The Securities and Exchange Commission brought another case out of its Aberrational Performance Inquiry initiative in the Enforcement Division’s Asset Management Unit. That initiative identifies funds with suspicious returns and flags performance that is inconsistent with a fund’s investment strategy or other benchmarks forms a basis for further investigation and scrutiny. The initiative nabbed GLG Partners for overstating its stake in an emerging market coal mining company.
This case’s headline caught my attention because it’s a challenge of a hard-to-value asset. A private equity stake in a company is a Level 3 asset that can’t be determined by outside data sources. I would expect that a fund that used a thoughtful process and could justify its assumptions in a valuation should not have the value challenged by the SEC.
For private funds, valuation is a key area of focus for the SEC. I’ve heard from examiners that they are looking for consistent valuation process with justified assumptions for hard to value asset.
GLG appears to have a few red flags on its valuation that would raise questions. GLG bought the 25% stake in Sibanthracite for $210 million March 20, 2008. Just 11 days later, GLG wrote up the value to $425 million on March 31. That’s a big jump in value.
The asset stayed at the $425 million valuation until December 2010. That’s a long time for an asset to stay at the same value. According to the SEC order, there was a failure in GLG’s process to determine the fair value of the investment.
I hope one of the reasons that the action was taken was because of the resulting impact the valuation failure had on the management fees earned by GLG. The inflated valuation resulted in GLG earning extra management and administration fees of about $7.8 million.
GLG was a hedge fund and earned its management based on valuation. That is unlike the private equity fund model where the fund does not typically earn a management on an increased valuation, but instead earns a promote on a realized value.
The investment happened just before the financial crisis in the fall of 2008 and the improper valuation occurred during the turmoil of 2009 and 2010. According to news reports, GLG created a side pocket for the Sibanthracite holding, limiting investors’ ability to redeem from the fund.
The SEC also piled on and faulted GLG for improper statements of AUM on its Form ADV filings.
The reports are not clear on how GLG came to the attention of the SEC. The press release credits the Aberrational Performance Inquiry initiative. I’m skeptical that GLG was flagged for over-performance when the investment was not subject to market pricing. Perhaps the Aberrational Performance Inquiry initiative it just running all of the cases where there are valuation issues.