During the downturns of the last decade, the SEC and other U.S. and international regulatory agencies homed in on hedge fund fraud and lack of transparency. Now, regulators have turned their attention to private equity funds, and the valuation of their portfolios is a central focus.
Bruce Karpati, chief of the SEC enforcement division's asset management unit, summarized the problem in a speech at the Private Equity International Conference in New York City earlier this year. “Many private equity products lack transparency, especially into the valuation of illiquid assets,” he says. This message was also central to an intensive half-day Private Equity Valuation Roundtable in New York City in May, hosted by Houlihan Lokey's Cindy Ma.
Some leading valuation firms are already seeing more requests for guidance on valuation compliance. In some ways this is not surprising; carried interests on the balance sheets of most financial institutions have been the subject of political and regulator attention for over a decade. Private equity investments have largely stayed clear of the glare of this negative attention, but Karpati's speech makes clear that this freedom is ending. The SEC and international regulators (particularly in the EU) have refocused resources on valuation-related areas. Increased enforcement must be expected.
Besides the regulators, one CEO of a PEG told BVU that his limited partners have become "insistent and focused" about the value of assets on his balance sheet. To some degree this concern about valuation results from higher competition for good investments is higher—so it's in the interest of those running private equity funds to professionalize their valuation compliance. A good system will support higher values for investors at entry—and presumably at exit.
Several PEGs have already had SEC reviews on their valuation practices. Karpati's speech includes a long list of SEC actions against investment funds around valuation issues—not just fraud. Oppenheimer, for instance, got in hot water for changing valuation methods on a fund of funds product, even though they said they were using independent valuation experts. The SEC noted that the change in valuation method resulted in a change of IRR from 3% to 38%.
Another case of enforcement is around the issue of ignoring market inputs, even though they existed.
A third SEC action noted discrepancies between public disclosures about independent valuation agents, valuation inputs, and more—when none of these had been used.
None of these enforcement actions goes after the classic "LBO" PE firm. But, still, it's clear PEGs are at risk for valuation examinations if:
- Disclosures were made to investors but not followed
- Market data were ignored
- New valuation methodologies created significantly higher returns