SEC scrutinizes firms’ ‘cherry picking’ in PE valuations

  • Comparisons with public market businesses, previous LBOs pose challenges
  • “It’s really tough for the SEC to make hay,” says one compliance attorney
  • Bowden previously brought up valuations in “Sunshine” speech

Questions about how firms value portfolio companies continue to crop up in Securities and Exchange Commission examinations of private equity firms, multiple sources told Buyouts.

Firms vary in how they value their portfolio companies, ascribing value based on cash-flow projections, the pricing of comparable publicly traded companies and transaction multiples on older leveraged buyouts.

While some in the industry have argued that interim valuations are immaterial, they also “signal to investors about the health of an adviser’s most recent portfolio, which may be the most relevant to an investor considering whether to invest in a current offering,” former SEC Director Andrew Bowden said in a 2014 speech.

“Anything that involves public comps is scrutinized,” said Jack Rader of ACA Compliance. “They’re going to look at the appropriateness of the comps and controls around how often that is updated. If it’s been the same for two years, is that appropriate?”

Altering valuations

Assessing the validity of those valuations is a complicated endeavor, however. Private-company valuations can be altered through a multitude of subjective factors, effectively making the practice “as much art as science,” University of Oxford’s Said Business School and University of Porto wrote in a 2013 study.

“It’s really tough for the SEC to make hay,” one compliance attorney told Buyouts. “There’s a lot of judgment in terms of defining what the value is. So as long as you’re doing this consistently … It’s a very difficult thing to prove.”

For this reason, issues surrounding asset valuations, as well as the disclosure of methodologies used to arrive at a valuation, present complex challenges for investors and regulators. In particular, certain public-comparison methodologies leave room for “cherry picking,” sources told Buyouts.

“Let’s say Microsoft was trading well last quarter, and you decide to put it in your comp set. Then the next quarter something goes wrong with Microsoft, and you pull it out,” said one source with knowledge of examinations. “It’s very hard to detect when you’re an investor or a regulator.”

Those difficulties extend to the use of leveraged-buyout transactions for other companies to derive a valuation, the source added. The universe of comparable private acquisitions may be small. Older transactions might make for a stale comparison, but the manager may still consider them appropriate.

Similar issues arise in how firms project portfolio-company earnings. Factoring one-time expenses such as lawsuits would detract from a company’s future value. To account for this, some GPs will add back those costs. That practice is common and widely accepted, but some GPs may add back material recurring costs as well.

“When you’re doing a valuation, and there is no third party looking over your shoulder, there’s a temptation to put [things] back,” the examinations source said.

Valuations emerged as an area of regulatory scrutiny in 2013, when Oppenheimer & Co agreed to pay a $2.8 million settlement after the SEC determined it had misled investors about the valuation of a PE fund-of-funds. The firm did not admit or deny the SEC’s findings.

‘Positive bias’ seen

The same year, the University of Oxford’s Said Business School and University of Porto researchers found that firms tend to inflate valuations when they raise funds. So much so that “it is hard to rationalize the pattern we observe except as a positive bias,” they wrote. Bowden later referenced the report in his widely covered “spreading sunshine” speech.

That said, LPs vary in how much attention they pay to valuation methodologies. Particularly in regard to re-ups, many limited partners prefer to focus on the distributions they’ve already received as opposed to the returns current holdings may yield.

“With established firms that have been around awhile, if they’d been playing those games, it would have caught up with them already,” one public pension LP told Buyouts. “If you’re investing based on newer things, and you haven’t been getting cash back, you have to pay closer attention to the marks.”

Action Item: The University of Oxford and University of Porto study:

Photo: U.S. Securities and Exchange Commission Chairwoman Mary Jo White is interviewed at the Reuters Financial Regulation Summit in Washington on May 17, 2016. Reuters/Gary Cameron