In an article published in August 2015, NERA Economic Consulting examined some of the effects of the SEC’s increasing use of quantitative analysis to identify potential problematic valuations in public company filings. Although the SEC previously used its tools in the private fund advisor sphere, the agency is beginning to turn its gaze to publicly traded companies. Thus far, the SEC’s focus has been on two main points, valuation policies that differ from actual valuation practices (including valuation methods and approaches, as well as the inputs used) and the incorporation of market conditions (or lack thereof).
The SEC’s tools have so far been successful at flagging unusual or suspect valuations in the private equity, mutual fund, and hedge fund arena, resulting in several enforcement actions:
- KCAP Financial, Inc. (2013) This matter was the SEC’s first enforcement action against a public company that failed to properly apply fair value principles (referred to as SFAS 157 in 2008). The SEC settled charges against three executives based on the alleged overstatement of the value of debt securities and CDOs. The company executives paid $125,000 in penalties.
- GLG Partners LP (2013) The SEC settled charges based on the alleged overvaluation of an emerging market coal company, which subsequently artificially increased fee revenue. GLG and its former holding company paid nearly $9 million in penalties, interest, and repayment.
- ThinkStrategy Capital Management LLC (2013) The SEC settled charges against the hedge fund’s manager based on the alleged overstatement of assets, misrepresentation of the firm’s history, the understatement of volatility, and the misrepresentation of credentials over a period of seven years. ThinkStrategy and the fund’s manager were ordered to pay nearly $5 million in penalties and repayments.
- Millennium Global Emerging Credit Fund (ongoing) The SEC charged the Fund’s portfolio manager with overstating the fund’s returns and net asset value and using fictional prices for two of the fund’s illiquid holdings. Although the matter is still ongoing, the portfolio manager was sentenced to four years and prison and was ordered to pay over $390 million in restitution.
In the KCAP matter, management of the company believed that the Level 2 price inputs available for the debt securities in question reflected distressed transactions and instead elected to use an “enterprise value methodology” to value the securities. By using a less visible input and implementing an atypical valuation method, KCAP opened itself to deeper scrutiny from the SEC. The agency alleged that KCAP did not adequately describe and disclose its valuation techniques, resulting in an overvaluation of the subject securities.
As put forth in ASC 820, there are three types of inputs in the fair value hierarchy:
- Level 1 inputs are directly observable in an active market with unadjusted prices. In general, market transactions are typically seen as the best indication of an asset’s value.
- Level 2 inputs are based on inactive market prices for the subject asset, active market prices for similar assets, or pricing models with Level 1 inputs.
- Level 3 inputs are unobservable (i.e., not derived from the market).
In general, valuation specialists should use directly observable inputs whenever possible. For example, if the specialist had the option of using a Level 1 or a Level 3 input, the specialist should choose to use the Level 1 input. If, for some reason, the specialist elects to not use a lower level input, the rationale for doing so and the valuation techniques used must be disclosed, lest the company incur the wrath of the SEC. Certain circumstances that would lead a valuation specialist to choose a another input level are typically specific to the asset, but in all cases should reflect the assumptions of market participants for the subject asset. These factors apply regardless of whether the asset in question is a debt security or an illiquid equity holding in a portfolio company.
As the SEC ramps up its use of quantitative analytics and increasingly examines public company fair value measurements, following valuation best practices and disclosing the appropriate information will be increasingly important.
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