Possible Amendments to the Investment Advisers Act of 1940 and Their Effect on Valuations

May 02, 2022

By David Goldstein

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A Q&A with Monica Blocker, Director, Houlihan Capital

EisnerAmper sat down with Monica Blocker, Director, Houlihan Capital, who shared her outlook on the possible amendments to the Investment Advisers Act of 1940 and its effect on valuations.

EISNERAMPER: Can you provide an overview of the proposed changes to the Investment Advisers Act of 1940 and specifically how they relate to valuation?
HOULIHAN CAPITAL: On February 9, 2022, the SEC voted to propose new rules and amendments to the Investment Advisers Act of 1940 to enhance the regulation of private fund advisers and protect private fund investors by increasing transparency, competition, and efficiency in the $18-trillion marketplace. The proposed rules would increase transparency by requiring registered private fund advisers to provide investors with certain information regarding performance. In addition, the proposed changes would create new requirements for registered private fund advisers related to fund audits and adviser-led secondary transactions.

  1. Performance Information – The proposed rule would require a registered adviser to disclose a gross internal rate of return and gross multiples of invested capital for the realized and unrealized portions of the illiquid fund’s portfolio, with the realized and unrealized performance shown separately. The value of the unrealized portion of an illiquid fund’s portfolio typically is determined by the adviser and, inherently, valuations of level 3 (“L3”) assets are challenging. For example, an adviser’s valuation policies and procedures for L3 investments may rely on models and unobservable inputs. This could create a conflict of interest because the adviser is typically evaluated and, in certain cases, compensated based on the fund’s unrealized performance. Further, investors often decide whether to invest in a successor fund based on the predecessor fund’s performance. Utilizing an independent third-party valuation provider can mitigate these conflicts.
  2. Audit Requirements – Registered private fund adviser audits would be mandatory. In addition to providing protection for the fund and its investors against the misappropriation of fund assets, the SEC believes an audit by an independent public accountant would provide an important check on the adviser’s valuation of private fund assets. Valuation is an integral part of the audit process. A fund audit includes evaluating the selection and application of valuation models, significant assumptions, and data used by the adviser in determining the fair value of a fund’s portfolio investments.

Adviser-Led Secondary Transaction Requirements – The proposed rule would require a registered adviser to obtain a fairness opinion in connection with certain adviser-led secondary transactions where an adviser offers fund investors the option to sell their interests in the private fund, or to exchange them for new interests in another vehicle advised by the adviser. This would provide an important check against an adviser’s conflicts of interest in structuring and leading a transaction from which it may stand to profit at the expense of private fund investors. The proposed adviser-led secondaries rule would prohibit an adviser from completing an adviser-led secondary transaction with respect to any private fund, unless the adviser distributes to investors in the private fund, prior to the closing of the transaction, a fairness opinion from an independent opinion provider and a summary of any material business relationships the adviser or any of its related persons has, or has had within the past two years, with the independent opinion provider. This process would provide an important market check for private fund investors by providing some assurance that the price being offered is based on an underlying valuation that falls within a range of reasonableness.

EISNERAMPER: What type of funds and investment strategies do you believe would be impacted most and why?
HOULIHAN CAPITAL: Registered investment advisers to private funds will be directly impacted, as will unregistered private fund advisers. Once rules are implemented, a new standard would be expected from fund advisers by the regulators and institutional investors. The proposed rules give great insight into valuation best practices and institutional investors will expect these to be followed, regardless of registration status. There are several funds under the $150mm AUM threshold, which choose to get audited, and have independent valuations on their illiquid assets to provide credibility and comfort to their investors.
EISNERAMPER: In preparation for the new rules, what can a fund manager do now to best mitigate their impact if the new rules go into effect?
HOULIHAN CAPITAL: Fund managers should begin to have early conversations with their auditors and independent valuation agents to ensure they are in compliance. Managers should begin to review their valuation policies and procedures (“P&Ps”) and prepare to eliminate potential conflicts of interest. P&Ps should be drafted to promote fairness, consistency and independence in the valuation process and clearly indicate the methods, principles and models that may be used to value investments.
EISNERAMPER:How can investors prepare for proposed rules?
HOULIHAN CAPITAL: As a part of the due diligence process, investors should ask fund managers the following:

  • Do you have a valuation policy in place?
  • Who is on your valuation committee and are there any conflicts of interest?
  • Is there an independent valuation agent utilized to mitigate the conflict of interest when calculating performance and associated fees on level 3 assets?
  • Do you have an auditor in place?

It is important for the investors to trust the service providers the fund is utilizing as well, making sure they are a reputable firm with sufficient experience in their specific area of service.
EISNERAMPER: Are there any additional thoughts you would like to address?
HOULIHAN CAPITAL: The SEC has increased its focus on valuation and compliance. Wherever valuation touches a fee stream, it must be performed as independently as possible. The SEC is constantly making changes to protect investors. Therefore, we see many reputable fund managers already outsourcing their level 3 asset valuations to independent valuation providers and getting audited annually by an independent accounting firm. Although these rules are not in place yet, many fund managers have begun to outsource their valuation work and have taken the extra step to get a fairness opinion to provide comfort to their investors with an independent set of eyes.

Houlihan Capital provides valuation, financial advisory, investment banking and litigation support to private equity funds, hedge funds, 1940 Act funds, corporations and business development companies.


Our Current Issue: Q2 2022

About David A. Goldstein

David Goldstein, Director in the Financial Services Group, expertise includes fund structuring, jurisdictions, regulations, service models and strategies. He has worked with an array of financial services organizations including hedge funds, private equity funds and other alternative investment strategies.