Pocket policy

An SEC investigation into the use of side pockets at hedge funds is a reminder that fair value is serious business and that private equity GPs must take pains to follow consistent valuation policies.

According to those close to the US Securities and Exchange Commission, the SEC has become a bit less polite these days. Instead of sending a letter requesting documents for an investigation, the commission is more likely to simply show up and seize those documents.

The driving force behind this change in approach is the new leadership at the SEC’s Enforcement Division. After its recent restructuring, those in charge come from criminal investigation backgrounds. Robert Khuzami, the new director, was a federal prosecutor for 11 years, and then chief of the Securities and Commodities Fraud Task Force for the US Attorney’s Office for the Southern District of New York. Upon his appointment to the SEC role, Khuzami promised in a statement that he would “relentlessly pursue and bring to justice those whose misconduct infects our markets”.

Within Khuzami’s Enforcement Division is the newly formed Division of Investment Management, which is charged with investigating the alternative investment market. According to The Wall Street Journal, which cited sources, the this new division is kicking off its mandate by looking into whether hedge funds used side pockets improperly to prevent investors from withdrawing their assets, and whether hedge fund managers inflated the values of the assets in the side pockets in order to charge higher fees. The investigation is said to extend to third party auditors and fund administrators as well.

Charges of malfeasance with regard to illiquid investment valuation are nothing new. The investigation is reminiscent of the post-dotcom crash troubles of some publicly traded mutual funds that invested in venture capital-like deals. After the bubble burst, some investors charged their mutual fund managers of holding VC deal values at unrealistically high valuations for too long. Some mutual funds found themselves facing lawsuits from investors claiming that they had artificially marked up the value of the companies.

Private equity GPs should take note of the SEC’s current focus, because if fees charged on illiquid assets are of interest, the commission may find private equity funds to be pregnant with possibility.

Of course, those GPs with a consistent, well documented valuation policies have nothing to fear.