The enforcement division of the SEC’s Asset Management Unit has recently brought a number of complaints against various hedge funds and their investment managers.
Several of these complaints allege that the managers inflated the values of their funds’ illiquid investments, so that they could overstate the fund’s performance figures and charge higher fees. These are neither new nor isolated incidents.
The SEC has been scrutinising fund valuations for years, although its focus was traditionally within the registered products world. In the past year however, as part of an initiative to combat hedge fund fraud by identifying abnormal investment performance, the SEC brought 50 cases against hedge fund managers.
These inquiries have also extended into the private equity space. While historical cases against private equity managers have focused on market-facing conduct, there is a renewed focus by the SEC towards perceived higher risk areas. One of the areas drawing their attention is investment valuation and whether the investment manager is applying a systematic and consistent approach.
In the alternative investment world there are at least three reasons the valuation of investments is important. Firstly, if fees are charged based on a fund’s net asset value (NAV), an overvaluation means that any fees based on that NAV (typically performance, management and administration fees) are being overpaid to the detriment of investors.
Secondly, if the fund’s interested parties are transacting based on the NAV, either on an exchange, in the secondary markets, or through subscriptions/redemptions, then a misstated valuation results in one of the parties to the transaction being harmed.
If a portfolio is valued too highly, a redeeming investor profits at the expense of those who remain in the fund. On the other hand, a conservative valuation leads to a transfer of economic gain from redeeming investors to remaining and new investors.
Finally, valuation issues result in fund performance being misstated; therefore investors and potential investors would be making decisions regarding investments in the fund, as well as overall allocation decisions, based on misleading data.
The absence of procedures and controls in the area of valuation can lead to misstatements of a fund’s value, which in turn may have a detrimental impact upon the decision-making processes of managers and investors. In certain scenarios, persistent overstatement of the value of a fund’s net assets may hide or facilitate misappropriation of those assets.
Private equity funds
Unlike many hedge fund managers, private equity fund managers do not spend much time or resources trading in public markets. Since private equity funds, by definition, invest in private illiquid securities, it is difficult to objectively gauge valuation by existing public market trading data.
Publicly quoted market prices are generally not available for the bulk of private equity fund portfolio investments.
Private equity funds are designed to hold illiquid investments that may take seven or more years to realise. Most private equity fund managers earn their management fees on committed and invested capital and may be entitled to carried interest on portfolio company realization events (such as a sale or IPO of a portfolio company).
Typically these fund structures do not allow for any type of redemption or investor exit prior to maturity of the fund. Consequently, private equity funds largely skirt two of the issues identified above.
An overstated valuation may cause a manager to pay out carry prematurely, but there are almost always claw-back features that allow this to be corrected. In terms of transacting, private equity funds do not allow for redemptions, so aside from secondary market transactions, investors do not realise a value based on the NAV.
Little immediate economic incentive would therefore seem to exist for most private equity fund managers to inflate the valuations of their portfolio companies because they are not typically paid on the basis of internal valuations. When raising new funds, however, private equity fund managers do typically disclose the internal valuations of their portfolio investments.
Most private equity funds also provide their investors with quarterly updates on the performance of the portfolios which typically include the current internal valuation of all portfolio investments currently held by the funds.
The incentive can exist, therefore, for private equity fund managers to inflate their own internal valuations in seeking to attract investors or to highlight to current investors the strong performance of their fund.
Hedge fund considerations
In contrast, hedge funds holding illiquid or difficult-to-value investments face all three of the valuation risk factors listed above. If fees are being improperly charged, or if investors are transacting at prices that do not reflect fair value, investors are being harmed, and the SEC (and other regulators) becomes very concerned when this occurs.
Obviously inflating performance to attract investors (or to keep existing investors from exiting) is also a major concern, but it is generally easier to quantify the impact of a bad valuation on fees or transactions than on “allocation” decisions.
Certain valuation issues are inherent to many hedge fund strategies. One such issue is that of the so-called “black box” trading strategies. There, the value of a fund’s portfolio is often determined on a “mark to model” basis, and it will generally be difficult for a third party to perform a comprehensive, independent valuation of that portfolio.
Other areas which raise particular valuation issues are; esoteric instruments, thinly-traded or concentrated positions, and positions with embedded uncertainties.
Typically, a significant component of hedge fund manager compensation is tied to fund performance based on the ultimately realised value of the investment positions held by the fund. These incentive fee arrangements are intended to align investor and manager interests, and provide the requisite motivation for top-quartile manager performance.
However, incentive fees can create conflicts of interest between managers and funds in the valuation of portfolio investments and presentation of fund performance. The conflicts are especially apparent for classes of investments that do not have easily-identifiable market prices.
Further, liquidity of most classes of investments may be (temporarily) impaired by inclement market developments, which adds to the difficulty in valuing these investments.
Solutions to valuation challenges
Valuation of financial assets is an area where inherent risks can never be fully eliminated, regardless of how straightforward the asset class, or investment vehicle, may appear. Nevertheless having a robust and proper valuation for difficult-to-value assets is now “table stakes” for alternative managers.
The first step is having a robust valuation policy and well-developed and defined valuation procedures. Next, funds need to implement and follow the policy.
It is industry leading practice to use an independent third-party valuation expert for difficult-to-value holdings that are also material, and this is good evidence of fulfilling fiduciary responsibilities for investors.
Another potential solution is for the fund to decide at inception that fees on illiquid investments will be based on historical cost or invested capital, rather than on fair value, until the investment is sold.
These investments can be side-pocketed, as many fund managers implemented during the recent financial crisis, until they are able to be sold or more reliably valued, so that neither redeeming investors nor the funds’ other investors are harmed by an exit occurring at either an above or below market valuation.
Hedge fund managers need to dispel conflicts of interest in the valuation of fund investments to gain investor confidence. Appropriate separation between fund management and investment valuation responsibilities, oversight of the entire valuation process, and a special focus on difficult to value investments are critical elements of a well-formulated valuation framework.
In addition, a robust valuation framework is best complemented by adequate disclosures that discuss the critical elements of the valuation framework.
Clearly the valuation of hedge fund investment portfolios can be fraught with conflicts of interests because of the incentive fee remuneration of most managers. These fees, designed to provide adequate motivation to the fund managers, can create perceived or real conflicts, in the context of investments that are difficult-to-value.
This is true whether the difficulties arise due to a dearth of market information for similar investments, or due to (temporary) illiquidity, or both.
However, a well-executed valuation framework that includes appropriate valuation policies and procedures, an adequate governance mechanism, and an able team of valuation personnel (either internal or external) can successfully minimise investors’ risk.
While external valuation expertise is not a substitute for a sound valuation framework, incorporating such expertise can considerably improve the effectiveness of the valuation framework in assuaging investor concerns related to the valuation of fund investments.