Private funds are often dealing hard-to-value assets. Real estate funds are overwhelmingly dealing with hard-to-value assets. For purposes of GAAP reporting those will be the Level 2 and Level 3 assets. For these assets, valuations can be manipulated if you have a wiling participant in the process.
For thinly-traded securities, like some bonds, private funds will often rely on quotes from a broker for a potential sale. For the fund manager, the source was usually a broker that was in the circle of those trading for the fund.
A potential conflict exists, with the broker hoping to get more business from the fund and the fund hoping for a higher valuation. There is not much for the broker to lose by quoting a slightly higher sales price for thinly-traded bond in a hypothetical sale. Especially if the broker knows that she or he will not be required to actually trade that bond. In return, the broker may get additional business from the fund.
The Securities and Exchange Commission has been looking at conflicts and potentially illegal practices in this area.
In May, a former broker named Frank DiNucci Jr., said under oath that he provided bogus quotes to a trader at a mortgage bond fund. DiNucci plead guilty to conspiracy and fraud and has been cooperating with a criminal probe by New York prosecutors. The DOJ has charged at least seven bond traders since 2013 with lying to customers about prices. Now the focus has widened to also include the buy-side of the market and is staring at practices at private funds.
Level 2 and Level 3 assets are by definition hard-to-value. A fund can not prove that the value is accurate. But it can be precise, by being consistent in its valuation procedures and ensuring that the pricing indications it receives are unbiased. Accurate and precise is the best result. But following procedures and being precise is the most important.