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SEC Investigates Private Equity Industry
February 13, 2012
The private equity industry, which has avoided regulatory scrutiny over the past few years, is now getting, perhaps, some unwanted attention. The SEC has launched a broad examination of the PE industry, seeking information about how firms value their investments, among other matters.
SEC Enforcement began the investigation late last year with letter to several of the largest PE funds - what's the Commission referred to as an “informal inquiry.” It's not clear which firms received the letter.
Inquiry, 'Without Wrongdoing Suspected'. Whatever the SEC's motives - whether the SEC is looking to confirm suspicions, or seeks to gather incriminating information, or simply is conducting a 'fact-finding' sweep - the Commission told recipients of the letter that a request for information should not be construed as an indication that it suspected any wrongdoing. However, people with direct knowledge of the matter said the SEC's objective is the second objective - to gather and investigate possible violations of securities laws.
Focus of the Inquiry. One focus is how PE firms value their investments and report performance. Unlike the valuing of publicly traded stocks, valuing private equity investments - largely in private companies that are not listed on an exchange and are not liquid investments - can be a difficult and subjective process. It can also be an opportunity for some PE funds to overstate the value of their portfolios - a concern of the SEC.
Recent Attention to Private Equity Industry. Thanks to Republican Presidential candidate Mitt Romney, the PE industry is now a central issue in the presidential election. What's known by politicians and the general public is that the industry had thrived over the past decade that was characterized as a "buyout boom." Firms used mountains of leverage in the form of bank loans to acquire such major American companies as Clear Channel Communications hospital chain H.C.A. and automaker Chrysler.
More recently, Washington began to look into the favorable tax treatment enjoyed by PE executives. Performance bonuses earned by PE executives, or "carried interest," are taxed at the capital gains rate of 15%, rather than taxed at rates applicable to salary or ordinary income.
The Justice Department also began investigating whether the world’s largest PE firms colluded to drive down the prices of acquisitions that they teamed up on.
Registration Under Dodd-Frank. Under the nearly 2-year old reform act, most PE firms must register with the SEC within 2 months - by the end of March. The SEC already oversees many firms - e.g., Blackstone Group, Kohlberg Kravis Roberts - which are publicly traded companies. All told, the industry comprises several thousand firms that manage more than $1 trillion in AUM, or assets under management.
More on Issue of Valuations. Again, the SEC inquiry appears less focused on big-picture questions like private equity’s effect on jobs or the companies that it buys. Instead, the commission wants to deepen its understanding of more arcane issues like firms’ fee structures and how they value investments.
Robert Kaplan, co-chief of SEC Enforcement's newly formed asset management unit, told attendees at a PE conference last month that he thought the lacked sufficient oversight and deserved more scrutiny.
With portfolio valuation, PE managers use varying, complex methodologies to value their holdings - often private companies bought using debt. With few if any ascertainable market prices, subjective judgments are significant. The industry has in recent years provided managers with a framework for valuing their private holdings. The Carlyle Group, for instance, which filed to go public, lists valuation as a “risk factor” in its registration statement with the SEC, making the following note:
“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.”
Many firms use independent financial advisory firms that specialize in portfolio valuation, like Duff & Phelps. PE firms also contend that interim valuations are less important to investors in PE funds than investors in other vehicles like hedge funds - i.e.,PE funds earn profits only upon selling a holding - often through a public offering. The valuation of assets was prominent in the recent arrests of 3 former Credit Suisse executives, who were charged with inflating the value of their mortgage-bond holdings to secure higher bonus payouts. The SEC also filed several recent actions against hedge funds for displaying “aberrational performances." Guess the SEC is beginning to employ its own BLACK BOX to root out those who violate securities laws. It's about time. For further details: [Dealbook, 2/12/12].Related Stories: Archive
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