In recent years, private equity has largely avoided the scrutiny facing the hedge fund industry. All this is changing, mostly due to the passage of the Dodd-Frank Wall Street Consumer Protection Act in 2010.
Under Dodd-Frank private equity advisors, typically general partners, must register with the Securities and Exchange Commission. So far, 1,504 hedge and private equity fund advisors have registered with the agency since passage of the Dodd-Frank Act.
Then beginning in late 2011 the SEC began an informal inquiry into the private equity industry. It sent letters to several firms asking for details on fund investments and asset valuations, according to a Bloomberg report. Of particular concern was whether firms used inflated valuations to attract investors when marketing new funds.
SEC Presence Exams
The SEC recently launched a new initiative to conduct Presence Exams for newly registered private fund advisors. These “focused, risk-based” exams will be carried out by the National Exam Program staff and will take place over the next two years. The NEP staff will review “one or more of the following higher-risk areas of the business and operations of advisers selected for an examination:”
- Portfolio Management
- Conflicts of Interest
- Safety of Client Assets
The SEC noted that if a serious deficiency is found it will send an examination summary letter and may refer the problem to the commission’s Division of Enforcement, or to a self-regulatory organization, state regulatory agency, or other regulator for possible action.
Valuation is a significant area of scrutiny. The SEC says that investment advisers must have “effective policies and procedures regarding the valuation of client holdings and assessment of fees based on those valuations.” The NEP will review valuation policies and procedures, including the methodology for valuing illiquid instruments. It will examine procedures for calculating management and performance fees, and the allocation of expenses to private funds.
Historically, many illiquid investments have been valued at cost or written up based on a recent financing. Write-downs were usually driven by down rounds. Such a limited approach today is incompatible with the concept of fair value.
Worth noting is that the Private Equity Industry Guidelines Group issued guidelines taking into consideration the Statement of Financial Accounting Standards 157, Fair Value Measurements in 2006 (“FAS 157,” now known as Accounting Standards Codification 820, or “ASC 820”). Included are the following key concepts:
- Exit price, in which the fair value is 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.”
- Price is measured using all assumptions market participants would use.
- Market participants are buyers and sellers in the principal market who are independent of the reporting entity, have the ability to transact and are willing to transact.
- Measurement assumes an orderly, hypothetical transaction in the principal market or the most advantageous market.
- A fair value hierarchy prioritizes market inputs into three broad levels and focuses on whether inputs are observable or unobservable.
Private equity firms should also be familiar with Accounting Standards Update 2011-04, which outlines requirements for disclosing information about fair value measurements, including valuation techniques.
These items require an increased level of documentation and should lead PE firms to review internal processes and controls, and perhaps bring in third-party appraisers.
Valuations of private equity investments are complex. Now more than ever, it is important to obtain supportable valuations that can withstand the scrutiny of the SEC and regulatory bodies.
Douglas Peterson, CFA, is senior vice president with Valuation Research. He specializes in the valuation of businesses related to mergers and acquisitions, reorganizations, shareholder transactions, tax planning and financial reporting. He can be reached at firstname.lastname@example.org.
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