Valuation paper trail essential for SEC exams

That a private equity firm can justify its valuation process is often of more concern to the US Securities and Exchange Commission than the accuracy of the outcome of the valuation, according to industry sources.

Discussing SEC valuation examinations at the PEI Private Fund Finance and Compliance Forum in San Francisco on Tuesday, both GPs and external auditors said the SEC is more likely to take enforcement action over misunderstanding of the valuation process than inaccurate valuations.

While an auditor places importance on the materiality threshold – the point above which missing or incorrect financial information is considered to have an impact on decision-making – the SEC doesn’t really consider this, one auditor said.

“Enforcement action was taken against one firm over the use of a valuation model, created by a major company, which had a mathematical flaw,” the auditor said.

“The action was taken because the firm hadn’t demonstrated why it believed in the output of the model, not because it used a model which produced a flawed valuation assessment.”

Panellists agreed it was essential a firm creates a paper trail, and a robust valuations practice, and that everyone involved in the process can justify their actions.

“There must be a written methodology, and you must make sure you follow it when producing valuations. Pull it out, review it annually, make sure everyone involved in the process can answer questions about it,” one GP said.

There was also consensus that robust, internal valuation was sufficient in the eyes of the regulator, and there is no need to subcontract the task to a third party.

“You won’t get extra credit from the regulator if you outsource your valuations. It’s fine to do so, if you need extra resources, or need to double check things, but it’s certainly not a requirement,” a second GP said.

A third panellist added the output of a third party valuation is only as good as its input, and much depends on the degree of assumption that goes into the calculation.

One area in which there was some disagreement was the extent to which the SEC is cracking down on valuation processes.

One GP said there wasn’t much focus on valuations; rather, it was examined in instances where a firm’s valuations process was deemed a significant risk. A second said there were many examples of the SEC “deep-diving” on the matter.

But there was agreement that firms must continue to bolster both the process itself and the documenting of the process, regardless of the extent to which they believe the regulator is scrutinising it.

“There is increased guidance being released, increased expectations from both regulators and LPs, and increased demand for the provision of valuation documents. It’s an ongoing evolution, its regulation will remain, so robust methodologies and reporting must continue,” one GP said.