A Lawyers Guide: Valuation Issues in Private Equity Funds

Abstract

The first private equity fund was formed in 1978 by Kohlberg Kravis Roberts. Since then, the private equity industry has grown exponentially reaching its peak size in 2008 in which a record $680 billion was raised globally in commitments. Historically, this massive industry has somehow managed to fly under the radar; receiving minimal attention from federal lawmakers and regulators.

As a result of last decade’s buyout boom coupled with the most recent recession, government agencies have begun to pay much closer attention to the private equity industry; leading to the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in 2010. Dodd Frank has enabled the SEC to increase its enforcement activity through examinations, audits, and stricter record-keeping standards. One of the SEC’s main interests/objectives is focused on how private equity firms value their assets and report their performance to current and potential investors.

Valuation is an art not a science; however the guidelines that Dodd-Frank has imposed are a step in the right direction towards consistency. Investors need to be aware and mindful of the valuation method established in the Limited Partnership Agreement. In addition, investors should conduct extensive due diligence on documents received during the fundraising stage; paying particularly close attention to the performance history and track record of the fund sponsor, with an emphasis on the particular valuation method they used. Private equity firms on the other hand need to also be cognizant of the valuation being employed on their funds. Federal antifraud provisions of the federal security laws prohibit manipulating or otherwise misrepresenting the fund’s prices, which was evidenced recently in February of 2012 when the SEC opened an investigation into Oppenheimer Global Resource Private Equity Fund LP, alleging possibly inflated or exaggerated valuations of one of its holdings from a prior year.