired the $95 million in loan funds to SMBC, according to the complaint, it isn’t clear whether any of the money was actually used to repay outstanding draws on the facility.
Smerling’s 3 March hearing was first reported by the Miami Herald. He was arrested in late February in Florida on charges of wire fraud and aggravated identity theft, and could face more than 30 years in prison if convicted on both charges. He is being detained on the weight of evidence against him and because of the risk of flight. Smerling and his wife both have US and Brazilian passports.
According to the complaint, Smerling and JES were not clients of the auditor from which he allegedly falsified an audit report. The CIO of the endowment had never heard of him or the fund and did not wire the $4.5 million investment referred to in the charges, and it is “highly unlikely” that the signature of the chief executive of the New York investment manager is legitimate, the complaint said. The investment manager “found no indication” that it had wired $4 million reflected in a bank statement provided by Smerling to SVB, either.
SVB, which saw record demand for subscription lines in the last quarter of 2020, recently boasted zero net losses on capital calls since its inception in the 1990s. SVB said in its last quarterly report that capital call line demand has been its largest source of loan growth in the last seven years. Such loans represent 96 percent of SVB’s approximately $25.54 billion Global Fund Banking portfolio, which itself comprises 57 percent of the bank’s total loans, according to its Q4 reports.
SVB declined to comment, as did the FBI special agent who requested a warrant for Smerling’s arrest. JES, a lawyer for the defendant and the US Attorney’s Office for the Southern District of New York didn’t respond to calls and emails seeking comment. SMBC declined to comment, saying it was cooperating with law enforcement.
The case has the market shaken. Not only was the sub line taken out for JES’s third fund in the series and a refinancing, but people familiar with the matter say that in past years, a number of banks had declined to lend to the firm because of unspecified peculiarities in its subscription documents, which include basic details of a manager and its funds’ commitments, payment instructions and tax information.
Unsurprisingly, SVB appears to be reviewing its subscription line exposure in detail. One client said their firm recently received a request by the bank asking when the firm expected to do its next capital call, which the person said was highly unusual.
But other banks are also reviewing their due diligence processes, and some in the market think the case could lead to increased pricing on lines or even a drying up of liquidity for some borrowers as lenders determine where there are weaknesses in their programmes. One risk officer at a sub line-lending bank said he was unsure how the bank’s due diligence process would be adapted in light of the news, but that he was considering increased spot checks, as well as potentially more robust documentation.
It isn’t the first fraud experience by the private equity industry or its lenders. In 2018, Abraaj, then the largest private equity firm in the Middle East, began its descent into collapse. Investigators would later find that the firm and its management had falsified their funds’ values and misappropriated hundreds of millions of dollars in investor funds. Along the way, Abraaj investors defaulted on subscription credit lines with two lenders, including Société Générale.
This article first appeared in sister publication Private Funds CFO