Private funds should take notice of a new rule from the Securities and Exchange Commission that outlines the responsibilities of registered investment company boards when it comes to valuations.
Rule 2a-5, adopted in early December, and its companion rule 31a-4, are the first updates to the fair valuation regime as applied to RICs in some 50 years, according to David Larsen, managing director at financial consultancy Duff & Phelps. RICs include some private equity funds such as business development companies, but exclude private funds, which nonetheless fall under SEC oversight as registered investment advisors.
But the fact that the rules describe the RIC board responsibilities and the documentation required of funds when determining fair valuations “in good faith” does not mean private funds should ignore them. “There’s no reason to expect that the SEC won’t look at them,” Larsen said of private funds, who adds that the principles of the rules are “virtually identical” to the Financial Accounting Standards Boards’ ASC 820, which also provides a framework for determining fair value.
“Our expectation is that the new rule will impact those registered investment advisors, which includes all the managers of all the large and middle-sized private equity funds – anybody who’s not exempt [from being an RIC],” Larsen told Private Funds CFO. “And even if you are exempt under the venture capital rule [Section 203(l) of the Investment Advisers Act of 1940], you’re still subject to SEC inspection to make sure that you are properly exempt.”
And, as Larsen said, “If there was ever a year to scrutinize valuations, it’s 2020.”
He adds that the key thing he expects the SEC to look at is whether private funds are rigorously following their established valuation procedures communicated to investors, including testing the methodologies used and ensuring the independence of the valuation. For funds that use broker prices, such as many hedge and private debt funds, it will be important that broker prices used have documented rationale behind them, Larsen adds.
Red flags for weak valuations processes
Funds with strong valuations processes, including those that use third parties for valuations, will largely be unaffected by the rules, Larsen thinks. But what are the signs that your processes might not be rigorous enough for the SEC?
Among the red flags Larsen points out:
- Your valuations don’t move. “Valuations move on a regular basis,” Larsen said. “Especially in times of great volatility like we’ve had in 2020.”
- Disagreements with auditors or third-party valuations service and deviations from broker or pricing services without documentation.
- A lack of disagreement with the deal team. “If the internal process rubber stamps what the deal team says without any kind of pushback, that’s a red flag,” Larsen says. “You would expect there to be some hard discussions at times for certain investments.”
The SEC is allowing an 18-month implementation period for the rules, though they legally go into effect 60 days after being published in the Federal Register.