Over the past few months, the US Securities and Exchange Commission (SEC) has noted more than once that it will be conducting presence exams for a large number of private equity funds. This SEC focus was reinforced in recent remarks delivered in January by Bruce Karpati, chief of the SEC Enforcement Division's Asset Management Unit (AMU). Mr Karpati noted that “it is not unreasonable to think that the number of cases involving private equity will increase.” Atop the list of the SEC’s perceived risk areas was private equity managers’ valuation policies and procedures, an area which has received considerable scrutiny in the SEC’s recent presence exams.
Firms dealing in private equity should prepare for possible detailed inquiry into their portfolio company valuations by the SEC. In particular, managers should expect the SEC to review, in detail, a sample of investment valuations and may even request to review valuations that pre-date the manager’s registration as an investment adviser. Potentially, a chief financial officer could be asked detailed questions about valuations that occurred prior to their arrival at the firm.
The SEC will seek to determine if there were multiple levels of review of the valuations prior to providing the final numbers to investors
Further, managers should be prepared to discuss the safeguards that they have in place to detect and prevent errors. If there have been errors in the past, the manager should document how they have been rectified and what procedures have been put into place to prevent a reoccurrence. As part of its evaluation, the SEC also will seek to determine if there were multiple levels of review of the valuations prior to providing the final numbers to investors. If a firm has a valuation committee, the SEC may wish to see minutes and other back up documentation from the meetings.
In addition, when preparing for an SEC presence exam, managers should review their past valuations to ensure that their valuation methodology has been consistent. If the methodology has changed over time, managers may wish to document the reason for the change. Similarly, the SEC may ask detailed questions regarding the selection methodology for comps and discounts.
Finally, as Mr. Karpati noted in his speech, the SEC may pay particular attention to instances in which a manager writes up assets during a fundraising period and then down soon after the fundraising period closes. This further emphasises the fact that the SEC is focused on interim valuations and not just the value upon a realization event.
Private equity firms and asset managers should keep each of these points in mind to ensure that they are ready to address any SEC questions regarding their valuation policy and should review their current polices to see if there are enhancements that can be made to valuation procedures, such as adding further review or creating a valuation committee. Finally, we suggest private equity firms and asset managers document any anomalies that may have occurred during the valuation process; for example, annotating the reasons for a change in methodology during the life of the investment.
Many newly registered investment advisers are approaching their anniversary date of registration with the SEC. As such, they must begin their annual review in the next few months. As part of the annual review, managers may wish to pay particular attention to their valuations and the associated policies and procedures and work with an outside consultant.
Amelia Stoj is vice president at HedgeOp Compliance, an IMS Group Company.
For a look into what LPs expect from private equity firms on their valuation policies and procedures, be sure to read the March edition of PE Manager.