Our money, our problem

Limited partners are used to taking risks. Private equity funds are inherently risky, and LPs have to get comfortable with locking up capital for several years.

It takes a pretty big leap of faith to become an LP and then keep piling money into the asset class. However, most LPs I talk to say they remain confident in the asset class – because returns consistently outstrip public markets. Private equity, they say, remains an essential part of the mix of investments that help their institutions hit return targets.

LPs need to have trust in managers. So it’s not surprising that some are happy about the US Securities and Exchange Commission taking a closer look at the ways general partners value their assets. What is surprising, perhaps, is that some LPs believe the SEC should just back off – on the grounds that ultimately, the choice to commit to a private equity fund falls to the LP, who then has to live with their decision, even when a fund loses money.

The SEC set up a team to focus on alternative investment asset classes, including private equity, in 2010. The team, led by Bruce Karpati and Robert Kaplan, is particularly interested in issues of valuation, complex structures and conflicts of interest related to private equity funds. “We’re looking at valuation-type issues, including misrepresentations of valuation and performance, and those advisors who may not be following through on their valuation policies and procedures,” Karpati said at the PEI Private Fund Compliance Forum in New York in 2010.


“It’s not about looking at bad performance; it’s about [GPs who are] misrepresenting performance to their investors,” Karpati said at the time.

At another conference earlier this year, two other officials on the team, Igor Rozenblit and Chad Alan Earnst, said the SEC will be focusing squarely on fundraising – specifically, the way GPs market themselves to potential investors, and whether they are being totally honest in reporting the performance of past investments.

The reliability of GP information around fundraising is likely to be a big issue this year, since the fundraising market is so crowded with managers looking to secure commitments. (Last year, estimates put funds in market at around 1,500, and sources have said this year there could be more.)

“We’re cognisant of the fact that … GPs have some discretion on how they value the portfolio. But valuation is still subject to the fiduciary duties the GP owes the fund,” Earnst said at the conference. “This market is tough to raise capital and we expect to see even more valuation issues.”

The question is: why should the SEC get involved in policing an asset class that is not governed by rules akin to public companies in the US? Private companies have relative freedom to operate, and to sink or swim without the interference of the government.

I had a long and enlightening conversation with a public institution LP recently, who questioned the need for the SEC to get involved in the asset class.

Investors who commit to private equity managers that have been puffing up valuations on their investments only have 

It's not about looking at bad performance; it's about [GPs who are] misrepresenting performance to their investors.

Bruce Karpati

themselves to blame, the LP said. To be in the asset class, investors have to be willing to get their “hands dirty”, and dig into the nuts and bolts of the manager’s prior portfolio.

Due diligence is imperative to ensure the success of an investment portfolio. LPs that complete the kind of rigorous analysis that is necessary to get comfortable with a manager are putting themselves on stronger footing than LPs who don’t dig as deep.

On top of their internal review, LPs are generally assisted by sophisticated and talented consultants, who also vet managers and come up with the best of the crop for their clients.

Even with all this rigorous diligence, LPs are still going to lose money on certain managers that strike out. That’s a possibility with any private equity house, even some of the best. 

But through all these layers of protection, LPs should be able to weed out those managers who are trying to con them. However, it might be harder for smaller LPs that have less in the way of in-house resources to do their own due diligence. So maybe that’s a good segment of the market for the SEC to focus on.