Private funds should take notice of a new US Securities and Exchange Commission rule outlining the responsibilities of registered investment company boards when it comes to valuations.
David Larsen, managing director at financial consultancy Duff & Phelps, says rule 2a-5, adopted in early December, and its companion rule 31a-4 are the first updates to the fair valuation regime as applied to RICs in 50 years.
RICs include some private equity funds, such as business development companies, but exclude private funds, which nonetheless fall under SEC oversight as registered investment advisors.
The rules describe the RIC board responsibilities and the documentation required of funds when determining fair valuations “in good faith”. However, this does not mean private funds should ignore them. “There’s no reason to expect that the SEC won’t look at them,” Larsen says of private funds. He adds that the principles of the rules are “virtually identical” to the Financial Accounting Standards Board’s ASC 820, which also provides a framework for determining fair value.
“Our expectation is that the new rule will impact those registered investment advisors, which includes all the managers of all the large and middle-sized private equity funds – anybody who’s not exempt [from being a RIC],” he says. “And even if you are exempt under the venture capital rule [Section 203(l) of the Investment Advisers Act of 1940], you’re still subject to SEC inspection to make sure that you are properly exempt.”
The key thing Larsen expects the SEC to look at is whether private funds are following the established valuation procedures they have communicated to investors, including testing methodologies and ensuring the independence of the valuation. He adds that for funds using broker prices, it will be important that the prices used have a documented rationale behind them.
The SEC is allowing an 18-month implementation period for the new rules. However, they will come into effect legally 60 days after being published in the Federal Register.
Red flags for weak valuations processes
Larsen thinks funds with strong valuations processes, including those that use third parties for valuations, will be largely unaffected by the rules. But what are the signs that your processes might not be rigorous enough for the SEC?
Your valuations don’t move: “Valuations move on a regular basis,” Larsen says. “Especially in times of great volatility like we’ve had in 2020.”
Disagreements and deviations: This might involve disagreements with auditors or third-party valuations services, or deviations from broker or pricing services without documentation.
A lack of disagreement with the deal team: “If the internal process rubber stamps what the deal team says without any kind of pushback, that’s a red flag,” Larsen says. “You would expect there to be some hard discussions at times for certain investments.”