Regulators May Examine Private Equity Valuation

Chidem Kurdas

The Dodd-Frank Act mandates the registration of hedge fund and private equity advisers with assets over $150 million. Venture capital managers and family offices are exempt from the registration requirement, but not private equity.

Once private equity managers become registered investment advisers, like all RIAs they will be subject to examinations by the Securities and Exchange Commission. The SEC looks at valuation polices and practices, among other issues. Private equity valuation will be scrutinized and has to be documented and supported, says Sal Shah, a partner at accounting firm McGladrey.

That could raise complicated questions. Unlike hedge funds that trade marketable securities with readily available prices (under normal market conditions), private equity funds hold companies that do not trade on exchanges. The value of the portfolio companies becomes certain only when they are taken public or sold to another private buyer, that is, when the private equity fund liquidates the investment. This typically takes years.

In the meantime the value of the portfolio can be estimated but such estimates have a wide margin of error.

Also, the distinctive structure of private equity makes valuation less essential until the portfolio is sold. In a hedge fund, investors may redeem or buy shares and managers are paid fees over time, which require the accurate valuation of net assets. Any mis-valuation affects fees and the prices of shares.

By contrast, in a private equity fund investors are locked in until the liquidation and managers don’t get paid the performance fee until that happens. During the life of the investment there may be no transaction that depends on current asset value.

In the past investors accepted the price uncertainty and the long lock-up in the expectation of eventual high return. But since the 2008 crisis some institutions, in particular university endowments, had to raise money by selling their private equity shares in the secondary market. They may be more concerned now with the value of private equity assets.

Hedge fund clients, too, worry about this matter with respect to investments that became illiquid in the credit crisis. There is still capital locked up in hedge funds and investors continue to push for assets in side pockets, says Jeffrey Yager of McGladrey. The valuation of those assets, moved to side pockets in 2008 when markets stopped functioning normally, is an issue.

One-size-fits-all rules for RIAs might not fit private equity and a subset of hedge funds that share some of the distinct features of  private equity.  But certain private equity managers have been registered with the SEC for years without problems. The regulator requires that advisers document and explain the calculations and apply them consistently. It does not require the use of a specific method.

However, the agency has become more aggressive since the Madoff scandal and other major frauds and its examiners are expected to look closely at valuation practices.


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