As the Dodd-Frank Act's impact continues to be felt, a concept that has become pervasive in the banking industry may find its way into private equity. Risk appetite is a term used to describe a comprehensive system for risk management. It aligns overall corporate strategy, capital allocation, risk and risk management. A comprehensive risk appetite framework has become a key concept in many sectors of the financial industry.
The Securities and Exchange Commission and other regulatory agencies have made it clear that the valuations of PE firm investments are facing increased scrutiny. While private equity funds have always focused on risk management, risk appetite is a broader framework through which the firms can communicate their valuation processes with investors, regulators and stakeholders.
There is a significant fixed cost (in terms of dollars as well as soft costs like manpower and time) associated with complying with valuation standards. Smaller PE firms have the same problem that all small firms have when it comes to regulatory compliance -- a lower cost base over which the increased compliance costs can be spread.
PE funds that are subject to SEC scrutiny will need to focus on the disclosure, consistency and application of valuation methodologies and procedures. It is critical for general partners to ensure that funds' positions conform to appropriate valuation methodologies and assumptions with contemporaneous documentation maintained. Smaller and midsize funds must take steps now to ensure valuation processes meet regulatory standards while planning for the impact that higher compliance costs will have.
Regulatory compliance is expensive and time consuming, but the following to-do list will help general partners mitigate some of the costs:
Reliable valuation information is critical for the fund's LPs and is one of the key documents analyzed by regulators and other stakeholders. Private equity funds have worked strenuously since the adoption of fair-value accounting standards to implement an efficient and effective fair-value process. Today there are three expectations for that process: transparency, objectivity and consistency.
Transparency. The valuation is based on a well-accepted methodology and well-reasoned assumptions. That is, the model is appropriate for the investment; the inputs and assumptions are congruent with market participants' expectations for an exit price; the analytics can be observed throughout the valuation process (the inputs can be observed and the output can be recomputed).
Objectivity. The valuation is bias-free with assumptions and conclusions supported by logic and evidence.
Consistency. Securities are priced in relation to the market's expectations of risk and return and, while recognizing changes over time, prepared in a manner congruent with a consistent policy.
Regulators will adopt the perspective that if the valuation analysis has not been documented contemporaneously with the mark, then the analysis was never performed. It is important, then, that the fund "show its work" from the beginning, and continue to rigorously document its valuation processes and analyses so that an informed reader can understand the fund management's valuation rationale without further explanation.
In our experience, a dedicated internal valuation department focused on performing quarterly valuations is an excellent investment that effectively articulates risk to stakeholders while minimizing the cost. While PE valuation poses undeniable challenges, a commitment to strong governance, diligent documentation and independent oversight will help meet those challenges.
Now more than ever, determining and documenting investment fair value is critical, and smaller and midsize firms will need to effectively manage the process to ensure they are not unduly burdened by compliance costs.
Larry Levine is a partner at McGladrey & Pullen LLP.