SEC Launches Inquiry Aimed at Private Equity

February 11, 2012

“That is why we created a merchant bank that has transparent returns secured against visible assets.”

By GREGORY ZUCKERMAN

Federal regulators have launched a wide-ranging inquiry into the private-equity industry that examines how firms value their investments, among other matters.

The Securities and Exchange Commission's enforcement division sent letters to private-equity firms of various sizes in early December as part of an "informal inquiry," according to the letter and people familiar with the matter.

It is unclear which firms received a letter, which includes language saying it shouldn't be construed as an indication the agency suspects securities-law violations.

The inquiry suggests regulators are ratcheting up the attention they pay to the $1.2 trillion industry, which typically hasn't been a major focus of the SEC. Private-equity firms generally use debt to buy companies and then spend time improving operations before trying to sell them at a profit. These firms, which usually don't trade stocks or bonds, weren't at the heart of the housing collapse, nor have they figured in recent high-profile trading scandals.

After the financial crisis, and as the private-equity industry has grown, the SEC has moved more resources to policing the area. The SEC now has "an inventory" of cases involving private-equity firms that it may bring, according to one of the people familiar with the matter.

SEC officials have told industry participants that the regulator is looking at how performance data is presented, said Michael Harrell, an attorney at Debevoise & Plimpton LLP. He said one concern could be presentation of misleading values when a firm is marketing.

Valuation issues have long been a subject of some debate around the industry because the companies that the firms own usually aren't listed on a stock market. There have been some instances when two separate private-equity investors in one company have assigned it different values; firms have said they use different methodologies and valuing a private company can be more art than science. Some firms, such as KKR & Co., use outside firms and auditors to review their valuations.

The SEC's letter requested information related to 12 broad areas, including fund raising and fund formation. It asks the firms for "support for valuations of the fund assets," and "documents setting forth a value for any assets owned by the fund" over the past three years. The regulator also asked for details on "all agreements" between the private-equity funds and others valuing a fund's assets.

The inquiry comes amid recent comments from SEC officials that the industry is drawing greater scrutiny.

"I think that private-equity law enforcement today is where hedge-fund law enforcement was five or six years ago," Robert Kaplan, co-chief of the SEC's asset-management unit, told the Dow Jones Private Equity Analyst Outlook conference in New York late last month.

The agency is looking at "higher-risk" activities, such as potential conflicts of interest, he said and pointed to concerns about fees and other issues.

At the same conference, Chad Earnst, assistant director of the SEC's asset-management unit, said valuations that private-equity firms place on companies they own are drawing greater SEC scrutiny. "We'll focus on whether there's a systematic and consistent way the valuations are applied," he said.

Some investors say valuations of companies owned by private-equity firms can have less importance than valuations of investments held by hedge funds and others. While both types of firms often take 20% of any investment gains for themselves, hedge funds typically claim this fee at the end of a profitable year. Private-equity firms, by contrast, receive their 20% cut only after they have sold a company for a profit and the private-equity fund achieves a certain level of gains, so an interim value is less important.

"There's often room for differences of opinion, and some firms are purposely conservative, while others want to make themselves look better," says Steven Kaplan, a professor at the University of Chicago Booth School of Business, and no relation to Robert Kaplan. "I'm not sure how much it matters, though, because [private-equity] firms only get paid when they return money" to investors after selling a company.