(Article from Registered Funds Alert, February 2017)
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Valuation, particularly the fair valuation of unmarketable securities, is a key topic for advisers to consider in managing registered funds. Advisers and fund boards must diligently monitor the valuation of a fund’s investments to ensure the integrity of the fund’s net asset value (“NAV”) and confirm that proper procedures are in place and are being followed. This Alert discusses several recent SEC actions that bear on fund valuation and raise issues for consideration by advisers and fund boards. These actions seem to confirm statements from the SEC Staff that valuation is an examination and enforcement priority.
Recent Enforcement Action Related to Fair Valuation Error and Attempted Remediation
In October 2016, an adviser agreed to settle SEC allegations, without admitting or denying the SEC’s findings, that it improperly valued a large illiquid bond holding using the same fair valuation for a period of more than three years. According to the SEC settlement order, the adviser, under the oversight of the funds’ boards of directors, primarily based the fair value of the bond on a third-party analytical tool. The SEC alleged that the adviser failed to take into account certain indicia of value, including the value at which the funds’ traded the bonds, the values at which other holders marked the bonds and other market data. The adviser also allegedly failed to back-test, despite engaging in back-testing for other portfolio investments.
The SEC alleged that, eventually, the adviser discovered a flaw in the third-party analytical tool used to value the bond that had led to an overstatement of NAV of certain funds and related performance figures. The adviser also received inflated fees based on the overstated NAVs.
After discovering the error, the adviser made payments to reimburse the affected funds and shareholders, but the SEC found that the reimbursement was miscalculated and inconsistent with the funds’ NAV error correction procedures. In particular, the SEC alleged that the adviser did not calculate the damages to the funds and shareholders with the specificity required by the NAV error correction procedures because it lacked necessary information about underlying shareholder activity in the sub-accounts of intermediaries. Instead of precisely measuring underlying shareholder activity, the adviser used the net subscription and redemption amounts of the intermediary. As a result, shareholders that acted through an intermediary were treated differently from direct shareholders.
The SEC also found that, when the adviser did disclose the error to shareholders, the disclosure was inadequate because the adviser did not disclose that the remediation diverged from the NAV error correction procedures or the potential disparity in treatment between shareholders who acted through an intermediary and direct shareholders.
Lessons for Advisers and Boards
Use of fair valuation is a serious undertaking, particularly when a material portion of a fund’s assets are represented by fair valued assets. Fair valuation can be accomplished by different means, but should always be determined pursuant to procedures adopted by, and overseen by, a fund’s board. When third parties (such as the third party that provided the analytical tool in this matter) are used to help determine fair valuation, the adviser should undertake thorough due diligence of such third parties and their valuation techniques.
Advisers should monitor whether market information becomes available that would better indicate the value of an investment than a currently-used fair valuation methodology. Indeed, the statute provides that fair valuation should only be used when market quotations are not available, indicating a legislative preference for the use of market activity where feasible. Thus, fair valuation methodologies should monitor for market quotes and could include back-testing (testing the accuracy of a fair valuation by comparing an investment’s carrying value at the time it was sold to the actual price at which it was sold), as cited in the SEC’s order. If fund directors are aware that such market information exists and is not used, they should inquire of advisers why such market information is not better than a currently-employed fair valuation methodology. Where ambiguity exists, to the extent possible, advisers should seek other sources of valuation, which might include how other funds value the same or similar holdings, as cited in the SEC’s order. All determinations should be made in accordance with the fund’s valuation procedures.
Funds should have a NAV error correction policy and should follow the policy closely when errors arise, avoiding shortcuts such as the allegation in this case that the adviser used net flows to reimburse omnibus account shareholders instead of seeking more detailed information from intermediaries.
Recent Enforcement Action Related to Valuation of Odd Lots
In December 2016, an adviser agreed to settle allegations, without admitting or denying any of the SEC’s findings, that it did not properly disclose the effect that investing in “odd lot” investments might have on an exchange-traded fund’s performance and failed to accurately value certain fund holdings. The SEC order describes a scenario where the fund in question purchased odd lot positions (small positions, typically under $1 million) in mortgage-backed securities that traded at discounts to round lots (larger, institutional-sized positions) in the same security. The SEC alleged that, despite the fact that these odd lot positions were purchased at a discount, the fund used a third-party valuation vendor’s institutional round lot marks in assigning values to the odd lot positions. This resulted in an immediate increase in the value of each odd lot position, and the fund’s NAV, which resulted in inflated performance. Notably, the fund disclosed significantly better performance than one of the adviser’s mutual funds that employed a similar overall investment strategy.
The SEC alleged that the adviser was aware of the impact its odd lot holdings were having on the fund’s performance and found that the adviser negligently produced misleading disclosures that failed to include this as a reason for the fund’s positive performance. These disclosures took the form of monthly commentaries that discussed factors that contributed to the fund’s performance and shareholder reports that are required to include such a discussion. The SEC characterized these issues as arising from inadequate disclosure policies and procedures, as the personnel preparing the disclosures may not have been adequately educated about the impact on valuation of the odd lot investment holdings and were not required to consider the effect of the holdings in describing factors that impacted the fund’s performance.
Additionally, the SEC cited the definition of value in Section 2(a)(41)(B) of the 1940 Act and found fault with the fund’s valuation of odd lot positions at round lot prices in circumstances in which the fund could not reasonably expect to sell its position at the round lot value. While pricing an odd lot at a round lot value is not always wrong, according to the SEC such a valuation must be substantiated with evidence that the position could be sold at a round lot price. The SEC generally found that while procedures were in place to value securities at the price that would be expected to be obtained in the market and for elevating pricing issues, the policies and procedures did not specifically account for odd lot pricing and did not provide guidance regarding when a person should elevate a pricing issue to the appropriate overseeing bodies.
Lessons for Advisers and Boards
As use of less traditional investment strategies increases, it is important for advisers (especially larger advisers) to ensure that various departments have sufficient understanding of how such strategies can impact each other’s responsibilities. Those with compliance and disclosure responsibilities should ensure that investment personnel are aware of the importance of fund valuation procedures and their role in ensuring that fund securities are properly valued. Investment personnel should ensure that compliance and disclosure personnel are educated about ways in which a particular investment holding could impact a fund’s portfolio, including the fund’s day-to-day operations and performance. Additionally, proper valuation procedures should include not only appropriate triggers for unusual pricing variances, which the SEC order acknowledged were in place in this case, but also clear instructions for elevating pricing issues to the appropriate personnel within the adviser and ultimately to a fund’s board.
Valuation of Large Private Companies
While no enforcement action has been announced, the Wall Street Journal has reported that the SEC may be focused on the valuation of mutual funds’ holdings in large private companies. These private companies have multi-billion dollar valuations, but there is no liquid market for their shares and they release limited information on their businesses (and may selectively release different information to different investors). As a result, the valuations at which different mutual funds carry their investments in the same private company can vary greatly.
The SEC is reportedly concerned about the wide variance in mutual funds’ fair valuation techniques for the same security and the variance that mutual funds’ valuations have from a private company’s valuations in subsequent private offerings. Most funds’ valuation policies provide for multiple fair valuation techniques that can be used to value an illiquid security. Even if the same valuation technique is used and funds are relying on the same information from the private company, there are still subjective determinations that must be made. For example, one fair valuation technique would be to multiply the private company’s EBITDA by a market multiple, which requires identifying benchmark companies and determining what multiple is appropriate based on the relationship between those benchmark companies’ market capitalizations and EBITDA figures. Different parties could arrive at significantly different determinations of what the appropriate multiple is, which can result in wide range of valuations for the same issuer.
In addition, the SEC may take issue with mutual funds using the market multiples of public companies as a proxy for multiples for private companies because public companies, which are typically more mature and are subject to more detailed reporting obligations, are inherently different than private companies. Public companies are more likely to have weathered the ups and downs of growth cycles and market vagaries under the watchful eye of investors. Therefore, the market’s valuation of these companies factors in extensive public information about these companies, including the knowledge of past, present or future struggles. On the other hand, earlier-stage private companies—many of which have not yet been burdened with the expectation of profitability—have often not faced as many market tests. Still, public peers offer a useful reference point for determining private company valuations because comparisons to other private companies do not give insight into liquid market valuations.
It is unclear what, if any, action the SEC will take to address variances in private company valuations. While the focus appears to be on investments in large private companies, the SEC may broaden that focus to fair valuation generally. If the SEC thinks a more uniform system of fair valuation is feasible, it is possible that guidance or rulemaking about fair valuation of private companies may be forthcoming.