Tag: Valuation

Alternative Funds and Valuations

It should come to no surprise that alternative funds have an extra level of scrutiny when it comes to valuations. RD Legal Capital is under scrutiny by the Securities and Exchange Commission according to a story in the Wall Street Journal.

Valuation

RD Legal is in litigation finance with a strategy to to buy stakes in a judgment at a discount to the likely settlement. The firm bankrolls lawsuits hoping to collect if damages are paid. It took a big stake in a lawsuit against Iran, buying claims at a steep discount.

Apparently RD Legal has been writing up the value of that stake even though no settlement has been paid.

Valuation, whether right or wrong, is more subjective when it comes to illiquid assets. Real estate fund managers and other alternative fund managers are aware of this. The fairness question and therefore the regulatory question is what the effect of the valuation is on the investors and the fund manager. If the fund manager can take an extra fee on unrealized gains, the valuation should be subject to extra scrutiny.

The SEC is accusing RD Legal of taking cash at the expense of investors based on the increased valuation.

I fear the outcome will be one based on hindsight. If the settlement gets paid, the increased valuation will be justified. If it never appears, then the firm will be subject to even greater scrutiny.

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SEC Brings a Valuation Case Against an Investment Adviser

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Lynn Tilton and her firm, Patriarch Partners, are known for their high-risk, high-return investments in distressed companies. The Securities and Exchange Commission brought a case against her and the firm claiming that they were using improper valuations, failing to mark down assets when the investment became more distressed.

At this point we only have the SEC’s charges. According to a quote in the Wall Street Journal: “I’m choosing to fight,” Ms. Tilton said. “My reputation is very important to me and my companies. When my integrity or my intent are questioned, I fight back and let truth prevail.”

She will have to fight the SEC on its home turf. The SEC chose to bring the case as an action in its administrative court,s instead of federal district court. According to the Wall Street Journal the SEC brought the case through its in-house court in part to try to move the case quickly, since one of the funds at issue has a maturity date in November 2015.

Debt tends to be trickier to value than equity. There is the judgment call about how likely you are to have the debt repaid. This is even trickier with Patriarch where the debt is being used to fund the company’s turnaround being managed by Tilton and her companies. She would have the direct power or influence to determine when debt was repaid.

Patriarch’s valuation policy calls for current loans to be valued at the principal amount of the outstanding loan. A defaulted loan is supposed to be written down under the policy. The SEC viewed a default under the documents to be when the debtor fails to make an interest payment. According to the SEC, Tilton determined a loan in default when she will no longer provide financial and management support to the company.

In addition, the funds were supposed to have GAAP-compliant financial statements. Under GAAP, a loan is impaired, and must be measured for impairment when, based on all available information, it is probable that the creditor will be unable to collect all amounts due for interest and principal based on the contract with the debtor.

The difference in characterizing a default resulted in more than $200 million in fees earned on the higher valuations. It sounds like many of the problems could have been fixed with a stronger compliance program. Disclosure would have solved many of the issues in the SEC Order.

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Valuations, Private Equity, and the SEC

The SEC has been poking around valuations for a while. First it was from the chaos of the 2008 financial crisis. The sudden illiquidity and drop in prices left many scratching their heads about the proper valuations for their assets.

That was the main charge against the Bear Stearns hedge fund managers. The Justice Department and the SEC brought parallel criminal and civil charges against former Bear Stearns executives Ralph Cioffi and Matthew Tannin in 2008. They were accused of lying to investors about the health of their hedge funds. The problem was that they were holding mostly complex securities backed by subprime mortgages that were hard to value.

Valuations are always difficult with private equity funds because by definition most of the assets are private securities, with little or no market to determine price. The difficulty is offset by the result of the valuation. That is, there is very little. It’s rare that a private equity fund limited partner/investor can redeem its interest. Private equity limited partners commit their capital long term to the fund since the fund makes long term investments that take many years to realize.

A private equity fund investor can be happy that the fund is performing well or be disappointed that the the fund is under-performing based on valuations. Either way, they are largely stuck as investor. But that’s okay because the investors true returns come when the investment is realized, not when there is a valuation.

There is some opportunity for malfeasance. Marketing would be the weak spot. A private equity fund manager might be inclined to overstate valuations on unrealized investments to make their track record look better when raising money for a new fund.

Federal regulators and the Massachusetts attorney general are investigating whether a private equity fund that was part of Oppenheimer Holdings Inc. overstated the value of one of its holdings. The result would be to make it look like the fund was performing better than it actually was.

According to the Wall Street Journal, the fund manager place a value of $9.3 million on an investment. Some other trading on that investment indicated a value of only $2 million, and an intermediary placed the value at $6 million. According to the Boston Globe, the result was to set the interim performance of the fund at 38 percent instead of a loss of 6.3 percent. I assume that the investigators are claiming that the fund manager used those inflated valuations to lure investors.

Valuations have clearly been a target for securities regulators for several years. The SEC sweep letter sent to several private equity firms was just a continuation of this investigative objective.

Part of the business model of private equity is that they are able to better value companies and re-structure them for success. That means that valuations of their underlying assets are going to vary from those of other firms and appraisers.

The key is documenting your approach and then documenting that you followed that approach.

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Image is Measuring by Jonathan Khoo