The valuation challenge

The SEC is looking into how GPs mark their assets amid concern that trumped-up valuations could be used in fundraising pitches. Its interest could help advance the discussion around the need for greater clarity around valuation methods.

Do private equity limited partners really need the US Securities and Exchange Commission to protect them from shifty fund managers?

Probably not, most of our sources said, after we asked them about the regulator’s investigation into fund valuations. After all, private equity LPs are sophisticated investors with rigorous due diligence policies and often employ third parties to help them appraise potential commitments.

But the SEC understandably will continue on in its quest to better monitor alternative investment funds. As most industry professionals agree, no one wants another Madoff debacle harming investors and tarnishing by association the reputations of upstanding, hardworking managers.

The agency declined to comment on whether the impetus for its investigation was because it felt some private equity GPs were indeed trying to mislead potential investors. Bruce Karpati, co-chief of the SEC’s asset management unit, said at PEI’s Private Fund Compliance Forum earlier this year that the regulator was concerned with whether third parties assessing valuations were truly independent. “Despite the fact that there is an independent party, we still need to scrutinise whether managers are accurately representing their valuation process.”

Another SEC official said recently that the agency expected “to see more valuation issues” going forward, given tough fundraising conditions.

Fundraising has become a treacherous journey; with intense competition in the market, GPs must look for any advantage to help differentiate themselves from all the other managers out there seeking capital. The biggest wrench in the toolbox, of course, is track record – you’re more likely to win commitments if you can show you’ve made solid investment decisions and achieved good results with current and past portfolio companies.

LPs decide for themselves if they want to commit to a private equity fund and they have to live with their decisions. Risk is, and always has been, part of the game. As one large US investor put it, GPs are “selling a dream” since no one can predict the future. It’s the LP’s fiduciary duty to ensure it is backing managers likely to deliver results – and one of the key parts of that equation is digging into the numbers presented by fund managers.

What makes it all the more difficult, of course, is that there are divergent methods for valuing fund assets – an issue that has plagued LPs and GPs for some time (and indeed, is likely to plague the SEC too).

The solution would be further standardisation of reporting and valuation methods, long an industry goal but one that’s been difficult to achieve. The Institutional Limited Partners Association, for example, has made great strides in this area, while the International Private Equity and Venture Capital Valuation Board has also been working on templates. A watchful SEC could perhaps nudge the industry closer to universal adoption of a valuation standard. That would help flag any inconsistencies more quickly and make it easier for LPs to benchmark competing managers on a genuinely like-for-like basis.