Get Ready – SEC plans National Sweep of Funds

In a recent speech to the Private Equity Forum of the Practicing Law Institute, Norm Champ, Director of the Division of Investment Management for the SEC, described the growing use of alternative investment strategies by ’40 Act open-end mutual funds. He noted that increased disclosure androbust valuations of illiquid investments held by these funds were needed due to the significant inflows into these funds.

Over the past several years, a newer breed of mutual funds offering hedge fund-like exposures has further emerged and garnered significant interest from retail investors. So called “alternative” mutual funds employ investment tactics traditionally found only in hedge funds, such as the use of leverage, short-selling, and investing in derivatives. However, unlike hedge funds that do not need to be registered with the SEC, alternative mutual funds are publicly offered, are regulated under the Investment Company Act of 1940, and are limited in their operations in ways not applicable to unregistered hedge funds. These investor protections include:

  • Limits on illiquid investments (typically no more than 15% of assets);
  • Limits on the amount of leverage;
  • Portfolio diversification requirements;
  • Daily pricing and daily liquidity; and
  • Oversight of the fund’s policies and procedures by independent directors.

At the same time, these ’40 Act alternative funds are offered to the retail-investing public with much lower minimum investments and other restrictions than hedge funds, significantly broadening the market for investors in alternative mutual funds. As a result, retail investors have been pouring money into these funds. According to Mr. Champ, alternative mutual funds managed over $300 billion in assets as of May 2014. While this represented only 2.3% of the total mutual fund market at the end of 2013, investments in alternative funds grew by $95 billion or about 43% in 2013, totaling 32.4% of the inflows into the entire mutual fund industry for the year. This represents more than five-fold increase over 2012.

Along with the increased interest from the investing public, alternative funds are also attractingincreased scrutiny from the SEC and other regulatory authorities. The SEC is taking a deeper dive into how alternative funds value their most illiquid assets, focusing on the robustness of funds’ valuation policies and procedures. Most investors may not understand how valuations are determined for illiquid stocks, bonds, or complex derivatives that lack active secondary markets, for which valuations can be subjective, and the SEC intends to increase its review of these asset values, among other aspects of alternative funds’ operations. As a first step, the SEC will conduct a “national sweep exam” of alternative funds, beginning with 15 to 20 fund complexes in the summer or fall of 2014, with additional funds to follow.

The increasing review of valuations by regulators, including the SEC, is just one example of the overhaul to the financial reporting and regulatory environment resulting from the Dodd-Frank Act, as well as further oversight and disclosures mandated since the recent financial crisis. In 2012, the FASB clarified existing rules for measuring the fair value of assets and implemented additional disclosure standards applicable to illiquid assets (i.e., investments in non-publicly traded securities) that do not have observable market prices. These investments, classified as “Level 3” assets, must be reported at fair value, which often involves significant professional valuation judgment. Funds are encouraged to employ independent third-party valuation specialists to value illiquid assets in compliance with the updated and evolving regulations and standards.

Houlihan Capital can provide critical valuation information to funds, including their directors and administrators 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, directors, regulators, auditors, legal counsel, and investors on financial reporting and tax compliance matters.

For more information regarding when and why to obtain a valuation, please see Houlihan Capital’s white paper Fair Value Best Practices and Implementation. For further information on independent third-party valuation services, please contact Paul Clark ( at 312-450-8656 or

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, private equity funds, ’40 Act funds, hedge funds, fund administrators, and both public and private operating companies, which benefit from Houlihan Capital’s comprehensive valuation and financial advisory services. Houlihan Capital is a Financial Industry Regulatory Authority (FINRA) and SIPC member, and is SOC-compliant. In short: Value. Added.

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