Blogs October 10, 2012 3 min read

SEC TO SRUTINIZE PRIVATE EQUITY FUNDS

I recently came across several articles discussing whether the SEC should get involved with the oversight of private equity (PE) funds’ valuation of their underlying investments (assets). Under the Dodd-Frank Act, more regulatory requirements are being put forth to protect the public interest. On the radar is the private equity industry. This industry has been flying under the radar as it has been determined that only the wealthy (accredited investors) can invest in these types of investment vehicles and these folks should be smart enough not to get burned. Tell that to the owners of the New York Mets.

PE funds invest in entities with the hopes that they can exit these investments and make a profit within 5 to 10 years. Generally, the objective of both the fund and the investors is to make a profit, of which most funds typically charge a 20% fee. The profit is only made upon the ultimate sale of the investment, causing the value of the investment to mean very little from year to year. Most PE funds do not allow investor redemptions until the fund terminates when all investments are sold or liquidated. Thus, there are those that question why valuations matter at all.

The SEC is not worried as much about protecting accredited investors (those individuals with annual income in excess of $200,000 and net worth in excess of $1 million) as they are with pension plans who have been allocating more of their funds in these “alternative” investments. The obvious concern is that higher values cause higher payouts to retiring participants in a pension plan, leaving the possibility of the last retiree holding the empty bag when the valuations don’t pan out.

Another reason for increased concern, and where I think this is leading, is that there is a push to allow more funds to accept non-accredited investor funds. A PE fund manager who uses his/her past performance to sell future funds to investors would cause these investors to base their decisions on these potentially over inflated values.

So, I get the SEC’s concern, but what I want to know is how they’re going to help “scrutinize” the valuation process. I am an auditor of PE funds, and I look to generally accepted accounting principles to determine how these investments held by PE funds should be valued. There are several different but acceptable methods for valuing assets. The methods are very subjective and can yield very different results. I have seen three valuation experts come up with three very different values for the same asset. Which is correct? I have no idea. Until an asset is sold to a willing buyer who is not compelled to buy, the value is anybody’s guess.

I will leave you with one thought: how would you have valued Facebook before its public offering?