Expressing its concern that “the current difficult fundraising environment … can incentivize private equity managers to artificially inflate valuations,” the Securities and Exchange Commission emphasized the need for private equity firms to “implement policies and procedures to ensure that investors receive performance data derived from the disclosed valuation methodology.” Failing to follow articulated valuation methodology – and having compliance personnel ensure the use of such disclosed valuation policies and procedures – can subject a private equity fund to substantial disgorgement, civil penalties and multi-year oversight of its valuation policies and procedures, as one private equity firm found out this week.
On March 11, 2013, the SEC issued an order that charged a private equity fund manager with violations of the Securities Act of 1933 and the Investment Advisors Act of 1940 because of its failure to follow disclosed valuation policies when preparing marketing materials and quarterly reports disseminated to prospective and existing investors. According to the order the SEC issued, the managers of a private equity fund that itself invested in other private equity funds, had a disclosed policy of valuing assets “based on the underlying managers’ estimated values.” The managers, however, valued their fund’s largest asset using a methodology that differed from that employed by the underlying manager – a switch that led to an internal rate of return mark-up increase from approximately 3.8 percent to 38.3 percent. But “[n]o one told investors and prospective investors that the reported increase in [the private equity fund’s] performance was a result of the Portfolio Manager’s change in valuation method and that, if [the private equity fund] had used [the underlying manager’s] value, as [the private equity fund] had done in the past and as was stated in the quarterly statements and pitch books, the performance numbers would have been materially lower.”
The SEC further criticized the private equity fund managers for failing to have compliance personnel review the portfolio manager’s valuations to ensure such valuations were determined in a manner consistent with written representations. In particular, the SEC found that the managers’ “failure to adopt and implement written policies and procedures” for such a compliance review allowed the dissemination of misrepresentations and omissions that attributed increased value to performance rather than to a changed valuation method, wrongly sourced the valuation write-up to a third-party valuation firm, and falsely disclosed that an independent auditor had audited the underlying funds. As a result, the SEC ordered the private equity fund managers to disgorge $2.27 million to investors, pay penalties of approximately $750,000, and engage an independent consultant to review its valuation policies and procedures; and insure for a period of two years that the private equity fund managers follow adequate valuation policies and procedures.