SEC Scrutiny and the Pitfalls of Valuation
by Steve Lueker, Managing DirectorMr. Lueker is managing director for NewOak, an independent financial services advisory firm built for today’s global markets. Led by a team of experienced market and legal practitioners, NewOak provides a broad range of services across multiple asset classes, complex securities and structured products for banks, insurers, asset managers, law firms and regulators. Visit newoak.com
Private equity managers know that any implication or reference that they may have engaged in some sort of fraud or filed misleading documents could be the kiss of death to their career.
The most recent Securities and Exchange Commission (SEC) order regarding AlphaBridge Capital Management and the litigation with Patriarch Partners may underscore a change that’s blowing in the wind.
Private equity managers are a target. Carried interest rules face different tax treatment, and the SEC is pursuing private equity firms that fail to maintain valuation procedures or have valuation procedures that fail to conform to representations made to investors. Recent speeches (over the last two years) made by SEC officials illustrate the focus and concern of SEC investigations, which is further exemplified by the AlphaBridge and Patriarch cases.
SEC Officials Express Concern on Valuation
Over the last two years, various SEC officials in public speeches have articulated concern regarding asset valuation in the private equity industry. In examining these speeches, a few themes emerge:
1 – Transparency
Transparency to investors is crucial. In a speech on June 30, 2014, Norm Champ, director of the SEC Division of Investment Management at the time, made clear that one key to effective valuation is the development of robust valuation policies and procedures.” Additionally, Andrew Bowden, director of the SEC Office of Compliance Inspections and Examinations, noted that transparency is definitely needed, but warned that a “lack of transparency and limited investor rights have been the norm in private equity for a very long time.” As discussed below, lack of transparency (with respect to valuation methodologies) was an issue in both AlphaBridge and Patriarch.
2 – Inherent Conflicts of Interest
Private equity managers must be cognizant of and careful to avoid potential conflicts of interest. Bowden warned that there are “inherent risks in private equity” that create real and significant conflicts of interest. As illustrated in AlphaBridge and Patriarch, such conflicts of interest can easily arise during the valuation process – e.g., fund managers are potentially motivated to value fund assets higher so as to maximize advisory/management fees.
3 – Clearly Defined Evaluation Procedures
Best practices dictate that partnership agreements (e.g., the fund-governing documents) should have clearly defined valuation procedures. Bowden noted that he has observed instances where fund documents (e.g., limited partnership agreements) are lacking in certain key areas – such as having “clearly defined valuation procedures.”
4 – Conformity with Disclosed Valuation Methodology
Private equity funds must use a valuation methodology that is consistent with the one that has been disclosed to investors. Bowden noted that the SEC’s examiners are scrutinizing whether the actual valuation process aligns with the process that an advisor has promised to investors. He noted that valuation methodology may evolve over time so that the methodology differs from what was originally represented to investors, but this would depend on the circumstances and the legal obligations and representations made to investors. However, he stressed that at minimum “the change in valuation methodology should be consistent with the advisor’s evaluation policy and should be sufficiently disclosed to investors.” This is an issue both in AlphaBridge and Patriarch, where both fund managers used different methodologies from what they disclosed to investors.
The Importance of Valuation
Private equity companies earn annual fees based on a percentage of the valuation of investments held in their underlying funds. Thus, the higher a fund carries its investments, the higher its fees. This creates a potential conflict of interest.
Two SEC orders – regarding AlphaBridge Capital Management, LLC and Patriarch Partners, LLC – illustrate its concern that the private equity fee structure has the potential to motivate managers to mark their Level III assets higher so they will generate higher fees. Generally, Level III assets fall into the category of assets that are highly illiquid and thus cannot be easily and readily valued by reference to market quotes or inputs. Instead, Level lll assets require modeling to determine their fair market value, which includes projecting cash flows, default rates, discount rates and prepayment or redemption/optionality features of the underlying assets. Thus this poses the question of who should perform the valuation of the fund’s Level III assets—should the fund perform the modeling itself or hire an independent valuation firm? The valuation of a fund’s assets is determined by either the fund’s governing documents or the representations made to investors.
Many times, a fund’s prospectus will make representations that the manager will obtain independent valuations or utilize a certain methodology to conduct valuations on its assets. Additionally, audited financial statements typically contain language describing how the fund arrived at its asset valuations along with representations as to the accuracy of the statements, which correspondingly would then include the valuation of the Level III assets as well. If a fund values its assets differently from what it has represented to investors, such action could amount to fraud.
In the Matter of AlphaBridge Capital Management, LLC, et al
In AlphaBridge, the company made representations—in its financial statements, responses to due diligence questionnaires and other written statements—to its investors as well as its auditor that it obtained monthly price quotes for its assets from two independent and reputable broker-dealers to support its monthly valuations. The general theme of these representations was that the price quotes obtained from these broker-dealers were truly independent of, and not controlled by or influenced by, the management company. In reality, however, AlphaBridge was performing the valuations on its own assets and submitting those valuations to independent persons for approval (who incidentally were not authorized by the broker-dealers for whom they worked to provide valuation marks). Additionally, from the facts it is clear that these “independent persons” were not independent but simply rubberstamping AlphaBridge’s valuations and being coached by AlphaBridge to justify how they arrived at the valuations when later questioned by AlphaBridge’s auditors.
The SEC found that, based on AlphaBridge’s conduct, it had violated the Investment Advisers Act of 1940 (the Act), Sections 206(1), (2) and Rule 206(4)-8. Generally, these sections prohibit an investment advisor from defrauding its investors/clients. Additionally, the SEC found that AlphaBridge violated Section (4) of the Act, which requires an investment advisor to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Act. As a result of the SEC’s investigation and findings, AlphaBridge’s funds were shut down and put into runoff. The SEC’s order barred AlphaBridge’s compliance officer from working in the financial industry (generally speaking) for three years and imposed monetary damages of $5 million on the company, its chief executive and its compliance officer.
In the Matter of Lynn Tilton; Patriarch Partners, LLC et al
The SEC issued a cease-and-desist order against Patriarch with the hearing to be conducted in the fall of 2015, which has been stayed by the Second Circuit for the time being. Thus, the findings in the order (and as described herein) are allegations until proven.
Patriarch created and managed the CLO funds—a CLO is a securitization vehicle in which a special purpose entity raises capital by issuing secured notes to its investors (indentures). The investment proceeds are then used to purchase a portfolio of commercial loans. These underlying loans are often referred to as “collateral.” As interest and/or principal are paid on the underlying loans, these funds are then available to make payments on the secured notes to the investors.
Each fund had a collateral management agreement, which describes the rights and responsibilities of the parties, including how valuations would be determined on the underlying loans. Patriarch essentially earned a 2% fee on the value of the assets in the fund. The indentures contained certain numeric tests that must be met on a monthly basis, and if those tests were not met, certain consequences would follow—including increased rights by the investor to control the fund and the elimination of Patriarch’s fees.
Between the indentures and the collateral management agreement, Patriarch represented to its investors that it would employ certain categorization methods in computing the value of the fund’s assets (e.g., if certain loans went into default, they would be given a lower categorization status, which would in turn trigger a lower valuation). Additionally, the funds’ financial statements made certain representations that valuations had been calculated in accordance with the indentures and/or collateral management agreement.
In search of transparent valuation
In particular, the financial statements said that “fair values are based on estimates using present value of anticipated future collections or other valuation techniques.” However, in practice the valuation techniques set forth in the indentures and/or collateral management agreement allegedly were not followed. Furthermore, the order found that valuation was subjectively determined by the CEO of Patriarch, and loans were moved from the highest categorization to the lowest categorization only when Patriarch decided not to “support” the company to which it had extended the loan.
In turn, the SEC order alleges that the CEO classified only “very few” loans as being in the default category, which was a pervasive pattern. As a result, the SEC order concluded that Patriarch collected or accrued almost $200 million in fees to which it was not entitled (because the value of the funds was improperly inflated). The order goes on to find that Patriarch’s approach to valuation created a significant and material conflict of interest and breach of its fiduciary duties to its investors.
Accordingly, the order alleged that Patriarch violated Sections 206(1), (2) and (4) of the Act as well as Rule 206(4)-8. As a result, the order instituted cease-and-desist proceedings against Patriarch to conduct a hearing on the above issues.
It should be noted that Patriarch responded by filing suit in federal district court challenging the constitutionality of the SEC’s in-house proceedings. U.S. District Judge Ronnie Abrams dismissed the suit in June for lack of jurisdiction over Patriarch’s claims, indicating that the SEC has sole discretion in deciding where it wants to bring an enforcement action. Currently, the Second Circuit has stayed the trial (which was set for October) while it considers the constitutionality of Patriarch’s claims.
While a final outcome has not been decided in Patriarch, the company has incurred significant expense in defending itself, and the time involved can be a distraction from the company’s business. Moreover, if the case is ultimately decided against Patriarch, damages and penalties could be significant.
AlphaBridge and Patriarch underscore the potential liability that funds and fund managers face when Level III assets are not valued according to transparent valuation procedures. This cannot be emphasized enough—fund managers should carefully plan out and document their valuation methodologies, and then be fully transparent with their investors. Because an inherent conflict of interest exists when a fund values its own assets, it often can be a cost-efficient decision to delegate valuation to an independent firm (viewed in the context of penalties, reputational damage and management’s time to focus on an investigation or defend investor allegations).
Disclaimer: The views expressed herein are my own, and do not necessarily reflect the views of NewOak or my colleagues.
 See “Remarks to the Practicing Law Institute, Private Equity Forum,” dated June 30, 2014, Norm Champ, Dir., Division of Investment Management.
 See “Spreading Sunshine and Private Equity, “dated May 6, 2014, Andrew Bowden, Dir., Office of Compliance Inspections and Examinations.
 Some of these fees were payable to the CEO of Patriarch or other Patriarch affiliates.Alphabridge SEC Enforcement OrderTilton/Patriarch SEC Enforcement OrderRemarks to the Practising Law Institute, Private Equity Forum, by Norm Champ June 30, 2014
Spreading the Sunshine in Private Equity, by Andrew J. Bowden May 6, 2014