Shortly after private equity fund managers became subject to registration, the U.S. Securities and Exchange Commission (SEC) made the integrity of the valuations by fund managers of portfolio company investments one of the agency’s top priorities. This effort reflects concerns raised by the SEC (and others) that such valuations have significant impact on marketing activities, the use of track records in fund raising, on secondary market trading of fund interests, and fund restructurings. Others wonder whether these concerns are justified, given the overall structure of private equity funds, the role that valuation plays in manager compensation, and the sophistication of private equity investors and their independent and increasingly sophisticated operational due diligence practices.
Private equity funds are typically structured as limited partnerships. Institutional and individuals invest in private equity funds as limited partners, each agreeing to commit and make available a specific dollar amount when the fund manager make a capital call for investment. The private equity fund manager, in managing the general partner, makes the investment decisions to acquire portfolio company investments, often acquiring either the entire target or a controlling share of the target’s stock. These investments will normally be initially recorded and carried on the books of the fund at the original cost. Between the date of the acquisition of a portfolio company and its ultimate disposition, the private equity manager will calculate interim valuations of the target company and decide whether the investment should continue to be held at cost or whether there is sufficient certainty to change, up or down, the current valuation in its periodic reports to the limited partner investors in the private equity fund. Today, as in the past, the valuation of portfolio company investments is largely done in-house by the private equity manager, as opposed to a third-party valuation service, given the manager’s knowledge of the company, industry and valuation metrics.
