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Focus on Private Funds: SEC Enforcement Priorities

Aug 15, 2017

When it comes to portfolio valuation, independent auditors frequently consider whether valuation policies and procedures are properly designed and implemented and are being monitored for ongoing operating effectiveness.  Consequently, private fund advisors devote resources to ensure that their valuation policies and procedures are “audit-ready.” 

But did you know that having properly designed valuation controls in place and operating effectively can also pay big dividends when it comes to SEC examinations?  

Speaking at the recent Securities Enforcement Forum West 2017, Jina L. Choi and Michele Wein Layne, directors of the SEC’s San Francisco and Los Angeles Regional Offices, respectively, noted that private fund advisors can expect that valuation practices will continue to be an exam and enforcement priority.  In particular, the SEC is focusing on structural issues around valuation, such as failure to follow firm policies and procedures or breakdowns in controls.  For example, Directors Choi and Layne noted recent enforcement cases where advisors failed to follow appropriate procedures in valuing illiquid securities and those individuals responsible for governance oversight, such as directors, were charged with failure to fulfill their fair value-related obligations.  The directors emphasized that both advisors and those responsible for governance can expect to face continued scrutiny of their valuation policies and procedures, including the oversight of those processes.

Structural Issues Around Valuation

As the SEC makes clear, the process by which a private fund advisor determines a fair value measurement can be just as important as the amount ultimately recorded in the portfolio.  Advisors can expect that their chosen valuation approaches (for example, market or income), the techniques selected under each approach (for example, guideline public company or discounted cash flow), and the inputs used will be scrutinized and challenged.  Being ready for this challenge requires policies and procedures that are robust and at the same time realistic.  In other words, it does no good to have a beautifully crafted set of valuation policies and procedures if the investment advisor is unable to implement and adhere to those policies and procedures.

Are Your Valuation Policies and Procedures Audit- and SEC-Ready?

A well designed valuation policy includes:

  1. A control environment in which those individuals responsible for governance provide active oversight of management’s valuation process.
  2. An assignment of authority and responsibility that ideally segregates the duties of those responsible for selecting investments, those valuing investments, those settling investments, and those accounting for the investments.  When an entity is too small to achieve ideal segregation of duties, the role of management and those charged with governance is of even greater importance.
  3. Ongoing monitoring of activities designed to detect and correct any deficiencies in the effectiveness of controls over investment transactions and their valuation.
  4. A valuation methodology that begins with a thorough understanding of the investment being valued in order to identify and evaluate all relevant market information that is available.  
  5. A defined process for handling deviations from valuation guidelines.

When developing specific valuation techniques, factors considered by management and those charged with governance may include:

  • Whether the valuation techniques are commonly used by other market participants and have been previously demonstrated to provide a reliable estimate of prices obtained from market transactions.
  • Whether the valuation techniques operate as intended, and there are no flaws in their design, particularly under extreme conditions, and whether they have been objectively validated. Indicators of flaws include inconsistent movements relative to benchmarks.
  • Whether the valuation techniques take into account the risks inherent in the investment being valued, including counterparty creditworthiness, and own credit risk in the case of valuation techniques used to measure financial liabilities.
  • How the valuation techniques are calibrated to the market, including the sensitivity of the valuation techniques to changes in variables.
  • Whether market variables and assumptions are used consistently and whether new conditions justify a change in the valuation techniques, market variables, or assumptions used.

Special Considerations when Using a Third-Party Pricing Source

Investment advisors may make use of a third-party pricing source, such as a pricing service or broker, in valuing investments. Understanding how the pricing service operates assists management and those charged with governance in determining the relevance and reliability of information provided by third-party pricing sources. The degree to which an investment advisor has controls in place to review and approve the use of the third-party pricing source, including consideration of the reputation, experience, and objectivity of the third-party pricing source and to determine the completeness, relevance, and accuracy of the prices and pricing-related data, affects the reliability of the fair value measurement.

The following matters may be relevant when an investment advisor uses a third-party pricing source:

  • The type of third-party pricing source. Some third-party pricing sources make more information available about their process. For example, a pricing service often provides information about its methodology, assumptions, and data in valuing financial instruments at the asset-class level. By contrast, brokers often provide no, or only limited, information about the inputs and assumptions used in developing the quote.
  • The nature of inputs used and the complexity of the valuation technique. The reliability of prices from third-party pricing sources varies depending on the observability of inputs (and, accordingly, the level of inputs in the fair value hierarchy) and the complexity of the methodology for valuing a specific security or asset class.
  • The reputation and experience of the third-party pricing source. For example, a third-party pricing source may be experienced in a certain type of financial instrument and be recognized as such but may not be similarly experienced in other types of financial instruments.
  • The objectivity of the third-party pricing source. For example, if a price comes from a counterparty, such as the broker who sold the financial instrument to the entity, the price may be less reliable than a price from an objective third party.
  • The third-party pricing source’s controls. A third-party pricing source may have strong controls around how prices are developed. In addition, the third-party pricing source may include the use of a formalized process for customers, both buy and sell side, to challenge the prices received from the pricing service when supported by appropriate evidence. This enables the third-party pricing source to constantly correct prices to more fully reflect the information available to market participants.

An important element to emphasize is that, while an advisor may engage others to assist with fair value measurements, the advisor remains ultimately responsible for the determination of fair value.

Other Enforcement Priorities

In addition to its focus on valuation of investments, the SEC earlier this year announced several other examination priorities including a focus on protecting retail investors, senior investors and retirement investments, addressing market-wide risks and cybersecurity. Further, SEC enforcement activity continues to be strong, with 868 enforcement actions during 2016 compared to 807 enforcement actions in 2015 and 755 during 2014. 2016 also saw a record-breaking 160 enforcement cases involving investment advisors and investment companies. The SEC also brought 8 enforcement actions related to private equity advisers, bringing the total number of actions relating to private equity to 11 in the last two years.

The SEC’s examination of private funds has focused on:

  • Insider trading – cases involving complex insider trading rings cracked using innovative data and analytics to spot suspicious trading;
  • Valuation of illiquid securities – failure to follow written policies and procedures disclosed to investors;
  • Undisclosed fees – failure to adequately disclose fees or compensation that directly and indirectly benefit the adviser; and
  • Trade allocation – focus on ‘cherry picking’ allocation to benefit the advisor by allocating favorable trades to high fee accounts or not allocating in a manner consistent with disclosure made to investors.

The SEC has also brought action against ‘gatekeepers’ such as attorneys, independent accountants, fund administrators and consultants for failure to comply with professional standards.

Conflicts of Interest

The SEC in the recent past has also focused on adequate disclosure of potential or perceived conflict of interest to investors. It recently brought an enforcement action against the subsidiaries of a large investment manager for failing to disclose conflicts of interest to clients. The firms charged admitted to wrongdoing in their settlements with the SEC.


The SEC generally views hacked entities as victims. However, based on recent statements made by the SEC staff, one cannot rule out the possibility that the SEC would hold a hacked entity liable, particularly if it failed to implement robust cybersecurity policies or procedures to mitigate risks, or knew it had vulnerabilities and failed to address them.

Do you do what you told your investors?

In conclusion, the SEC seems to be focusing on whether the private fund advisers are following through on the commitments/promises made to investors through their offering documents and financial statements. Be it controls around valuation, cybersecurity, trade allocation or conflict of interest, the focus is on implementing in proper spirit the policies, procedures and safeguards communicated to the investors that create a reasonable belief or expectation that such policies will be followed.

Todd Hankin is a partner at EisnerAmper and Gautham Deshpande is a senior manager.

Asset Management Intelligence – Q3 2017

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