By Sean Winter, Executive – Alternative Investments (Africa), RisCura
Private Capital fund managers are required to carry out the periodic valuation of their investments, usually on a quarterly basis. Performing these valuations falls under the core duties of the fund managers and forms an integral part of the reporting process to Limited Partners (LPs).
So, what is valuation all about? Simply put, valuation is the process of determining the fair value of an asset or a business. The challenge for private capital funds, from a valuation perspective, is that they primarily invest in private markets, or companies not listed on a stock exchange with a share price determined by the market. These fund managers have to therefore follow the rigorous benchmarks set by International Private Equity Valuation (IPEV) standards to calculate a Fair Value of their unlisted investments.
Who is affected by an improper valuation?
Fund managers are expected to report investments on a ‘Fair Value’ basis in order to portray real market conditions. Where a fund manager employs subjectivity and judgement in the valuation process, there is potential for bias. Concerns over valuation practices amongst closed-ended private equity (PE) managers have attracted increasing attention from regulators over the years.
For example, the US Securities and Exchange Commission (SEC) began an inquiry in 2011 into the valuation practices of 12 large US private equity managers. In March 2013, Bruce Karpati, Chief of the SEC Enforcement Division’s Asset Management Unit, indicated that the number of cases focusing on alleged misrepresentations of the value of private equity assets will rise.
Having said that, the problem of biased valuations affects more than just the regulators – and affects the entire chain of participants, from LPs to fund managers to fund administrators and portfolio companies, and ultimately the growth of the asset class with investors.
For LPs to use a fund’s reported Net Asset Value (NAV) as the starting point for a fair value estimate of their interest, the investor must satisfy itself that the fund’s valuation policies and procedures produce a NAV that is based on a robust determination of the fair value of underlying investments. For this, independence in the valuation process is a crucial pre-requisite.
Similarly, for fund managers, the danger of improper valuation can manifest as a reputational hazard. An over-valuation of the Fund NAV at the fundraising stage can cause investors to distrust, such fund managers, for subsequent funds, creating challenges for future fund-raising success. Even worse, scrutiny by regulators for an inflated valuation and possible enforcement actions could result in penalties, fines, suspension, debarment, and/or the hiring of an independent third-party (often at a substantial cost) to oversee remediation. In addition, fund administrators allied with such fund managers expose themselves to similar reputational risks and prospective penalties.
What are some potential conflicts of interest standing in the way of independence?
Of course, the fund manager may in practice, be the most reliable source to value an unlisted investment, given their in-depth understanding of that particular investment and the fact that they employ sound financial analysts capable of valuing unlisted assets. They may also design and implement their own valuation policies, which must be IPEV compliant.
However, potential conflicts of interest arise for a fund manager that takes an active role in valuing their portfolio without engaging an independent valuator to verify the valuations.
For example, the fund manager often receives an advisory and/or performance fee based on the value of the fund’s portfolio. In addition, the fund manager has a significant interest in its ongoing success and the understandable desire to optimise performance and the flow of investment to the fund.
Soberingly enough against this backdrop, several hedge funds and other private funds have been penalised in recent years over valuation problems. In 2018, the SEC issued its first penalty for overvaluation in a private-equity secondary sale, with fund manager Veronis Suhler Stevenson fined for allegedly concealing valuation details from LPs during a deal. Another such case included a US$5 million settlement with Deer Park Road Management Company over valuation inaccuracies that reportedly sprung from their use of an unqualified committee to oversee valuations. In 2019, the SEC charged SBB Research Group with a complaint stating that executives misled investors by using an internal valuation method that artificially inflated the value of structured notes.
Why the fund industry is seeing an increasing emphasis on independence in valuations
Whatever the cause of valuation misstatements, biased or improper valuations of unlisted assets may actively harm the interests of investors, for instance, as they buy and sell their stakes in the fund.
No wonder LPs increasingly require greater transparency regarding valuations, and regulators like the US SEC are expanding oversight and investigative resources to ensure sufficient safeguards are in place to protect investors. For example, in the US, the advent of Dodd-Frank and the Consumer Protection Act has increased emphasis on making sufficient disclosures to investors. Needless to say, non-compliance is not an option.
From a valuation perspective, there are several requirements, such as whether IPEV-compliant valuation policies and procedures have been formalised, and whether an independent third party is involved in performing the valuation. In addition, specific questions such as how illiquid securities are modeled and how independently valuations are calculated need to be addressed and disclosed. Limited Partners are now including the requirement of independent valuations in Limited Partner Agreements (LPA). In Europe, the AIFM Directive makes similar compliance demands for alternative investment fund managers (AIFMs) to adequately protect investors.
Against this backdrop, fund managers are waking up to the advantages of outsourced valuations that deliver complete independence and help shield the firm from accusations of overvaluation.
By trusting the entire valuation process to an independent, third-party expert, the burden of thoughtfully crafting a valuation policy, portfolio company valuations, and preparing adequate supporting files is completely shifted off the fund managers’ shoulders so that they can focus on their core competencies. Further, an independent valuation expert can provide LPs with additional confidence in the final outcome, as the results are prepared by a disinterested party who performs hundreds of valuations annually. A completely outsourced solution also avoids duplication of effort as the fund manager need not conduct the valuation in-house and then have it verified externally – but can simply turn to their trusted valuation advisor to oversee the entire exercise.
Why RisCura?
Many fund managers are finding out that the rigour, responsiveness, and reliability of an independent valuation – conducted end-to-end in an outsourced process – substantially benefits their LP relationships, improves their reputation, and mitigates risk. This is where we, at RisCura, come into the picture as independent valuation experts who bring to the table a range of specialised expertise in unlisted investments. As a leading provider of independent valuations to private capital funds, investment holding companies, credit funds, banks, and other investors, our valuations are used for investor reporting, audits, or to support investment decisions.
Although we have conducted valuations in nearly every continent, our emerging market focus has resulted in the largest proprietary database of African deals to give us the greatest insight into valuations in Africa. Our written reports provide valuable insight throughout the alternative investment cycle, including acquisition, reporting, and exit. We provide accurate and detailed independent valuations needed to comply with globally recognised standards such as AIFMD, IPEV, IFRS, IVS, US GAAP and ILPA.
Transparency and independence are key to the growth of the PE industry
In view of the rising share of PE – which had assets under management (AUM) at an all-time high of US$9.8 trillion as of July 2021, up from US$7.4 trillion the year before – the industry is becoming simply too big to ignore.
Overall, fund managers can expect greater scrutiny as they secure new investors and expand their portfolios. Consistency, objectivity, transparency, and the ability to stand up to rigorous examination must become a vital part of their operations in a compliance-focused age where firms are under pressure to constantly ensure that their activities meet the approval of regulators and investors alike.
