PETER LATTMAN: US regulators open examination of private equity indistry

In recent years, the private equity industry has escaped much of the regulatory scrutiny that has been directed toward hedge funds and Wall Street banks. But that appears to be changing.

The Securities and Exchange Commission has begun a broad examination of the private equity industry, seeking information about the business practices of some of the country’s most powerful financial firms.

The S.E.C.’s enforcement unit sent a letter late last year to several private equity funds as part of what it called an ”informal inquiry” into the industry, according to two people with direct knowledge of the matter who requested anonymity because they were not authorized to discuss it publicly. It is not clear which firms received the letter.

While the S.E.C. emphasized that the request should not be construed as an indication that it suspected any wrongdoing, its goal in gathering information was to investigate possible violations of securities laws, these people said.

One focus of the inquiry is how private equity firms value their investments and report performance. Unlike the valuing of publicly traded stocks, valuing private equity investments – largely in private companies that are not listed on an exchange – can be a thorny and subjective process.

The S.E.C.’s concern, say people familiar with the government inquiry, is that some private equity funds might overstate the value of their portfolios to attract investors for future funds.

”Private equity firms work hard, with auditors and company managements, to provide accurate valuations of their largely illiquid holdings to their investors,” said Steve Judge, the chief executive of the Private Equity Growth Capital Council, the industry’s trade group.

The S.E.C. inquiry, which was reported earlier by The Wall Street Journal, adds to the increased scrutiny of the private equity industry in Washington and expands the agency’s interest in how financial institutions value their holdings.

While private equity billionaires like Henry R. Kravis and Stephen A. Schwarzman have long made headlines for their audacious deals, the industry has historically received minimal attention from federal lawmakers, in part because private equity clients – typically pension funds and the investment arms of foreign governments – are considered to be more sophisticated than average investors.

The inquiry also comes at a time when private equity has been thrust onto the national stage as a central issue in the presidential election. Mitt Romney, a leading contender for the Republican nomination, earned his fortune running Bain Capital, one of the world’s largest private equity firms.

The industry drew heightened interest during last decade’s buyout boom. Backed by billions of dollars in loans from flush banks, the firms acquired major American companies, including the radio giant Clear Channel Communications, the hospital chain H.C.A. and the automaker Chrysler.

Washington began to pay attention. The favorable tax treatment that private equity executives receive on a large portion of their compensation came under attack. The Justice Department began investigating whether the world’s largest private equity firms colluded to drive down the prices of acquisitions that they teamed up on.

Under the Dodd-Frank financial reform law, most private equity firms must register with the S.E.C. by the end of March. The commission already oversees many firms. The Blackstone Group and Kohlberg Kravis Roberts, for example, are publicly traded companies that provide the commission with detailed financial information.

While the largest private equity shops receive the most publicity, the industry is vast, with several thousand firms and more than $1 trillion in assets under management.

Critics of the industry argue that private equity’s core investment strategy – taking on large amounts of debt to buy companies – too often results in bankruptcies and job losses.

Private equity officials counter that their acquisitions drive economic growth by making companies more competitive. They also boast of delivering superior investment returns to clients, including public pension funds.

The S.E.C inquiry appears less focused on big-picture questions like private equity’s effect on jobs or the companies that it buys. Instead, the commission wants to deepen its understanding of more arcane issues like firms’ fee structures and how they value investments.

Handling the inquiry is the S.E.C.’s enforcement division, which drew criticism for its ineffectiveness as a regulator in the period leading up to the financial crisis. The agency has recently taken a more aggressive public stance, vowing to root out misconduct on Wall Street.

Speaking at a private equity conference last month, Robert B. Kaplan, co-chief of the S.E.C. enforcement division’s newly formed asset management unit, said he thought the private equity in
dustry lacked sufficient oversight and deserved more scrutiny.

One area of focus is portfolio valuation. Private equity managers use varying, complex methodologies to value their holdings, which are often private companies bought using debt. Because there are no easily ascertainable market prices for private companies, subjective judgments play a significant role in their valuation.

While the industry has in recent years provided managers with a framework for valuing their private holdings, even its largest, most sophisticated players acknowledge the complexities involved.

The Carlyle Group, for instance, which has filed for an initial public offering, lists valuation as a ”risk factor” in its registration statement with the S.E.C.

”Valuation methodologies for certain assets in our funds can involve subjective judgments,” Carlyle said, ”and the fair value of assets established pursuant to such methodologies may be incorrect, which could result in the misstatement of fund performance.”

Private equity funds argue that they are rigorous in their valuation process. Many firms use independent financial advisory firms that specialize in portfolio valuation, like Duff & Phelps.

They also contend that interim valuations are less important to investors in private equity funds than investors in other vehicles like hedge funds. That is because private equity funds earn profits only when they sell a holding. By contrast, hedge fund managers are paid on their gains at the end of each year.

”Because private equity investments are not traded on stock exchanges, investors and company management can focus on creating value over the long term and not on the monthly or quarterly pressures of the public markets,” said Mr. Judge, the chief of the industry trade group.

The valuation of assets has become a main focus of law enforcement authorities, not only at private equity firms but also at hedge funds and Wall Street banks.

Earlier this month, federal prosecutors charged three former Credit Suisse executives with inflating the value of their mortgage-bond holdings to secure higher bonus payouts.

The S.E.C. recently filed several actions against hedge funds as part of an initiative to combat fraudulent valuations and phony returns. The effort – called the ”aberrational performance inquiry” – uses what the S.E.C. calls proprietary risk analytics to evaluate hedge fund performance.

In announcing the initiative, the S.E.C. emphasized that it was interested in assessing returns across Wall Street.

”We are applying analytics across the investment adviser space – beyond performance and beyond hedge funds,” the agency said.

This is a more complete version of the story than the one that appeared in print.

Source: NYT, 2/14/2012