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TalkingPoint: Private Equity Portfolio Company Valuations « Back
July 2012
FW moderates a discussion focusing on private equity portfolio company valuations between Charles Lundelius at Berkeley Research Group, LLC, Michael Ryan at Hamilton Lane Advisors LLC, and Michael Athanason at KPMG LLC.

FW: Why are regulators now focusing more attention on private equity portfolio valuations?

Athanason: Increased regulation of the private equity industry is a global trend, and several factors are driving it, including the financial crisis, high profile cases against fund managers, new legislation, and limited partner complaints, amongst other reasons. The Securities and Exchange Commission (SEC) has increased its scrutiny of the private equity industry, by growing headcount of personnel that concentrate on fund managers and are themselves industry specialists. Regulators are particularly focused on risk areas such as valuation, investor reporting, fee structures, expense calculations/allocations, and conflicts of interest. Robert Kaplan, Co-Chief of the SEC’s Asset Management Group, recently affirmed at a conference that the SEC is squarely focused on the private equity industry. “I think that private equity law enforcement is where hedge fund law enforcement was five or six years ago,” Kaplan said, according to The Wall Street Journal. Reuters also recently quoted Carlo Di Florio, Director of SEC Office of Compliance Inspections and Examinations, who was speaking at the Private Equity Analyst Outlook Conference 2012, as commenting, “A significant percentage of new [Private Equity] registrants will face coordinated examinations focused on the highest risk areas of their business.”

Lundelius: There are no market prices for private companies. Valuing a private company is a complex and imprecise task because it often requires the use of estimates, forecasts, and models. Assume a 2006 valuation of a new start-up that proves to be dramatically higher than the actual value realised by investors in 2009. Did investors lose because of a faulty valuation or did the financial crisis play a role in the loss? In this example, regulators may investigate the 2006 valuation as well as the write-downs taken between 2006 and 2009. Regulators will investigate the periodic valuation assessments to ensure that the estimates were prepared in good faith and in accordance with regulatory and industry standards. In the US, the SEC has taken a keen interest in valuation issues related to private equity and has recently initiated several enforcement actions against PE funds that are publicly traded.

FW: How can general partners achieve portfolio valuation results that are robust, fully independent and functionally segregated from the investment team?

Lundelius: The Private Equity Industry Guidelines Group (PEIGG) has provided managers with a framework for valuing their private companies. The framework recommends that written valuation parameters be established and periodically reviewed by an oversight committee. In addition, some valuations may benefit from review by external valuation experts. An external valuation is especially useful if the portfolio company is operating in a difficult business environment where its solvency or high value may be challenged. The benefits of a robust process can be significant. For example, if the portfolio company has a complex capital structure where, under certain conditions, one class of third-party shareholders may receive additional shares of stock and dilute the PE fund’s investment, a robust process would evaluate the potential impact of such an event and inform limited partners to avoid rude surprises.

Athanason: General partners are able to achieve independent valuations by focusing on three key areas. First, develop a formal valuation policies and procedures document that is clear to investors in the offering memoranda or partnership agreements. Second, be consistent in the adherence to these policies and procedures. And third, develop a fully segregated valuation team, contract with an external third party reviewer, or use a combination of the two. A key question at middle market and small funds is how to assure CFO independence. One way for them to enhance independence controls is to use independent third party reviewers to augment their own staff, which is a common practice of large funds for regulatory, limited partner and auditor reporting.

FW: Why is having a written, detailed and independent valuation process in place important and how can general partners maintain compliance discipline?

Subjective judgments play a significant role in private company valuations. Therefore, investors or regulators may perceive bias in a non-independent valuation performed by a private equity fund’s manager. For instance, the SEC recently accused a major investment adviser of overstating the value of two portfolio companies in order to generate higher investment advisory fees. The SEC believed that because the companies were kept on a tight leash with regard to capital contributions, the companies’ ability to fund future operations was in doubt and that they were effectively insolvent. The PE manager valued them at tens of millions of dollars. This dispute could have been avoided if the manager had a written, detailed and independent valuation process to ensure that the investment team is not inappropriately influencing the valuation process.
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