In this Ropes & Gray podcast, Jeremiah Williams and Casey White discuss compliance issues surrounding the valuation of debt investments held by credit funds. Debt investments create unique valuation challenges for sponsors making such determinations, such as managing potential conflicts of interest. This podcast discusses certain regulatory compliance considerations relevant to the valuation of debt instruments and the importance of instituting and following valuation policies and procedures.
Casey White: Hello, and thank you for joining us today for this Ropes & Gray podcast, the latest in a series of podcasts aimed at credit funds. My name is Casey White, and I am an associate in the asset management group. And joining me is Jeremiah Williams, a partner in our litigation and enforcement practice group with a focus on securities and futures enforcement. Today, we’ll be talking about some of the compliance issues facing managers with respect to the valuation of investments held by credit funds. So Jeremiah, private credit funds often hold investments that do not have a readily available market value, so valuation is ultimately determined by the sponsor. Are there unique risks associated with assigning values to debt investments that the SEC would expect to be clearly explained to investors in offering documents?
Jeremiah Williams: Ultimately, from a regulatory perspective, the concerns are the as in a traditional buyout fund – information presented to prospective and existing investors should not be materially misleading. However, there are various risks associated with debt investments that create unique valuation challenges, such as prepayment and default, as well as interest rate risks, each of which can undermine yield assumptions critical to a valuation determination. The SEC will expect to see a description of these challenges, their impact on valuation determinations, and the risks they create for investors, as well as the conflicts of interest they present, clearly disclosed in the fund’s offering documents.
Casey White: Can you talk about what types of conflicts and compliance considerations arise where sponsors are making these types of valuation decisions?
Jeremiah Williams: Yes. When private funds hold illiquid assets that are expected to be difficult to value and for which market prices are not readily obtained from third parties, the sponsor itself will often be responsible for determining the value of those assets, which results in potential conflicts of interest. The most poignant example arises where the sponsor’s management fees are calculated based on the value of a fund’s portfolio, which creates a clear incentive for the manager to assign a higher value to the assets. To the extent that the manager’s valuations do not reflect a market price or a valuation that the manager would have determined using an alternative valuation methodology, the outcome may be more favorable to the manager, and result in higher fees paid by investors, than would otherwise have been the case. Another context in which valuation decisions can create conflicts of interest is when a manager uses performance information and valuations relating to investments made by a fund in connection with its marketing efforts, as sponsors are motivated to present returns in a way that is favorable to the fund. Employees of a manager who participate in the valuation process may also receive compensation based in part on the performance of the fund, again creating an incentive to assign a higher value. If an adviser wants to use performance information that is dependent on the adviser’s valuation determinations, the risk that the value may not reflect market value as well as conflicts of interest that may impact the adviser’s determinations, should be disclosed alongside such performance information. In addition to conflicts of interest, materially inaccurate valuations may cause a manager to run afoul of anti-fraud regulations. Each of these issues create the types of concerns that have led the SEC to focus on valuation policies and outcomes.
Casey White: Right. There have been a number of recent enforcement actions relating to the valuation of assets and the procedures that sponsors have used to reach these determinations. Could you talk a little about these cases?
Jeremiah Williams: Yes. The valuation of securities, and the related conflicts and risks to investors, have been flagged by the SEC for years as a key regulatory concern, but there have been a few recent cases that suggest the SEC really is focusing on this issue. Just this summer, an SEC investigation found that an investment adviser’s policies had failed to prevent its traders both from providing inaccurate information to a pricing vendor, and then valuing bonds based on the vendor’s calculations, and from undervaluing securities, which allowed them to then sell those securities for a profit when needed.1 In this case, the adviser had established valuation policies and procedures, but the SEC took a close look at those policies and determined that they were substantively inadequate to ensure fair and accurate outcomes. For example, although the firm had established a valuation committee to oversee decisions, the members of the committee were relatives of one of the firm’s investment professionals, who lacked relevant experience and expertise. So the real focus was a review of whether the policies and procedures that this adviser had implemented were in fact well-designed to mitigate the risks associated with valuing investments held by the funds it managed.
Casey White: Does the SEC’s focus generally seem to be on those types of policies and procedures, as it was in that case, or have there been cases where the SEC focused on the value they determined itself, or the outcome to investors?
Jeremiah Williams: There was actually a case last December where the SEC found that a business development company had failed to monitor the valuation models being used by one of its portfolio investments to value illiquid assets that lacked market prices, which ultimately resulted in the company issuing overvalued shares to the public.2 Because preventing harm to investors is a goal that underlies all SEC regulation, that type of concrete harm is sure to alert regulators. However, the issue that led to this outcome was again, a failure to implement adequate procedures designed to ensure fair and accurate valuations. In another case a couple of years ago against an adviser who had established a GAAP-compliant valuation policy, the SEC took issue with the adviser’s failure to properly apply that policy, resulting in violations of the anti-fraud provisions of the Advisers Act.3 Typically, the SEC does not bring an enforcement action against an adviser with well-designed valuation policies and procedures that were implemented and followed. It would be highly unusual for the SEC focus on a valuation determination without finding any deficiencies in the policies and procedures. Inaccurate outcomes tend to suggest a flaw with the procedure that was followed, so past valuations should be reviewed and policies should be regularly evaluated and updated as necessary.
Casey White: Given the SEC’s position in these cases, what should private fund, and particularly credit fund sponsors be thinking about?
Jeremiah Williams: The first key takeaway is that, as a baseline measure, sponsors should have valuation policies in place for making valuation determinations. However, the SEC has made it clear that simply having a valuation policy is not sufficient – the policy must be substantively designed to mitigate conflicts and achieve as accurate a determination as possible. This generally means that the policy should comply with GAAP, and that assets without readily available market values should be valued with consistent procedures that are subject to oversight. Advisers often provide for the use of third party valuation agents, and establish independent valuation committees to review decisions. Again, this should not be a nominal measure – the valuation agents should be thoroughly vetted and committees should be comprised of qualified members with relevant experience, not only in valuation, but in valuation of the types of assets being reviewed. That said, just putting in place even a robust policy is not sufficient. Advisers must make sure that their valuation decisions are actually made in accordance with the policy and that all applicable procedures are followed. To ensure that this is the case, and that it can be demonstrated to the SEC, valuation decisions should be carefully documented.
Casey White: The strategies of credit funds we’re seeing in the market and the debt instruments they are investing in seem to be increasingly diverse and creative. Are there any compliance risks that are particularly pronounced in the context of valuing investments of a private credit fund that is investing in a less conventional product, such as a structured credit fund or a fund focused on distressed debt?
Jeremiah Williams: While all of the regulatory considerations that are relevant to the valuation of equities apply to debt instruments, the appropriate valuation procedures themselves may differ, and managers that have typically focused on private equity who are moving into the credit space will need to reevaluate their policies to ensure that they are adequate for accurately valuing debt instruments generally, and particularly for higher-yield strategies such as those focused on investments in distressed debt and collateralized loans. To the extent advisers are valuing investments in more bespoke products, it is less likely that there will be a standard methodology that regulators will expect to see followed, which can both alleviate and create regulatory pressure. While this may allow advisers more flexibility in determining the appropriate procedures, there is also a greater risk of misvaluing these assets. In this case, it is even more critical that procedures, and the rationale for establishing and following them, are well-documented. And, as with all private fund regulatory issues, the risks and limitations associated with valuing illiquid securities, particularly for asset types that are relatively new to the market, should be clearly disclosed to investors.
Casey White: Thank you, Jeremiah, and thanks to our listeners. For more information on the topics that we discussed or other topics of interest to the asset management and credit funds communities, please visit our website www.ropesgray.com. And of course, if we can help you navigate any of the topics we’ve discussed, please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
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