Many FCPA practitioners have predicted FCPA enforcement actions in the private equity industry.  This has been long-predicted and many say, long overdue.

Anti-corruption enforcement against the private equity industry has to be considered in the context of the SEC’s focus on the private equity industry.  The SEC has sent the private equity industry a wake up call and one thing is for sure – the SEC means what it says.

The private equity industry’s growth has been staggering.  As of this month, private equity managers  manage nearly $200 million in assets.  Private equity managers are now required to register under the Investment Advisers Act of 1940.  This registration requirement will impose a whole new set of disclosure obligations, along with great SEC scrutiny of private equity operations. 

What will the SEC focus on?  Not insider trading since, by definition, private equity funds do not devote significant time to trading in public markets.  However, private equity managers will be closely scrutinized on two significant risks – conflicts of interest and valuation of the funds’ assets.

Private equity funds depend on the valuation of private assets – an area which is ripe for conflicts and questions since the process is not very precise.  The SEC has already focused on this issue by issuing letters of inquiry to a number of private equity fund managers requesting information on portfolio valuation. 

Private equity managers can get into hot water by failing to disclose potential conflicts in the valuation process, or quarterly internal valuations to investors.  In seeking new investors or additional funds from existing investors, private equity managers hahve to be careful not to inflate internal valuations.  By definition, there is no public data on market valuations and the process can be subjective.  As a result, the process has to be transparent and free from any appearance of a conflict of interest.

The best example of the inherent difficulties in valuing private equity was demonstrated by the recent registration of the Facebook Form S-1 Registration Statement.  The SEC filing included highly confidential financial data and begged the question – how much is Facebook worth?

What is clear is that new methods for valuation need to be developed by the private equity industry.  It is no longer satisfactory for a private equity manager to value its investments at its initial costs – some type of valuation process has to be developed.  When the mark-to-market accounting rules were made applicable to private equity, managers were required to come up with some “fair value” – a concept which has been broadly defined as the price a buyer would pay for the asset in a standard transaction.  Such a price should reflect a number of relevant factors: cash flow, comparable businesses, multiples of revenue, offers to purchase, and other standard procedures. 

Fund managers need to develop and adhere to a transparent process for valuing the fund’s assets.  It is important to adopt written procedures for valuing assets which can be supervised by senior management or a valuation committee, which should review and revise the policies as needed.