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Private Equity and Valuation: Separating Hype from Reality

Authors: James D. Rosener and Edward T. Dartley

5/19/2014

This article is reprinted with permission from the May 19, 2014 issue of the New York Law Journal. © 2014 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. ALMReprints.com - 877.257.3382 - reprints@alm.com.

Shortly after private equity fund managers became subject to registration, the U.S. Securities and Exchange Commission (SEC) made the integrity of the valuations by fund managers of portfolio company investments one of the agency's top priorities. This effort reflects concerns raised by the SEC (and others) that such valuations have significant impact on marketing activities, the use of track records in fund raising, on secondary market trading of fund interests, and fund restructurings. Others wonder whether these concerns are justified, given the overall structure of private equity funds, the role that valuation plays in manager compensation, and the sophistication of private equity investors and their independent and increasingly sophisticated operational due diligence practices.

Private equity funds are typically structured as limited partnerships. Institutional and individuals invest in private equity funds as limited partners, each agreeing to commit and make available a specific dollar amount when the fund manager make a capital call for investment. The private equity fund manager, in managing the general partner, makes the investment decisions to acquire portfolio company investments, often acquiring either the entire target or a controlling share of the target's stock. These investments will normally be initially recorded and carried on the books of the fund at the original cost. Between the date of the acquisition of a portfolio company and its ultimate disposition, the private equity manager will calculate interim valuations of the target company and decide whether the investment should continue to be held at cost or whether there is sufficient certainty to change, up or down, the current valuation in its periodic reports to the limited partner investors in the private equity fund. Today, as in the past, the valuation of portfolio company investments is largely done in-house by the private equity manager, as opposed to a third-party valuation service, given the manager's knowledge of the company, industry and valuation metrics.

Private equity firm managers were first required by law to be registered with the SEC in the first quarter of 2012. It did not take the SEC long after that to make valuation a key issue with respect to private equity funds. On Oct. 9, 2012, the SEC announced the formation of its National Exam Program (NEP) and its "Presence Exam" initiative directed at newly-registered private equity firm managers and hedge fund managers.1 The SEC announced its intention to conduct examinations of new registrants, and identified five major areas of focus. One of these areas was valuation. The SEC made clear its view that new registrants must have "effective policies and procedures regarding the valuation of client holdings and assessment of fees based on those valuations," and that the NEP's examinations would include a review of these policies, "including their methodology for fair valuing illiquid or difficult to value instruments." Although not expressly stated in the Oct. 9, 2012 announcement, private equity firm investments, which are, by their nature, illiquid and difficult to value, were a focus of the SEC at that time.

In a January 2013 speech before a Private Equity International conference, Bruce Karpati, then-chief of the SEC Enforcement Division's Asset Management Unit, highlighted the importance that the SEC ascribed to valuation matters when it came to private equity fund managers. Characterizing the industry as "lack[ing] transparency" when it came to the valuation of illiquid portfolio company assets, Karpati staked out the position that "[v]aluations, while always important, take on greater significance during the period of fund marketing." Karpati cited past SEC experiences where managers would increase portfolio company valuations during the marketing of a new fund in order to exaggerate performance of the quality of the portfolio holdings, thereby underscoring the need to ensure the integrity of interim valuations.

Over the last year, the SEC has emphasized the importance that it places on valuation in the private equity industry through several new enforcement action settlements. In one recent proceeding, for instance, the SEC settled charges with U.K. firm GLG Partners after alleging that GLG's internal control failures caused the overvaluation of the fund's 25 percent private equity stake in an emerging market coal mining company. GLG settled these charges for nearly $9 million.2

This and other recent SEC enforcement settlements have kept valuation high on the list of talked-about subjects in the private equity industry. Industry participants have noted that the importance of valuation of portfolio company investments extends well beyond marketing into other areas of private equity. For instance, there is a developed secondary market for private equity fund interests where limited partners and secondary buy-out funds negotiate the price at which those interests will trade. The valuation of underlying portfolio investments by the manager is a starting point for the negotiation of the prices at which such transactions take place. These secondary funds will maintain a database of each private equity fund investment's portfolio company valuation as determined by that private equity fund manager, and use those valuations as a reference point for other private equity fund interests holding portfolio investments in the same industry. Valuation also provides a reference point in instances where a private equity fund undergoes a restructuring, which involves the infusion of capital from new investors, or where such infusion comes through an annex fund established for the purposes of making such an investment.

Some institutional investors are also placing greater emphasis on valuation of portfolio investments held by the private equity funds in which they are limited partners. Given the long-term nature of the investments and the extended horizon for monetization, institutional limited partners can use interim valuations as a gauge for the private equity fund manager's overall selection and management of the portfolio's investments. In addition, institutional investors such as pension funds and endowments divide their overall investment portfolios among numerous asset classes, only one of which is private equity. These institutional investors may also have further allocation percentages for specific private equity strategies (energy or health care sectors, for instance). For these investors, interim valuations can drive allocation decisions, and may be used when making decisions about rebalancing of overall portfolio holdings among various asset classes.

And yet with all of this focus on valuation, there are participants in the private equity industry who simply do not ascribe as high importance to the topic as the media covering the alternatives industry might lead one to think. The fact of the matter is that the structure of private equity funds and the nature of private equity investments are such that valuation plays a less important role than in other types of investment vehicles, such as hedge funds or mutual funds. Private equity funds are long-term investment vehicles in which investors are subject to lock-up periods that can extend for 10 years or more. Thus, the illiquid nature of the investment and significant transfer restrictions imposed by the private equity fund's governing documents moderate the need and, therefore, expectation for precise valuation at any point in time. Accordingly, most private equity fund investors accord the actual sale price of a particular portfolio company investment as the only truly meaningful measure of performance.

In addition, private equity funds are independently audited on an annual basis. As valuation has become an increased focus, private equity firms have been working more closely with their auditors, both in the annual audit process and at interim points in the year, where the private equity manager may initiate a dialogue with the fund's auditor about potential changes in a portfolio company's valuation. In this manner, the auditing process has provided a somewhat more rigorous review and measure to test a private equity manager's portfolio company valuations.

The relevance of the valuation of a fund's portfolio investments to the compensation of the private equity manager has also been questioned. Private equity funds are structured so that during the initial cycle of the fund's life, the private equity fund manager has the ability to call capital from limited partners in order to fund new portfolio company investments, to provide further funding to existing investments, and to pay management fees, monitoring fees and transaction fees. During this period, which is known as the "commitment period," management fees are calculated by multiplying the total amount of capital commitments made by limited partners to the private equity fund by an agreed-to percentage (normally, between 1 percent and 2 percent depending on the size and age of the fund). Accordingly, the valuation of the specific investments in the portfolio of the private equity fund has no bearing on the management fee compensation that will be paid to the private equity manager during the commitment period. Following the end of the commitment period, which typically ranges for a term of three to five years, management fee compensation is determined by multiplying the aggregate amount of capital that has been invested in the private equity fund by a set percentage (often less than the percentage set during the commitment period). Again, because this calculation is based on the total dollars that have been invested by limited partners in the private equity fund, the specific valuations of the portfolio company investments will have no direct effect on the amount of compensation paid to a private equity manager during the post-commitment period. If, however, there is a write-off in connection with a specific investment, management fees will be calculated off the post-write-off valuation of the specific investment. Finally, the typical private equity structure will include a right for the private equity manager to earn a percentage of the profits when portfolio investments are sold, calculated by multiplying a set percentage (normally, up to 20 percent) by the amount of profit earned after limited partners have received back their contributed capital plus a set return on their investment. The payment of this compensation, which is known as "carried interest," depends upon actual realized proceeds from the sale of the investment, and not upon the valuation determination by the manager (although in instances where the fund's portfolio includes an investment that will likely result in a significant loss, even where there is a clawback obligation for carried interest that was paid where there was no such loss yet, the fund would likely accelerate or inflate the distribution of carried interest).

The typical model for the calculation of management fees has led some industry participants to question whether the focus on valuation in the private equity industry by regulators and the media is warranted. After all, if management compensation is for the most part divorced from specific portfolio company valuations, then the potential that the private equity fund manager will have a conflict of interest when making valuation determinations is minimal, or so the thinking goes. Accordingly, even with all of the attention that valuation is being given in the private equity industry, relatively few private equity firms have taken the step to hire an independent valuation service to validate and/or support the valuation work that is currently done in-house by the private equity fund manager.

The reality surrounding the importance of valuation to the private equity industry may be a function of time and the health of the financial markets. In markets where industry fundamentals are sound and comparable company valuations remain solid, the valuation that a private equity fund manager ascribes to its portfolio company investments will have less importance than if there is a severe downturn in the markets generally or in the specific portfolio companies' industries. The same is true to the extent that a downturn in the markets requires a private equity fund manager to explore options for the restructuring of the private equity fund that it manages, such as a restructuring or annex fund that involves the infusion of new capital, by either existing investors or new third parties.

Similarly, if investors are satisfied with the overall performance of a private equity manager for the funds in which they are invested, there will be less motivation to challenge and question interim valuations of specific investments, which may include the decision to hold the investments at cost. Furthermore, if the private equity fund manager is not actively raising a new fund, concerns about performance and track records are not present, as they would be if the private equity fund manager were actively marketing a new fund.

The real importance of valuation also can be expected to rise as institutional investors become increasingly interested in portfolio company valuations as a benchmark for overall interim performance, in making asset allocation decisions, in co-investments by related funds and in manager retention. Institutional investors are also paying more attention to operational and compliance matters surrounding the day-to-day operations of the managers with whom they invest. The trend for institutional investors to conduct independent operational due diligence is expanding in scope, both at the time of initial investment, and as a component of ongoing monitoring of investments. These institutional investors are becoming increasingly sophisticated and demanding in terms of the level of information provided to them, and in the standards to which they expect their managers to adhere. When it comes to valuation practices, this means increased scrutiny of internal valuation practices and procedures, increased interest in private equity managers' internal valuation committees (both as to the existence and scope of responsibilities of such committees), and potential increased interest in the retention of independent valuation firms to conduct annual or more frequent valuations of significant portfolio company investments.

Finally, the SEC's focus on valuation in private equity may well be driven by the fact that private equity funds by their nature are not susceptible to certain regulatory concerns that arise with other asset classes. Private equity funds typically do not engage in active trading of securities, and typically do not use exotic forms of leverage in their strategies, as hedge funds do. Private equity funds also do not regularly face decisions concerning allocations of investment opportunities, as separate account managers may face on a routine basis (private equity fund managers may need to deal with allocation issues in cases where the commitment period of one private equity fund overlaps with the raising of a new fund, but the structure of private equity makes this the exception rather than the rule). Recent attempts to introduce bills in Congress that would result in the de-registration of private equity firms may provide additional motivation for regulators to focus on areas of concern in private equity, regardless whether the industry and the investment community regards such areas as in need of attention.

Regardless of the media treatment of the importance of valuation in the private equity industry, looking ahead one can and should expect that different constituents of the industry—investors, regulators, and others—will continue to heighten the focus on valuation practices and procedures of managers of private equity funds.

Endnotes

1 SEC Letter to the Industry, dated Oct. 9, 2012, available at http://www.sec.gov/about/offices/ocie/letter-presence-exams.pdf.

2 In the Matter of GLG Partners and GLG Partners, SEC Release No. 71050 (Dec. 12, 2013), available at http://www.sec.gov/litigation/admin/2013/34-71050.pdf.

James D. Rosener and Edward T. Dartley

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

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