SEC Increases Scrutiny of Valuation of Alternative Fund Investments

SEC Increases Scrutiny of Valuation of Alternative Fund Investments

A recent Wall Street Journal article highlights that the U.S. Securities and Exchange Commission and other regulators are increasing scrutiny of how alternative funds, including hedge funds, value their investments in illiquid holdings, noting that unscrupulous fund managers may falsely inflate values.

As the primary regulator of the managed fund (i.e., hedge fund) industry, the SEC is taking a deeper dive into how hedge funds and other alternative investment funds value their most illiquid assets, and some opinions suggest that more investors should do the same. The valuation method used by a fund can impact investors' returns significantly, including affecting whether an initial investment is made, the fees earned by a manager, and the value of a fund's assets at sale. However, many investors do not understand how value is determined for illiquid holdings such as stocks, bonds, or complex derivatives that lack active secondary markets, which values can be subjective by nature.

The increased focus on valuation issues by regulators, including the SEC, largely stems from the overhaul to the financial reporting and regulatory environment implemented in the wake of the Dodd-Frank Act. As a result of this law passed in 2010, hedge fund managers must register with the SEC and undergo the same regulatory oversight as other SEC-regulated investment advisers. At the beginning of 2014, there were 4,136 investment advisers to private funds registered with the SEC, of which 2,586 advised hedge funds. The Wall Street Journal reports that the recent financial crisis put greater focus on the importance of regulatory scrutiny and SEC officials are now in a position to oversee how funds are performing valuations and, as a result, more abuses are coming to light.

In 2012, the Financial Accounting Standards Board clarified its existing rules for measuring the fair value of assets and implemented additional disclosure requirements. FASB standards now require assets to be classified into three levels ranging from Level 1, which are assets such as listed stocks and bonds that are less complex and less subjective to value, to Level 3, which are assets for which observable market pricing is not available and are typically more complex and more subjective to value. Valuation of Level 3 assets can often involve significant elements of professional judgment.

An area of focus by the SEC has been potential over-valuation of assets during periods of fund marketing. Regulators are attempting to prevent managers from overstating the performance or quality of fund holdings by inflating reported values during a fundraising period, and writing them down suggested to such marketing. In many cases it's difficult to prove if a valuation is accurate or fair. To date, the SEC has tended to pursue claims that an adviser has not adhered to its stated valuation practices. The Wall Street Journal reports that due to the increased scrutiny, many funds now hireindependent 3rd-party valuation specialists to ensure compliance for illiquid asset values.

Houlihan Capital can provide critical valuation information to funds, fund administrators, and investors by rendering an independent valuation opinion, which can supply the necessary support and documentation to stand up to SEC and other regulatory scrutiny. Houlihan Capital provides clients with independent valuations and has a history of working closely with clients’ management, regulators, auditors, legal counsel, and investors on financial reporting and tax compliance matters.

Houlihan Capital is a leading, solutions‐driven valuation, financial advisory and boutique investment banking firm committed to delivering superior client value and thought leadership in an ever‐changing landscape. The firm has extensive experience in providing fairness and solvency opinions, and objective, independent and defensible opinions of value that meet accounting and regulatory requirements. Our clients include some of the largest asset managers around the world, and private equity funds, hedge fund advisors, fund administrators, and other asset management firms benefit from Houlihan Capital’s comprehensive valuation and financial advisory services. Houlihan Capital is a Financial Industry Regulatory Authority (FINRA) and SIPC member, committed to the highest levels of professional ethics and standards.

For more information on independent third party valuation services, please visit or contact Paul Clark at 312‐450‐8656.

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