October 4, 2023

The Future of Valuation: Technology Will Be Critical to Help GPs and Their Advisors and Auditors Address the New SEC Rules for Private Funds

In a world where financial innovation is at the forefront of progress, valuation remains at the heart of every sound investment decision. Yet, with rising complexities in the landscape of asset classes and evolving regulatory environments, ensuring accurate valuations is becoming an increasingly complex endeavor. The recent rules for Private Funds, established by the Securities and Exchange Commission (SEC), will only increase the complexity and requirements. An industry-standard technology for valuations will be instrumental in addressing these challenges adequately, efficiently and in a timely manner.

Over a year after an initial proposal, the SEC voted to adopt rule changes relating to the private fund industry on Wednesday, August 23, 2023. While the consequences are still not yet fully clear as certain stakeholders have decided to sue the SEC in an attempt to overturn these rules, the expected changes aim to bring more, and faster, transparency to private fund investors (“LPs”) and accountability to fund advisors (“GPs”), including on the valuation and reporting sides.

The final rules mandate enhanced disclosure by private fund advisors:

  1. SEC-registered advisors are now required to provide LPs with quarterly reporting, which must disclose performance, cost of investing in the fund, fees and expenses paid by the private fund, as well as compensation paid to the GP.
  2. Every private fund advised by an SEC-registered advisor must obtain an annual audit. The rule also lays down the minimum qualifications an auditor must possess to conduct these audits.
  3. In the event of a secondary transaction led by an advisor, either a fairness opinion or valuation opinion is required. The rule requires advisors to distribute to their investors a summary of business relationships, if any, that they have had with independent opinion providers.
  4. Advisors are prohibited from engaging in certain activities and practices that might endanger investors. However, they can participate in these activities if they provide specific disclosures to investors and, in some instances, receive investor consent.
  5. There is a strict prohibition against providing certain types of preferential treatment that could adversely affect other LPs. Additionally, any other kinds of preferential treatments are only allowed if they are fully disclosed to both current and prospective LPs.

Understanding the Valuation Landscape

The SEC has deep-dived into the intricacies of valuation. From the risks associated with incorrect valuations to the cost implications of obtaining fairness or valuation opinions, the document provides an exhaustive exploration of valuation.

It's worth noting the importance the SEC places on obtaining valuations:

  • Valuations are now required on a quarterly basis. What was once simply a best practice and negotiated between the LP and the GP is now a regulatory mandate.
  • These valuations will be audited annually by auditors with the right competencies – specifically, a deep understanding of valuation concepts and methodologies.
  • For secondary transactions, opinions will serve as a critical safeguard, protecting investors from flawed valuation exercises. Moreover, obtaining these opinions is not just about ensuring the accuracy of the valuation exercise; it's also about guaranteeing a fair process, providing transparency to LPs, and ensuring compliance with regulations.

The Multifaceted Role of Valuation

Valuation, especially in financial markets, is not a one-dimensional concept. It has often been described as a combination of art and science and its significance varies depending on the context and the stakeholders involved. The SEC document offers several insights into this, emphasizing the importance of third-party validation in asset valuation, its associated cost implications, the unique challenges faced by small GPs, the undeniable importance of documentation and record keeping, and the delicate balance between risks and benefits.

At its core, valuation serves a singular purpose: assessing how much an asset is worth. A flawed valuation can distort this assessment, potentially harming LPs. This raises the question: How can we ensure proper valuation mechanisms, given valuation can be subjective and dependent on many assumptions and time-specific metrics?

The SEC document stresses several aspects of this dilemma:

  1. Purpose of Valuation: The fundamental role of valuation is to provide an accurate measure of an asset's worth. Without precise valuations, investors stand at risk.
  2. Valuation Opinions: The document places significant emphasis on obtaining valuation opinions, particularly from independent sources. This push for independence highlights the SEC's commitment to ensuring that valuations remain transparent and unbiased.
  3. Cost Implications: While valuation opinions are crucial, they come with associated costs. These costs, although essential for transparency and fairness, could dent the net returns on investments.
  4. Business Practices & Ethics: Ethics take center stage with the mention of business practices that might benefit advisors without adding value for investors. The SEC's focus here underscores the need for regulations that align advisors' interests with those of their investors.
  5. Regulatory Requirements: With mandates for advisors to keep records of fairness and valuation opinions, the SEC aims to bolster transparency and enable regular audits. Such measures are aimed at fortifying trust within the financial ecosystem.
  6. Empowering Smaller Advisors: The document acknowledges the compliance cost challenges that smaller advisors may face. This recognition points towards the SEC's intent to create a balanced regulatory landscape.
  7. Professional Skillset: Asset valuation isn't for the faint-hearted. The SEC document nods to the specialized skills and expertise essential in this domain, implying the significance of professional training and experience.

The Role of Technology

This is where technology comes into play. Let's envision a few ways in which technology can revolutionize this landscape:

  1. Automated Record-Keeping: Modern systems can automate the documentation process, ensuring that advisors maintain proper and easily auditable and documented records of any valuation work performed, and even material business relationship summaries.
  2. Need for timely reporting: The reporting rule requires the quarterly statements to be sent to investors in funds that are not funds of funds within 45 days after the first three fiscal quarter ends and 90 days after end of the fiscal year. Most private funds, especially the smaller ones, are not equipped with in-house processes and capabilities that would facilitate such quarterly reportings, such as data collection.
  3. Reducing Cost Implications: Advanced software solutions streamline the valuation process, thereby reducing associated costs. By leveraging big data analytics, advisors can gain insights that would have otherwise required expensive manual analysis.
  4. Avoid human-led mistakes: We are all human and prone to mistakes! During any valuation project, many people contribute to the workstream, which often leads to mistakes. Some can be minor without any significant impact, while others can have major impact! For example, in 2016, the investment bank advising SolarCity on its $2.6 billion sale to Tesla made an error in its valuation analysis that discounted the value of the energy company by $400 million (!!).
  5. Skill Augmentation: While the professional skills required for valuations are intricate, technology can augment these skills. Advanced analytics tools, for example, can help advisors dissect complex financial data faster, providing more time for strategic analysis and making it easier to arrive at accurate valuations.
  6. Empowering Smaller Advisors: Technology can level the playing field. By offering tools that were previously accessible only to larger entities, technology ensures that even small advisors can meet regulatory demands efficiently and timely.

How 73 Strings Can Help

In essence, the future of valuation as portrayed by the SEC's document, represents a major challenge to the private fund advisors who are now required to provide quarterly reports and yearly audits to their investors. While the risks of flawed valuation exercises are real and concerning, the potential help that software solutions can provide to fund advisors is undeniable. In addition, the pressure to generate quarterly reportings within a short time frame (45 days) is a bigger challenge that will push funds to adopt technological solutions that enable them to optimize both time and effort in data collection. By embracing technological solutions like 73 Strings, the private fund industry can ensure that the data collection and valuations exercises are not only accurate but also transparent, fair, efficient, timely, and compliant. 73 Strings software offers an easily auditable, step-by-step account covering every user activity, data point entered or updated, comparable or benchmark used, document referenced, and formula detail. This solution aids in achieving third-party objectivity and provides necessary insight into the "black-box" of valuations, ensuring that clients can confidently navigate these new and rapidly changing regulations.