Scandal (and I don’t mean HP)

The SEC has received a temporary restraining order against AA Capital Partners, after alleging that the Chicago-based private equity firm had misappropriated at least $10.7 million from its six union pension fund clients. More specifically, the SEC charges that AA Capital used the fraudulent guise of capital call-downs to cover such expenses as private jet rentals, Super Bowl tickets, donations to political candidates and the operations of a Detroit strip club (you just can’t make this stuff up).

Those unfamiliar with AA Capital probably just assume that it is some boiler room that preyed on unsophisticated pension funds – like a private equity version of the Nigerian email scam. But AA Capital is anything but fly-by-night, having been formed in 2001 as a spinout from ABN Amro Fund Investment Group. It has more than $194 million in committed capital, which is supposed to be disbursed for both fund-of-funds and direct investment activities.

Some of the money has indeed gone where it is supposed to, with fund commitments to: Charterhouse, ComVentures, De Novo Ventures, Evergreen, Gabriel Venture Partners, Leonard Green & Partners, Mission Ventures, Quantum Value Management, Sterling Partners, The Jordon Co. and Veritas Capital. Its direct portfolio includes a number of hotel, casino and housing projects, plus a music publishing company.

But it’s the other money that the SEC takes issue with. AA Capital in 2005 generated around $2.02 million from its 2% management fees, but apparently had more than $7.15 million in “operating expenses.” Guess who was allegedly tricked into paying the difference?

From an SEC summary of the complaint (which can be found here in its entirety):

AA Capital withdrew at least $5.7 million from its client trust accounts in more than 20 separate installments and sent the client funds to various accounts [AA managing partner John] Orecchio designated, including those of a Michigan horse farm owned by Orecchio and a company that manages a Detroit strip club. The complaint further alleges that Orecchio told AA Capital’s CFO that the withdrawals were needed to reimburse him for what he claimed was a miscalculation of taxes he owed relating to at least one of AA Capital’s affiliated private equity funds. The Commission’s complaint also alleges that, during 2005, AA Capital misappropriated at least $5 million in client funds to cover the shortfall between its revenues and its operating expenses. The complaint further alleges that AA Capital misrepresented the nature of the withdrawals by sending monthly account statements to its advisory clients that falsely characterized the withdrawals as “capital calls” on the clients’ existing investments.

The SEC pins the original sins on Orecchio, but also claims that other firm executives maintained the fraud after learning about Orecchio’s misdealings. In fact, Orecchio was not suspended until after the SEC had presented its findings to AA Capital, and he remains on the firm’s website as one of three managing partners. Moreover, he still has 50% ownership of the firm and equity stakes in its funds. Fellow managing partner Paul Oliver directed by questions to in-house marketing director Jennifer Pedigo, but she did not return my voice mail message.

These are very serious charges, and the court already has put law firm Barack Ferrazzano in temporary charge of AA Capital’s operations. I can understand – albeit not condone – why Orecchio did what he is alleged to have done. He didn’t respect his fiduciary duties, nor did he respect his partners. What I cannot understand, however, is why those partners did not immediately throw Orecchio out the door once they found out, or at least resign themselves. And there is an outstanding question as to how a firm of this size had so few financial controls that Orecchio was so easily allowed to divert cash into inappropriate accounts.

I’ll keep tabs on this, and report in when there are new developments. Perhaps AA Capital has a reasonable defense, and the SEC has gotten its facts wrong. But I doubt it.