While accounting standards, valuation frameworks and industry guidelines have been moving towards standardization of valuation principles, private equity (“PE”) fund managers still have substantial freedom when valuing their portfolio companies. For example, there is inevitable temptations to present interim performance numbers in a particularly favorable light when raising a follow-on fund or limiting write-downs during down markets. On the other hand, there may be general incentives to smooth returns by using conservative values in normal or good times to avoid a negative surprise to investors when assets are ultimately sold.
Recent academic studies have shown that some advisers do in fact inflate valuations during periods of fundraising. The first large scale study on this topic by Tim Jenkinson, et al. stated:
“We find that valuations of remaining portfolio companies, and therefore reported returns, are inflated during fundraising, with a gradual reversal once the follow-on fund has been closed. This finding is clearly relevant to recent regulatory concerns about conflicts of interest facing private equity fund managers.”- Tim Jenkinson, Miguel Sousa, and Rüdiger Stucke, “How Fair are the Valuations of Private Equity Funds?” (Feb. 27, 2013)
Because a fund’s valuation method can have a significant impact on investors’ returns and the management fees charged by the advisor, the SEC has increased scrutiny surrounding valuations since the boom in registration of PE firms following the passage of Dodd-Frank five years ago. Valuations have a subjective component and therefore are naturally laden with conflicts of interest for advisors to PE funds. In fact, one of the SEC’s 2017 Priorities is to examine private fund advisers with a focus on conflicts of interest and disclosure of conflicts as well as actions that appear to benefit the adviser at the expense of investors. Conflicts of Interest related to valuations will be one area of focus encompassed within the broader priority of examining private fund advisers.
What the SEC Looks For
Some advisors mistakenly believe that the SEC is focused on whether a PE firm’s valuation of its portfolio company is accurate. Generally, the SEC is not focused on the accuracy of the valuation unless the valuation is clearly erroneous. In reality, the SEC is more concerned with the actual valuation process and whether it is consistent with the valuation process disclosed by the adviser to its current and potential investors.
The SEC’s concerns can be summarized in the following five questions:
To avoid being cited for a valuation related deficiency, PE advisors should abide by industry best practices. First, lay the foundation for compliant valuation processes, by clearly defining the portfolio manager’s role in the valuation process and monitoring to ensure that the disclosed methodology is being followed.
Second, draft valuation policies and procedures that address the following issues:
Consistency is important. While private equity firms may use discretion with regard to their valuation methods, they need to track which approaches they have used and remain consistent quarter after quarter. Maintaining a consistent methodology will instill confidence and help streamline the valuation process.
NAIC Member Benefit: Any NAIC Member may have its Valuation Policy reviewed by ICSGroup’s team of compliance experts on a complimentary basis now through the end of June. Contact us today. As always, we are here to help.