Lone Star Funds — Errors in the implementation of vertical integration

On September 12th, 2022, the United States Securities and Exchange Commission (“SEC”) entered into a Settlement with Hudson Advisors L.P. and Lone Star Global Acquisitions, Ltd. (“Lone Star”), a vertically integrated real estate manager based in Texas.
During a period between 2005 and 2017, Lone Star inappropriately included its founder’s tax liability as part of its cost basis for certain services it provided its funds.
According to the Order, Lone Star identified the mistake before contact with the Commission, repaid the misallocated funds with interest, and informed investors. In addition, Lone Star agreed to pay a $11.2 million civil penalty to settle the matter.

Lone Star’s Limited Partnership Agreement allowed it to charge the funds for “ancillary and underwriting services” on a cost-plus basis.
Typically, costs include salaries, bonuses, benefits, and other indirect costs but Lone Star inappropriately included the founder’s tax liability as part of its cost calculation. As a result, investors overpaid $54.6 million over the affected period.
- Analysis:
  - Cost recovery is one of three ways to implement vertical integration and is the most difficult and error-prone to execute. While this conduct has particularly troublesome optics, these types of mistakes are common.
  - The most two common errors in cost recovery calculation are time tracking/allocation errors and inaccurate cost basis calculation. The latter appears to have occurred at Lone Star.

Vertical Integration Is Error Prone: There are three general approaches to vertical integration: (1) cost recovery (2) market rate; (3) asset-based fee.
1. Cost Recovery – This is the first step for managers becoming vertically integrated. This is because investors are most likely to agree to a cost recovery method to allow the manager to provide services normally provided by third parties. This is also the most error-prone approach because it requires accurate time tracking and cost calculation.
2. Market Rate – This approach requires the manager to provide services “at or below market rate”. While this is less error-prone than the cost recovery method, it recovers regular benchmarking which can be challenging to execute.
3. Asset Based Fee – In this method, the manager charges an extra “services fee” calculated based on the assets of a fund. This is the least error-prone approach, but also the most difficult to implement from an investor relations perspective.