How due diligence could have stopped an arrow through the heart

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These stories, thankfully, don’t come along too often. But they do come along. Here’s an entertaining – assuming you weren’t an investor – example of greed, hubris and a lavish lifestyle. And what better place to bring those factors together than in California?

In its latest client note, Castle Hall, the global due diligence firm, paints an interesting picture, which, intriguingly, has a lot to do with the ancient art of archery. This is the firm’s full note :

Castle Hall, recounts that the Security Exchange Commission (SEC) of the US charged Stuart Frost, and his investment advisory firm Frost Management Company, LLC, with fraud and breach of fiduciary duties for charging over US$14 million in undisclosed and excessive incubator fees to start-up companies.

As per the SEC’s complaint: “When Frost needed more cash to fund his lavish lifestyle, including a personal chef and housekeeper, an archery range, beach club membership, a boat, and luxury cars, he created new start-up companies, invested more fund capital in them, and then used Frost Data Capital to extract additional incubator fees.”

Frost provides an interesting example for investors. Alex Wise, Castle Hall’s Sydney-based representative says: “The risks of related party transactions and, especially in the private equity / venture capital space, the risks of fraud and collusion between the manager and underlying portfolio companies are real. If true, these actions are rare, however the governance structure that presides over them (that is, minimal external oversight) is one that we see frequently with these types of funds.”

So, what happened next? As per the SEC: “From 2012 through 2016, Frost Management Company, LLC (FMC), an investment advisor to five private venture capital funds, and its sole owner, Stuart Frost, defrauded the funds and their investors of over US$14 million by charging undisclosed and excessive incubator fees to start-up companies in which the funds invested, in violation of their fiduciary duties as investment advisors.

The SEC said: “During that five-year period, Defendants raised nearly $63 million for the funds, mostly from high net worth individuals and trusts. The funds were invested in a portfolio of start-up companies (portfolio companies), using the so-called ‘Frost incubator model’, in which a Frost-owned company, Frost Data Capital (FDC), purportedly provided operational support and other services to help “incubate” the portfolio companies in anticipation of those companies maturing and ultimately being sold or acquired by another company. In return for those support services, the portfolio companies paid incubator fees to FDC.

“In reality, a significant portion of the incubator fees charged to the portfolio companies was used to cover FDC’s overhead and to pay Frost’s exorbitant salary and extravagant personal expenses. When Frost needed more cash to fund his lavish lifestyle, he created new portfolio companies and, after investing more fund capital into the new companies, FDC then extracted even more incubator fees.

“At the same time, Frost and FMC failed to disclose to the funds either the existence of or the actual amount of incubator fees being paid by the portfolio companies, and also charged the funds undisclosed and improper management fees.”

– G.B.

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