Practical Implications for Hedge Funds Investing in Private Equity

More and more, traditional hedge funds seek diversification and added returns from private equity investing. These moves heighten regulatory and accounting oversight concerns.

Direct Ownership  

Regulators are watching this area closely. In a speech last year, Lori Richards, Director of the Office of Compliance Inspections and Examinations at the SEC, made the following statement, “And the lack of controls over valuation remains a serious problem at firms of all types. I think that these areas should be scrutinized by independent auditors”. Although applicable to all hedge funds, this statement is particularly relevant to hedge funds that have made or are considering private equity investments to boost fund performance.

Ownership of private equity or debt necessitates controls and valuation procedures that often are different than those customarily established by hedge funds. Also, since market prices are not readily available, the hedge fund manager must estimate the fair value of private investments.

Fair Value 

The valuation process should be performed at regular intervals during the year, usually on a quarterly basis. Valuations can be done in-house or by a third party. In both cases, the process of determining fair value should be consistent over time and be regularly documented.

More frequent valuations would be necessary if the private investments are part of the general portfolio in which case a valuation should be prepared every time there is a change in ownership among the limited partners. Some managers avoid this situation by holding each private investment in a special situation sub-account whereby each limited partners’ ownership percentage is frozen until the investment is disposed, assuming it is allowed by the funds’ organizational documents. The sub-account approach eliminates the need to revalue each private investment every time there is contribution and withdrawal, but it doesn’t eliminate the need to perform periodic valuations and maintain documentation.

Controls over Private Equity Valuation  

The key to good controls over valuation is maintaining documentation of the following:

  • Policies and procedures: Management needs to have written policies and procedures setting forth their overall approach to the investment process.

Documents should specify how managers select investments, perform pre-investment due diligence, monitor the ongoing progress of each investee company, prepare periodic valuations of investments and maintain appropriate documentation to demonstrate that the procedures were performed. 

  • Ongoing monitoring of the private company’s operations: Before an investment is consummated, you need to be assured that the extent and frequency of operating and financial information the investee company plans to disseminate is sufficient.
  • In addition to the financial information, access to company management, whether through representation on the board or regular telephone calls, is helpful to obtaining qualitative information.

Discussions with management of the private company: Regular, periodic discussions with investee company management provide the opportunity to “get behind the numbers”. In addition to asking questions about financial reports, you can also inquire about problems/successes in areas such as, human resources, technology, raising capital and customer relations. 

  • Rationale of how each value is determined: A hedge fund manager has a fiduciary duty of care and loyalty to investors to prepare such estimates in good faith even though estimating fair value of private investments is somewhat subjective.

Support for the estimated values should include calculations, third party documentation, and logical assumptions that are consistent with the information obtained from ongoing monitoring procedures and discussions with management. 

  • Periodic assessment of the appropriateness of the overall process: Inevitably, as policies and procedures evolve some are expanded, some are curtailed and some are eliminated. The policies and procedures need to be periodically updated so they are in sync with actual practice.

Funds will be better prepared for the increasing scrutiny from regulators by following these suggestions. By providing regular valuations paired with an effective system of controls and documentation of private equity investments, hedge funds can take full advantage of the diversification afforded by direct investing.

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