SEC Reviews Private Equity’s Valuation of Portfolio Companies

Federal Agency Identifies Valuation Risk Factors and Best Practices

Could the Securities Exchange Commission’s informal inquiry regarding valuation be an opening salvo to allow more formal investigation, or even regulatory action? The McLean Group shares an in-depth analysis of the SEC’s findings.

The Investigation—An “Informal Inquiry”

In December 2011, the Securities and Exchange Commission (SEC) launched an “informal inquiry” asking private equity firms to provide detailed documentation as to how they value and report their valuation of portfolio companies. The McLean Group has reviewed the SEC letter, which may be a potential precursor to a formal investigation or other regulatory action.

The Inherent Conflict of Interest

Many people—including lending organizations and investors, among others—rely on private equity firms’ financial statements. However, the presentation of the financial statements poses several inherent conflicts of interest. Higher valuations help private equity firms demonstrate a successful track record, which helps them solicit new investors and attract and close more deals. However, given the inherent illiquidity of a private equity firm’s investments, the ultimate returns on investment cannot be known before the investment is sold. In the interim, fund managers must estimate the value of their investments and present their estimates to investors. 

Although conflicts may exist, they are not as severe as those existing with hedge funds, where performance fees typically are paid annually. Private equity funds earn performance fees only when a gain has been realized through the sale of an underlying private equity investment, thereby making interim valuations less significant.

Potential for Different Valuations

Variances between a private equity firm’s valuation and the portfolio company’s valuations may also raise several issues. For instance, a private equity portfolio company will perform valuations throughout the year when stock options are being granted or in conjunction with a goodwill impairment test or for other accounting purposes. A portfolio company’s board and management may present one valuation while a private equity fund presents another. 

The Valuation Challenge

Privately held business valuations have long been an issue. Since most portfolio companies are not publicly traded, exact values are not readily available. While the valuation industry’s rapid development over the past decade helped establish more valuation standards and accounting guidance, private company valuations remain “more art than science,” given the role of subjective assumptions and professional judgment in the process. The fact that private equity portfolio valuation is not an exact science constitutes one of many risks that private equity fund investors encounter.

More frequent and effective communication and sharing of valuation models and assumptions among board members, management, private equity funds, and others involved in the oversight and management of the business is critical in order to provide the most consistent perspective and best estimate of value.

The New York Times’ Peter Lattman reported that when The Carlyle Group filed for its initial public offering, it listed valuation as a “risk factor” in its SEC registration statement: “Valuation methodologies for certain assets in our funds can involve subjective judgments and the fair value of assets established pursuant to such methodologies may be incorrect, which could result in the misstatement of fund performance.”

As a result, private equity funds incur greater costs to establish rigorous internal valuation processes and engage third party experts to incorporate a level of independence in the reported results. The resulting costs, in turn dampen financial returns. 

Best Practices

More frequent and effective communication and sharing of valuation models and assumptions among board members, management, private equity funds, and others involved in the oversight and management of the business is critical in order to provide the most consistent perspective and best estimate of value. 

Large private equity firms like KKR & Co. and publicly traded private equity firms like American Capital Strategies minimize conflicts by engaging third-party valuation firms and auditors to perform and review their portfolio companies’ valuations. At January 2012’s Dow Jones’ Private Equity Analyst Outlook Conference, SEC asset management unit co-chief Robert Kaplan said, “Private equity law enforcement today is where hedge fund law enforcement was five or six years ago.” Consequently, as regulation and scrutiny increase, more private equity firms will seek out third party valuation experts to analyze their portfolio companies.