Investment adviser registration, as mandated by the Dodd-Frank Act, has led to increased scrutiny of hedge fund and private equity investment managers. By most accounts, the Securities and Exchange Commission has given greater concern to hedge funds over the past several years, but it increasingly appears that private equity will receive more regulatory attention going forward.
In March 2012, Robert Kaplan, former co-chief of the asset management unit of the SEC's Division of Enforcement, asserted that “private equity law enforcement today is where hedge fund law enforcement was five or six years ago.” The number of SEC enforcement actions against private equity managers has been a fraction of its actions against hedge fund managers. This discrepancy is due in part to the SEC and Department of Justice's focus on insider-trading cases, which, because of their nature, are less of an issue for private equity managers. In its efforts to expand private equity law enforcement, the SEC has provided an indication of where it is directing its scrutiny.
The SEC considers portfolio valuation a paramount concern within the private equity space. As reported by Bloomberg, in December 2011, the SEC sent information requests to a variety of private equity firms inquiring about their investment valuation policies. Within the hedge fund arena, valuation issues often focus on misreporting by investment advisers to increase management and performance fees. Both the SEC and hedge fund investors, including large public pension funds, have tried to address the related issue of funds that have suspended redemptions, but continue earning management fees on held up investments.
These ongoing fees, in many cases, are assessed on what might be inflated portfolio valuations. (Firms that broker secondary market trades of hedge fund interests list many that are bid or offered for less than 50% of reported net asset value.) Remarkably, five years after the credit crisis, “zombie funds,” which have not returned capital to investors because they are invested in “illiquid” but purportedly valuable assets, are still a meaningful part of the hedge fund universe.
Valuation issues are somewhat different for private equity. Private equity investment funds generally charge investors a management fee based on committed and contributed capital, as opposed to a percentage of the marked-to-market value of fund assets. However, private equity investment advisers report their fund performance to investors based on mark-to-market valuations and managers use these valuations for capital-raising purposes. Private equity funds are long-lived investment vehicles. A typical fund will have a 10-year life with separate one-year extensions at the discretion of the manager. With this extended time frame, a private equity manager may see a very long runway in which to report inflated valuations to investors to raise additional capital.
In October 2011, the SEC and the Massachusetts attorney general, according to a 10-Q filed by Oppenheimer Holdings Inc., launched an investigation into Oppenheimer Global Resources Private Equity Fund I LP. The investigation, according to the Wall Street Journal, sought to determine if the fund had greatly exaggerated returns in 2009 and 2010 in order to raise an additional $55 million from investors. Specifically, it is alleged that Global Resources reported an internal rate or return of 38% as compared with an actual loss of 6%. Neither the SEC nor the Commonwealth of Massachusetts has filed actions in the case. Global Resources and Oppenheimer remain subject to separate civil actions on the part of Global Resources investors.
A key valuation issue at Global Resources specific to the fund, according to the plaintiffs in the civil case, was a very large investment in another fund wholly invested in the shares of a publicly traded foreign company. In this situation, there may have been a market price at odds, at least in part, with the valuation reported by the fund.
Valuation measurement assumed greater significance for private equity funds on account of a 2007 change in rules allowing a fund to carry and report its investments at a value other than its cost. In September 2006, the Financial Accounting Standards Board adopted Statement 157 to clarify the meaning of “fair value” for GAAP reporting purposes. FASB 157 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This revised definition emphasized projected exit value as the measure of an investment's fair value. In response to FASB 157, the Private Equity Industry Guidelines Group, a PE industry organization, issued new guidelines allowing private equity firms to value their investments at fair market value. Prior to this, private equity firms generally valued their investments at cost until a significant event, such as a subsequent round of financing or a liquidity event, created a clear need for a restatement of asset value.
The issue for private equity managers, investors and regulators, unsurprisingly, is that “fair value” is subject to interpretation. While FASB 157 stated that active trading market prices are the most reliable indicator of value, this Level I data generally is not available for private equity investments. Private equity investments are much more likely to be determined based on what FASB 157 defines as Level II and Level III valuation techniques. The PEIGG has advised private equity managers to use all available data in exercising their fair-value judgment. Traditional business valuation techniques including public company trading multiples, company acquisition multiples, and discounted cash flow analyses should be considered, as should any third party valuations.
It is important for private equity managers to have thoughtful, written policies describing their valuation procedures. Each investment adviser should have a valuation committee which meets on a regular basis to review where and how portfolio investments have been marked. Valuations should be documented and updated to account for industry specific events as well as changing conditions in the equity, debt, and interest rate markets, among other factors.
In reviewing private equity valuation, regulators are likely to focus on the suitability of the policies, the rigor of the analysis, the commitment of the managers to best practices, and the extent to which the policies have been followed. In addition, the SEC has also made clear that it will review portfolio valuation issues with a skeptical eye toward what may be the underlying motivation behind the valuation and the reporting of these valuations to investors.
Mike Seery is a director in the New York office of Kinetic Partners, where he advises hedge fund and private equity managers and investors in areas including portfolio valuation and regulatory compliance.