Valuing Private Equity Assets: One Step Forward, Two Steps Back
The valuation of illiquid assets is a vital activity in the private equity business. In today’s post we will see how the SEC is taking a small step forward in examining the industry’s practices, while the industry is taking a huge step backward in undermining the independence of the valuation process.
Before we get to the SEC and the industry’s efforts, a bit of background might be helpful. Until a private equity or real estate manager sells an asset, investors must rely on the estimates produced by investments managers. Not surprisingly there’s a great deal of guesswork that goes into coming up with the value of a company or property that’s not actively traded in a stock market. While investors can take some steps to check key assumptions, they are heavily reliant on the good faith of money managers in producing these estimates. Unfortunately, money managers may have reason to inflate valuations in order to hide bad news or to make an existing fund’s track record look good while they market a new fund. Hence the SEC’s interest in nosing about a bit.
|Road Trip (2002)|
A recent settlement between the SEC and Oppenheimer appears to send a message that the SEC is becoming active in this area. In this matter, the manager grossly inflated the value of the largest asset in one of its funds, which allowed them to report that the fund had a 38.3% gain when, in fact, the gain was only 3.8%. The fund was small with only about $500 million in assets, and the fine isn’t particularly noteworthy at just under $3 million. Apparently the inflated returns were in marketing subsequent products.
Oppenheimer's violation is a bit more egregious than merely misestimating a valuation in a private equity fund, because its misdeed occurred in a fund of funds. In a fund of fund, the manager receives a valuation from the underlying manager. Thus, Oppenheimer didn’t have to go out on its own and come up with a valuation. It received an estimate from Cartesian, the underlying manager, and then deliberately altered Cartesian’s estimate. The violation was pretty straightforward. Nonetheless, Oppenheimer did not have to admit to the charges in settling the case. In the end, this is a small victory for investors.
Let’s turn to private equity’s recent action in controlling the valuation process. In reporting about the Oppenheimer story, Peter Lattman of The New York Times noted that Carlyle and a group of other private equity investors are acquiring Duff & Phelps, which does valuation work on illiquid assets for private equity firms. When this deal is completed, private equity will control the firm that is supposed to produce independent valuations of private equity assets. In short, Duff & Phelps will be hopelessly conflicted. How can a private equity firm own a business that values private equity assets? How can D&F provide an independent valuation if it is owed by a PE firm?
So on the one hand, the SEC is taking tentative steps to examine the valuation practices of private equity. Meanwhile, private equity is taking giant steps to control the largest independent source of valuations. From where I sit, that’s one step forward and at least two steps back.