The Securities and Exchange Commission (“SEC”) recently launched a series of investigations focusing on hedge fund managers’ conduct toward their investors. Specifically, the regulator is examining managers’ valuation of illiquid, thinly traded securities and how they respond to investors' redemption requests.

SEC enforcement director Andrew Ceresney said examiners are looking for "all types of misconduct by hedge fund managers," adding that valuation “is one of the core issues.” Although hedge fund managers have traditionally avoided scrutiny when it comes to determining the value of their underlying investments, both investors and regulators are now examining them more closely as private investments in certain sectors have performed poorly amid market instability.

Valuation is becoming a more common target for the SEC in 2016 and was listed among the Office of Compliance Inspections and Examinations’ (“OCIE”) examination priorities. Although the agency has always held a hard line against private firms that knowingly mislead investors, it has rarely waded into examinations of the private market, participation in which is limited to institutions and accredited investors. However, the sector has come under increased regulatory scrutiny as private companies have become larger and more important to the economy.

SEC Chairwoman Mary Jo White recently issued a warning to Silicon Valley – and those securities valued at more than $1 billion, in particular – about unrealistically high valuations. Although she acknowledged the inherently subjective elements involved in early-stage valuation, she encouraged tech startups, including fintech firms, to share more information with investors and behave more like public companies in order to avoid making misleading statements regarding valuation or performance.

While a valuation is based on certain objective facts, it is also determined through the subjective assessment of the person performing the valuation. For example, a company’s earnings, capital structure and physical assets may be more easily agreed upon than the value of less-tangible factors, such as the value of its executive leadership group. Despite this subjective element, hedge fund managers should be aware of the added regulatory scrutiny of their valuations and ensure their compliance, auditing and record-keeping practices comply with the SEC’s expectations.