SEC casts its eyes on third-party valuations processes

US Securities and Exchange Commission examiners are asking registered fund managers to explain how they police the boundaries between their firms and the valuation experts they hire, opening a potential new regulatory front against an industry that already feels under siege.

Valuations have been an open flank for the private funds industry for a long time. Now, affiliate title Regulatory Compliance Watch has learned, the Commission is coming at the matter along a new axis: outsourcing. In recent months, a source with knowledge of the inquiries told RCW that at least two different private equity real estate managers have received document requests – one from the Commission’s Boston regional office, the other from the Division of Examinations’ private funds unit – asking them questions about their firm’s “input” into the valuations from the third-party firms they have hired.

Regulators are also asking the managers’ compliance officers whether they are monitoring communications between fund staff and the valuation company’s staff, the source said. They are asking for samples of surveyed chats as part of the document request, the source said. The source spoke on condition of anonymity.

‘Risk of client harm’

It is unclear whether these requests are for a discreet investigation, or from a broader concern about undue influence on valuations and the SEC declined RCW’s request for an interview with exams or enforcement staff. Private fund valuations – and the fees and expenses that often rest upon them – have been a consistent theme in regulators’ risk alerts, guidance letters, exam priorities and enforcement cases since the Great Recession.

SEC chairman Gary Gensler and his aides have all but said that private fund fees are too high. They have hinted that they think valuation models are suspect. The Commission brought a record number of cases against private fund managers to prove its points.

At the same time, regulators have accused funds of foisting their fiduciary duties onto outsourced firms and vowed to crack down. New rules have been proposed that would require registered advisers to vet, and continually re-vet, third-party providers. Examiners are already asking about ongoing diligence and monitoring in such contracts.

Regulators say they want managers to understand they can outsource some jobs without outsourcing any responsibility.

“The risk of client harm… exists when [a manager] outsources to a service provider functions that are necessary to the provision of advisory services without appropriate advisory oversight,” William Birdthistle, investment management director at the SEC, said in a 20 March speech. “These risks are compounded when the outsourced functions are highly technical or proprietary to the service provider.”

Testing the fences

The specificity of the SEC’s requests underlines a point compliance experts have been warning the industry about in increasingly alarmed tones over the past half-decade: regulators are getting shrewder about private fund regulation.

“The SEC has in-house experts, too,” said H Gregory Baker, chair of Patterson, Belknap’s securities litigation group. “The Commission clearly sees this as a critical issue. A lot of these questions can get very technical, and they are committed to bringing in the technical experts they think they need to bring complex cases.”

On 29 March, Gensler testified before a US House Appropriations subcommittee to ask for even more examiners and enforcers.

“If you’re playing catch-up with regulators, you’re already behind the game,” said Richard Olson, managing director and head of European valuations for Chicago-based investment bank Lincoln International. “For most managers, valuations are an important communication tool with your LPs. It’s the way of delivering the message of how well things are going.”

Sounds and signals

The message sounds sweeter in a strong economy, Olson said. Now that things are a little wobbly, the risk of noisy investors grows – especially for firms that target retail or high-net-worth investors, Olson said.

“There are times when the markets become disorderly and you almost have to ignore the noise and focus on portfolio company fundamental performance, which is a key driver of private company valuations,” Olson said. “For certain investors, that’ll be fine. They’ll be able to ignore the noise, they don’t need the liquidity. Within the group of high-net-worth and retail investors, though, sometimes folks will have different liquidity and time horizons than the managers.”

For private funds, the difficulty is that those noisy investors are increasingly being met by increasingly perceptive regulators, said David Tang, a partner at Dorsey & Whitney. He said he has noticed exponential growth in the technical savvy of SEC examiners.

Tang cites two recent exams as case studies. In one, the regulator found a small fee billing error that the fund’s auditors had missed. In another, the adviser was asked about a missing footnote about a related-party transaction that the firm’s auditors didn’t think was material. It shows that regulators, some of whom come from accounting backgrounds, are reading everything closely. “In the same way, [fund] advisers must mind every detail,” Tang told RCW.

‘Problematic for managers’

If regulators are questioning the level of collaboration between third-party valuation agents and private fund managers, “it could become problematic for managers”, says Igor Rozenblit, a former top SEC exams official, now a partner at Iron Road Partners.

“It is necessary for third-party valuation agents to work with managers to gather data and learn about each holding. Additionally, there could be discussions about how to interpret certain information and the methodology used by the third-party valuation agents to set the final marks.

“It will be very challenging for regulators to draw the line between normal collaboration and inappropriate influence,” Rozenblit added. “Any line the regulators ultimately do draw would have substantial repercussions throughout the private markets and the valuation industry.”