While accounting standards, valuation frameworks and industry guidelines have been moving towards standardization of valuation principles, private equity (“PE”) fund managers still have substantial freedom when valuing their portfolio companies. For example, there is inevitable temptations to present interim performance numbers in a particularly favorable light when raising a follow-on fund or limiting write-downs during down markets. On the other hand, there may be general incentives to smooth returns by using conservative values in normal or good times to avoid a negative surprise to investors when assets are ultimately sold.
Recent academic studies have shown that some advisers do in fact inflate valuations during periods of fundraising. The first large scale study on this topic by Tim Jenkinson, et al. stated:
“We find that valuations of remaining portfolio companies, and therefore reported returns, are inflated during fundraising, with a gradual reversal once the follow-on fund has been closed. This finding is clearly relevant to recent regulatory concerns about conflicts of interest facing private equity fund managers.”- Tim Jenkinson, Miguel Sousa, and Rüdiger Stucke, “How Fair are the Valuations of Private Equity Funds?” (Feb. 27, 2013)
Because a fund’s valuation method can have a significant impact on investors’ returns and the management fees charged by the advisor, the SEC has increased scrutiny surrounding valuations since the boom in registration of PE firms following the passage of Dodd-Frank. Valuations have a subjective component and therefore are naturally laden with conflicts of interest for advisors to PE funds. In fact, one of the SEC’s 2017 Priorities is to examine private fund advisers with a focus on conflicts of interest and disclosure of conflicts as well as actions that appear to benefit the adviser at the expense of investors. Conflicts of Interest related to valuations will be one area of focus encompassed within the broader priority of examining private fund advisers.
What the SEC Looks For
Some advisors mistakenly believe that the SEC is focused on whether a PE firm’s valuation of its portfolio company is accurate. Generally, the SEC is not focused on the accuracy of the valuation unless the valuation is clearly erroneous. In reality, the SEC is more concerned with the actual valuation process and whether it is consistent with the valuation process disclosed by the adviser to its current and potential investors.
The SEC’s concerns can be summarized in the following five questions:
- Are firms relying too heavily on prices provided by third-party valuation consultants without fully understanding how they are calculated?
- Are some managers overly optimistic about the performance or quality of portfolio company holdings, particularly during fundraising? Do some managers have inconsistencies, misrepresentations or lack of proper disclosure in their performance marketing materials?
- Are managers changing the valuation methodology from period to period without additional disclosure, even if such actions fit into a broadly defined valuation policy? While modifying the methodology is not improper in and of itself, the change in valuation methodology should be consistent with the adviser’s valuation policy and should be sufficiently disclosed to investors.
- Did the firm have a key team member resign or announce a reduced role soon after a fundraising was completed? This raises suspicions that the adviser knew changes were forthcoming that might impact fund performance but never disclosed such changes to investors before closing.
- Are firms cherry-picking comparables or adding back inappropriate items to EBITDA — especially recurring costs that persist even after a strategic sale — without sufficient rationale and/or disclosures to investors?
To avoid being cited for a valuation related deficiency, PE advisors should abide by industry best practices. First, lay the foundation for compliant valuation processes, by clearly defining the portfolio manager’s role in the valuation process and monitoring to ensure that the disclosed methodology is being followed.
Second, draft valuation policies and procedures that address the following issues:
- Address potential conflicts of interest
- Designate who is responsible for oversight
- Use specific methodologies for pricing portfolio securities (listing factors from ASR 118 is insufficient)
- Get real bids or quotes rather than “accommodation quotes” when possible
- Allow LPs to review the methodologies used for portfolio company valuations, and in some cases, approve the valuations themselves
- Include a procedure for the auditor to present their view on valuations and answer questions at the fund’s annual meeting
- Provide quarterly reports on each portfolio company, including valuation and methodology information
Consistency is important. While private equity firms may use discretion with regard to their valuation methods, they need to track which approaches they have used and remain consistent quarter after quarter. Maintaining a consistent methodology will instill confidence and help streamline the valuation process.