SEC Launches Private Equity Inquiry?

Cristina Alesci and Joshua Gallu of Bloomberg report, SEC Looking Into PE Firms’ Valuation of Assets:

The U.S. Securities and Exchange Commission has started an informal inquiry of private equity firms, asking for a broad range of documents on how the funds value assets and who invests in them.

Among issues regulators are examining is whether firms use inflated valuations to attract investors when marketing new funds, said a person familiar with the matter, who asked not to be identified because the inquiry isn’t public.

The agency’s Los Angeles office last year sent letters to several firms asking for details on fund investments and the valuation of assets, as well as communication with clients, according to the copy of a letter obtained by Bloomberg News. Firms were asked to produce the documents by the end of last year.

Private equity firms have come under scrutiny in the aftermath of the financial crisis, which forced firms to mark down holdings acquired during a three-year boom that ended in 2008 when the collapse of Lehman Brothers Holdings Inc. froze credit markets. Financial reform measures such as the Dodd-Frank Act have proposed more oversight of the firms’ businesses.

An inquiry six years ago into whether firms drove down prices of takeover targets in so-called “club deals” didn’t result in government action, although several firms were subsequently accused by private plaintiffs of conspiring to rig the market for leveraged buyouts.

SEC Letter

The SEC said its “request should not be construed as an indication by the commission or its staff that any violation of the federal securities law has occurred, nor should it be a reflection upon any person, entity or security,” according to the 16-page letter, which is dated Dec. 8.

SEC spokesman John Nester didn’t immediately respond to an e-mail sent outside normal working hours. The SEC’s inquiry was reported earlier by the Wall Street Journal.

Private equity firms pool investor money to buy companies, using mostly debt, with the intention of selling them or taking them public later for a profit. They typically charge an annual management fee of 1.5 percent to 2 percent of committed funds and keep 15 percent to 20 percent of profit from investments.

The SEC in June voted to require private-fund advisers to register with the agency, although publicly traded private equity firms already provide detailed information in quarterly and yearly filings. The mandate forces 750 advisers to disclose “census-like data” about their investors and employees, the assets they manage, potential conflicts of interest and their activities outside of fund advising.

Antitrust Lawsuit

In October 2006, the government launched an informal inquiry into club deals to determine whether firms were colluding to thwart competition and artificially hold down the prices paid for companies. While no actions were brought by the government, 11 firms including KKR & Co. and Blackstone Group LP (BX) were sued the following year by plaintiffs including a Detroit police and fire pension fund.

The lawsuit, initially filed in 2007, claims the firms conspired to drive down prices in the largest leveraged buyout deals in violation of federal antitrust laws. U.S. District Judge Edward F. Harrington said in a ruling Sept. 7 that the plaintiffs, whose suit was initially limited to 17 transactions, can expand their investigation.

You can read the WSJ article here, but here is more on this story from My Fox Houston, SEC Launches Private Equity Inquiry:

Federal regulators have launched a wide-ranging inquiry into the private equity industry that examines how firms value their investments, among other matters, The Wall Street Journal reported Saturday.

The Securities and Exchange Commission's (SEC) enforcement division sent letters to private equity firms of various sizes in early December 2011 as part of an "informal inquiry," according to the letter and people familiar with the matter.

It is unclear which firms received a letter, which includes language saying it should not be construed as an indication that the agency suspects securities law violations.

The inquiry suggests regulators are ratcheting up the attention they pay to the $1.2 trillion industry, which typically hasn't been a major focus of the SEC. Private equity firms generally use debt to buy companies and then spend time improving operations before trying to sell them at a profit. These firms, which usually don't trade stocks or bonds, were not at the heart of the housing collapse, nor have they figured in recent high-profile trading scandals.

After the financial crisis, and as the private equity industry has grown, the SEC has moved more resources to policing the area. The SEC now has "an inventory" of cases involving private equity firms that it may bring, according to one of the people familiar with the matter.

SEC officials have told industry participants that the regulator is looking at how performance data is presented, said Michael Harrell, an attorney at Debevoise & Plimpton LLP. He said one concern could be presentation of misleading values when a firm is marketing.

Valuation issues have long been a subject of some debate around the industry because the companies that the firms own usually aren't listed on a stock market. There have been some instances when two separate private equity investors in one company have assigned it different values; firms have said they use different methodologies and valuing a private company can be more art than science. Some firms, such as KKR & Co., use outside firms and auditors to review their valuations.

The SEC's letter requested information related to 12 broad areas, including fundraising and fund formation. It asks the firms for "support for valuations of the fund assets," and "documents setting forth a value for any assets owned by the fund" over the past three years. The regulator also asked for details on "all agreements" between the private equity funds and others valuing a fund's assets.

The inquiry comes amid recent comments from SEC officials that the industry is drawing greater scrutiny.

"I think that private equity law enforcement today is where hedge fund law enforcement was five or six years ago," Robert Kaplan, co-chief of the SEC's asset-management unit, told the Dow Jones Private Equity Analyst Outlook conference in New York late last month.

Private equity is drawing greater scrutiny and it's about time. I can tell you that valuation issues have being the subject of ongoing debate among pension funds investing in private equity.

And even though pension funds are queasy over private equity, they too are guilty of playing accounting tricks in their private equity, real estate and infrastructure holdings, writing assets down aggressively in bad years, only to write them up huge in good years to collect big bonuses. Accounting gimmicks are alive and well in private equity funds and pension funds doing direct deals in private markets.

The problem is that mark-to-market doesn't make sense in private equity because it leads to gross distortions in the real underlying value of the investments. When you are investing in a private company, a building or infrastructure project, you can't value everything according to current market conditions. Moreover, these are long-term assets for pensions, they do not need to sell them to realize gains.

For PE funds, it's a different story. Some of them are sharks and value their assets very liberally to "pad" their performance. It's high time the SEC and other regulators start looking closely at how these funds value their investments. While I don't like mark-to-market, I am not a big believer in mark-to-model or mark-to-myth as many call it.

Interestingly, some private equity titans have reported their fourth-quarter earnings and they're not good. Reuters reports that Apollo earnings fall on mark-downs:

Apollo Global Management LLC (APO.N) on Friday became the latest private equity group to report lower fourth-quarter earnings because of the way it accounts for profits, even as the cash flow from its share of investment profits more than tripled.

Private equity groups make a living by buying companies, working to bolster their profits, and then booking gains when they sell them. While they own these companies, or hold stakes in them, their profits on paper also depend on their value.

Like peers Blackstone Group LP and KKR & Co LP, Apollo has seen its private equity assets hit by market turmoil because the fair value of its funds is affected by publicly listed stakes it holds as well as the performance of listed companies in the same sector as unlisted firms it owns.

Lower valuations of its funds translate into lower paper profits because carried interest -- Apollo's share of the investment profits of its funds -- is accrued in part based on estimates of what assets would be worth if sold.

This in turn weighs on economic net income (ENI), an accounting measure of the firm's profitability. ENI fell to $357 million in the fourth quarter from $926 million a year earlier.

After-tax ENI was 80 cents per share, down from $2.52 a year ago. Analysts in a Thomson Reuters poll were expecting after-tax ENI per share of $1.41.

However, cash profits from carried interest soared thanks to payouts from some of Apollo's investments. Total realized gains from carried interest were up 238 percent to $278 million for the quarter.

Apollo, whose investments include casino operator Caesars Entertainment Corp, chemicals company LyondellBasell Industries NV and real estate investor Realogy Corp, was co-founded by former Drexel Burnham Lambert bankers Leon Black in 1990.

"We generated a record $645 million of realized carry revenues in 2011, which demonstrates the value of our integrated investment platform, particularly amidst challenging market conditions," Black, Apollo's chief executive, said in a statement.

The realized carry in the fourth quarter was driven by the sale of Parallel Petroleum to Samsung C&T Corp for $772 million, the divestment of Connections Education to Pearson PLC for $400 million and a special dividend of $4.50 per share by LyondellBasell.

CREDIT INVESTMENTS

Apollo, which went public last year in a $565 million initial public offering, is one the private equity industry's most prolific corporate credit investors and its capital markets portfolio is set to overtake its private equity assets in size.

Apollo agreed to buy debt investor Stone Tower Capital LLC last December. Once the deal is completed in April, Apollo will boost its assets under management by $18 billion. Apollo had $35.4 billion in private equity assets and $31.9 billion in capital market assets as of the end of December.

Assets under management were $75 billion at the end of 2011, up 15 percent year-on-year.

Credit investments, on average, yield lower returns than buyouts but investors often prefer them on a risk-adjusted basis and Apollo has also often invested in distressed debt situations with an eye to clinching a company's equity.

By December 2011, Apollo had returned to investors in its private equity funds $38.6 billion on committed capital of $35.9 billion. On $6.1 billion of committed capital to its capital market funds it has returned $4.3 billion, according to the firm.

Apollo declared a fourth-quarter distribution of 46 cents per Class A share, bringing its 2011 dividend to $1.12. Apollo shares traded down 4.3 percent at $14.68 on Friday morning, while broader market was lower by about 1 percent.

All this shouldn't surprise us. Last year was a tough year for hedge funds and mutual funds but it was especially tough for private equity funds. Record volatility made it hard to realize gains because conditions weren't right to realize gains by exiting in public markets. We shall see what 2012 brings. So far, so good but that could all change.

But don't shed a tear for private equity. Below, Carlyle Group, the Washington-based private-equity firm seeking to go public, said its three founders received a combined $413 million last year as profits rose. William Conway, Daniel D’Aniello and David Rubenstein each earned a $275,000 salary, a $3.55 million bonus and $134 million in distributions, the firm said yesterday in a filing with the U.S. Securities and Exchange Commission. Cristina Alesci reports on Bloomberg Television's "InsideTrack."