The Securities and Exchange Commission (SEC) has decided to increase regulation of the private equity industry, which has previously faced less regulatory scrutiny than other industries such as banking and hedge funds. At the end of 2012, the SEC sent several letters to private equity funds as “informal inquiries.” It is unclear which firms actually received the letters. The SEC maintains that its actions are not a result of suspecting any particular wrongdoing by specific firms, and it claims that its goal is to investigate possible violations of securities laws.
In the letter, the SEC requested information from private equity firms in relation to 12 broad areas including:
- Financial statements;
- Support for valuations of fund assets;
- Documents setting forth a value of any assets owned by a fund over the past three years; and
- Information on agreements between the firms and those that value fund assets.
The SEC is placing greater emphasis on the valuation of private equity firms since the firms are not publically traded and there is no listing price on the stock market. As a result, there is no easily ascertainable price for private companies. This allows for subjective judgments to play a large role in valuation. Private equity managers use varying, complex methodologies to value their holdings, which are often private companies bought using debt.
In response to claims that private funds are inflating their valuations, many private equity firms claim that they have adequate valuations methods in place. In addition, many firms use independent financial advisory firms that specialize in valuation. They also claim that interim valuations are less important to investors because the private equity funds only earn profits when they sell their holdings. This is different from other investment instruments such as those that make distributions from gains on underlying investments.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) should have put the private equity industry on notice that the SEC would increase supervision. Dodd-Frank requires fund managers with more than $150 million in assets under management to register with the SEC as investment advisers by March 2012.
The SEC and the Massachusetts Attorney General are already taking action in this field. According to the Wall Street Journal, both regulators are reportedly investigating Oppenheimer Global Resource Private Equity Fund LP, a private equity fund affiliated with Oppenheimer Holdings Inc. Oppenheimer Global Resource Private Equity Fund LP, which invests in other private funds, currently has $140 million assets under management. This represents a large increase from the $20 million in assets it managed in April 2008.
According to the Wall Street Journal, Oppenheimer Global Resource Private Equity Fund LP may have overstated its holdings in late 2009 by more than $4 million. The article stated that the overstatement reportedly helped push the fund’s reported internal rate of return to 38 percent, after fees, from a loss of 6.3 percent in the previous year. As a result, the private equity fund subsequently raised more than $55 million from individuals and various institutions. The fund and related assets were spun off by Oppenheimer Holdings this year.
When Oppenheimer learned that the SEC and the Massachusetts Attorney General expressed concerns, it began an internal investigation in June 2011. The company claimed that its investigation did not show any wrongdoing within the private equity fund, and a spokesperson for the company stated, “The investigation, which included numerous interviews of Oppenheimer employees and the independent auditors for the fund, concluded that the valuation increase was within U.S. accounting standards and the allegations were without merit.”
The SEC and the Massachusetts Attorney General declined to comment. Private equity firms should keep a close eye on developments in this and other investigations.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds and issuers of securities, among others. Our regulatory practice group assists financial service providers with the complex issues that arise in the course of their businesses, including helping private equity firms comply with new regulations.