Private equity funds held by Apollo Global Management Inc. and Blackstone Group Inc. nose-dived by more than 20% in the spring as the pandemic spread across the globe, only to rebound in the second quarter.
But the hit to private equity portfolios varied depending on the exposure to certain industries, like travel or energy, and how closely those valuations are tethered to public stocks. And for competitors KKR & Co. LP and Carlyle Group Inc., the decline in valuations weren’t as steep, according to a Fitch Ratings analysis.
Accurate valuation of those typically long-term commitments is crucial to investors, who can end up paying fees that are too high or make investments based on inaccurate valuations. And fund managers often earn performance fees based on fund growth or face clawbacks if fund values shrink below certain thresholds.
How investment companies come up with those values, including the use of third-party advisers and pricing services, has come under growing scrutiny in recent years by regulators and investors alike. The Securities and Exchange Commission has proposed a new rule that would modernize how fund boards oversee the process for private equity and other investments like mutual funds.
The goal is to put more reliable information in the hands of investors as they consider companies and other assets that are typically hard to value because of a limited buyer pool and less frequent trading.
“There is no better time than right now to modernize the rule because it is exactly focused on those assets that require additional judgment. And in this market condition because of the pandemic, more judgment is required than ever,” said David Larsen, managing director in Duff & Phelps’ alternative asset advisory practice.
KKR declined to comment along with Blackstone, which pointed to its earnings releases. In the first quarter, Blackstone reported that energy market and pandemic disruptions were the drivers of a 21.6 percent decline in values from the previous period. Values rose 12.8 percent on the performance of the public markets and “partial recovery in the private portfolio” the following quarter.
Apollo and Carlyle didn’t respond to requests for comment.
The value of private investments is often linked in part to how funds’ public peers are performing, but it can vary depending on the method used, said Dafina Dunmore, who is a director in the non-bank financial institutions group at Fitch Ratings.
Investors in private equity include pension funds, insurance companies, and ultra-high-net-worth individuals. They trust that ultimately these long-term investments—with commitments of a decade or more—will eventually bring a healthy return, and that the pain of the pandemic will be temporary.
“There will be an impact. But these are sophisticated investors. They understand that there’s going to be volatility from month to month, from year to year,” Dunmore said.
A Governance Framework
The SEC’s proposed rule 2a-5, released at the end of April, would put in place a framework for how boards oversee the process, from picking a method to testing whether that method is sound.
Existing SEC guidance hasn’t changed since 1970 and doesn’t reflect the $2.2 trillion private equity market that has ballooned over the past two decades or the technology and data that fuel asset management practices today.
The update would align better with fair-value accounting rules and changes in audit standards and provide a governance framework to help fund boards oversee the subjective and technical work that typically requires the help of specialists like Larsen.
It also would clarify that boards can delegate the technical work to an adviser or third-party pricing service, and add reporting and recording-keeping requirements.
“It’s a big change if you didn’t have a very good process. It’s not a big change if you have a sound process,” Larsen said.
Greg Smith, senior director for fund accounting at the Investment Company Institute, said the updated rule would be an improvement over the current landscape, and he expects the SEC will finalize it later this year.
Still, he said the rules could better reflect the differences in risk and oversight required to value fixed income securities versus the complex judgments required to value private equity investments.
“The rule needs to recognize that pricing services play a significant role in this whole process,” Smith said.
Put a Price on It
Fund boards rely on daily pricing services for fixed income securities—debt investments, like bonds, that pay investors a fixed rate of return. The pricing service comes up with the method and determines the data inputs that feed into the method, and it, not the board or the adviser, documents the work.
Requiring fund boards or their advisers to maintain the same set of records, as suggested in the draft rule, would be costly and burdensome, Smith said.
Such a requirement could result in a fire hose of information being shared with advisers to track the methods and inputs.
Thousands, and in some cases tens of thousands, of fixed income securities are priced daily, the Capital Group said in a July comment letter to the SEC. The company cautioned that the volume of required testing and reporting could distract boards from focusing on more significant issues and conflicts of interest, undercutting their oversight role.
In a statement to Bloomberg Tax & Accounting, Vanguard Group Inc. urged the SEC to give more flexibility to mutual fund and ETF boards and advisers. Other large investment firms, including John Hancock Investment Management LLC, shared similar concerns with the SEC although they generally supported the goal of modernizing the regulations.
Warning to the Market
Valuation issues are among the top enforcement issues for the SEC, and the commission has brought several cases against funds in the past several years, said Kurt Wolfe, a securities lawyer with Troutman Pepper.
Recent enforcement cases involved revenue recognition and overvaluing of certain positions that affected fund performance results. Another case cited a fund board for inadequate policies governing its use of pricing services—what Wolfe called a warning to the market.
With prices all over the map this year, boards should be thinking about the methodology, Wolfe said. They should document and disclose any changes that were made to the valuations, and be able to defend any judgments that were made.
“It’s about getting it right at quarter end and making sure that what you are reporting aligns with what your investors would expect to see,” Wolfe said. “The market is down—or has been extremely volatile across the sector—that should come out in your valuation.”
Pension funds in particular have heavily invested in private equity. And the SEC’s rule overhaul is designed to improve the accuracy of the information that the professionals managing those pensions have, said Kyle Welch, a former valuation consultant who is now an assistant professor at George Washington University.
But cajoling leaders at the investment funds to pay closer attention to those figures isn’t enough, and the SEC needs to do more, Welch said.
The commission is missing an opportunity to increase the experience requirements for fund board members, said Lev Bagramian, senior securities policy adviser with the consumer group Better Markets. Boards must be able to vet the experts they hire and to assess their recommendations, he said.
“How can you be an engaged board member if you don’t understand those things clearly? And the presumption is they don’t,” Bagramian said.
The SEC needs to be clear that boards still ultimately are responsible for overseeing that fund assets are properly valued, said Sandy Peters, head of global financial reporting for the CFA Institute.
“When everyone is accountable, no one is accountable,” Peters said. “Our concern is that we want to make sure that the buck stops” at the board.