SEC Increases Scrutiny of Fund Valuations
Five ways to minimize the risk of enforcement actions.
In late 2011, Bruce Karpati, the co-chief of the Securities and Exchange Commission (SEC) Division of Enforcement’s Asset Management Unit, announced his priority areas of focus for 2012. Topping the list are valuation and performance issues, specifically: aberrational performance, fraudulent valuations, and weak or unenforced valuation policies and procedures.
In many ways, this feedback is not new; the SEC has been scrutinizing valuation practices for years. However, recent cases highlight a growing SEC trend of examining alternative investment managers, both hedge funds and, increasingly, private equity managers.
The fiduciary duties of investment managers are to make a solid return and maximize profits to investors. But conflicts can arise because of inherent issues with compensation plans—fund managers generally are paid based on investment performance, and performance is determined by asset valuations. Because of this, the SEC and shareholders want to see more robust processes put in place to ensure that valuations are accurate. This is especially critical when firms mark illiquid investments to market values.
The importance of accurate valuations
Accurate valuations have been and continue to be critical for several reasons. First, if management fees are charged based on a fund’s net asset value (NAV), an inflated valuation means that fees will be improperly inflated as well. Second, if fund interests are transacted based on NAV—whether on an exchange, in the secondary market, or through redemptions—then one of the parties to the transaction will be harmed if the valuation is inaccurate. Finally, if the NAV is inaccurate, the fund performance will be measured incorrectly, and investors may make future investment allocation decisions based on misleading data.
Private equity funds largely skirt two of these three potential valuation problem areas. Designed to hold illiquid (and often risky) investments that may take five or seven or more years to sell, private equity funds typically charge management fees only on committed or invested capital. Additionally, these investments usually do not allow for redemption or investor exit prior to maturity of the fund.
True, an overstated valuation may cause a fund manager to pay out carried interest prematurely, but such funds nearly always possess claw-back features that allow this to be corrected. And although some investors might engage in secondary market transactions, most private equity investors aren’t realizing a return based on the NAV, so the valuation is of less concern in those cases as well. However, these are litigious times. The issue of investment allocation remains a concern for private equity firms and even an accusation of impropriety against a fund—right or wrong—can subject fund management to unwanted and
potentially damaging publicity.
As a result, even though hedge funds have much greater exposure than private equity firms in terms of directly harming investors through improper valuation, both have a stake in providing accurate valuations.
Five strategies to address valuation risks
For these reasons and more, possessing a defensible process for valuing difficult-to-value assets is mission critical for all fund managers today. Following are five strategies to consider.
- Develop robust and consistent valuation policies and procedures. Fund managers should be able to show that valuation methodologies are applied consistently to various classes of assets throughout the company , including collecting data, making valuation assumptions, and documenting the valuations. Transparency and consistency are key attributes that regulators and investors are likely to look for in these policies and procedures.
- Actually implement those policies and procedures. Regulators in particular, but also investors, increasingly want to know that fund managers are walking the walk. It is not enough to profess to have strong policies and procedures; there needs to be evidence that policies and procedures are being implemented uniformly and that returns are not being embellished, especially in cases where one investor or investment manager is making a higher return than others in a way that transcends pure industry performance.
- When appropriate, use a third-party valuation specialist. Some investments, especially illiquid ones, are difficult to value. They require managers to use their professional judgment and apply advanced knowledge of appropriate techniques and regulations. Meanwhile, more shareholders are requesting that a third-party valuation specialist either assess the fund manager’s NAV estimate, or perform an independent valuation. As a result of all this, using third-party valuation professionals for controversial holdings is fast becoming an effective industry practice. Doing so has the added benefit of providing evidence that a manager has fulfilled its fiduciary responsibilities for investors.
- Base fund fees on measures other than NAV. Another potential solution is for the fund to decide at inception that fees on these types of investments will be based on historical cost or invested capital rather than on NAV until the investment is sold. This is a more objective and easily verifiable measure.
- “Side pocket” funds that can’t be reliably valued. As many fund managers did during the recent financial crisis, illiquid investments can be side-pocketed until they are able to be sold or more reliably valued. In this way, neither redeeming investors nor the funds’ other investors should be harmed when an exit occurs at either above or below market valuation. There are obviously other issues with the use of side pockets, but it allows the “valuation” issue to be side-stepped.
Consistent and well-documented valuations are good business practices
Even valuation issues that don’t lead to a lawsuit or are settled before reaching court can do harm to the way a fund is perceived in the marketplace. Although the prosecutor has the sometimes-difficult challenge of adequately proving intent to defraud, few fund managers would want to risk despoiling their names and reputations in the eyes of potential investors. So the stakes are high for putting measures in place to address the risk of enforcement action or other scrutiny. Giving consideration to the measures described above can be a solid first step in the right direction.