Will the SEC probe bear much fruit?

There are some good reasons why the US Securities and Exchange Commission probably will not unearth much fraudulent activity as it investigates how private equity firms value their investments.

For starters private equity investors are sophisticated creatures who hold their protectors of capital to a higher standard than their retail counterparts, a group the SEC holds a much more important role for. Generally speaking, limited partners expect independent auditors to fact-check GPs’ valuation figures, and in recent years have become more inquisitive in what controls oversee the valuation process above and beyond that audit. Indeed our sister title PEI recently made a point of LPs’ rigorous due diligence policies in its own take on the SEC investigation.

Regulators will also discover an industry required to participate in the subjective art of marking illiquid private assets to public market benchmarks. In valuations where a readily determinable fair value does not exist, demonstrating fraud becomes a much more serious challenge.

But of course the possibility for fraud does exist, and the SEC suspects room for temptation when GPs hit the fundraising trail. Already the agency has filed actions against several hedge fund managers after investigating “abnormal” investment performance claims, which led to the discovery of fraudulent valuations and other gimmicks. So could similar discoveries be made in the private equity universe?

Probably, but it would be surprising if near the same degree. Unlike closed-ended private equity vehicles, hedge funds are constantly in marketing mode and compensate managers on year-end portfolio valuations. So a massaged valuation here means more in terms of investor interest and a juicier payout. In contrast private equity investors reward GPs by the amount of cash in hand. Carried interest in the private equity model isn’t based on interim fund valuations, but on realised cash flows subject to unwelcome potential clawbacks.

In fact, if anything, private equity firms are more guilty of low-balling their estimates. Better to surprise LPs with a handsome return by using conservative initial estimates than explain why a valuation estimate suffered at the actual time of exit. Perhaps here the SEC’s investigation can be a benefit, assuming it spurs GPs to produce more genuine estimates for LPs, who must file their own fair value portfolio valuations.

More importantly, auditors are not perfect and some in the industry rightfully point out a lack of standardisation in valuation and benchmarking methods opens the door for abuse as GPs enter a competitive fundraising trail.

It’s hard to say whether the SEC inquiry will discover a significant level of fraud in the private equity industry – and a call put in to the agency to question some of the specifics around the probe resulted in the time honoured “no comment” – but it can be said that it reflects the SEC’s determination to familiarise itself with an asset class it must now supervise as a result of Dodd-Frank. Will the SEC query an impossible number of firms claiming top-quartile status? If so, surely that would be a good outcome.