SEC Looking at How Alternative Funds Value Investments; Regulators say some unscrupulous managers inflate the value of illiquid holdings

SEC Looking at How Alternative Funds Value Investments

Regulators say some unscrupulous managers inflate the value of illiquid holdings


Updated Feb. 3, 2014 4:22 p.m. ET

Regulators are taking a close look at how hedge funds and other alternative investment funds value their most illiquid assets. It’s time more investors did the same.

A fund’s valuation method can have a big impact on investors’ returns: It can affect whether an initial investment is made, how much a manager is paid, and the sale value of a fund’s assets. Yet many investors don’t understand how uncertain and subjective pricing can be for holdings such as complex derivatives or bonds and stocks that lack active secondary markets.

The increased focus on valuation issues by regulators is largely the result of the Dodd-Frank financial overhaul. Signed into law in 2010, Dodd-Frank made hedge-fund managers subject to the same registration and regulatory oversight as other investment advisers regulated by the Securities and Exchange Commission. At the start of this year, there were 4,136 investment advisers to private funds registered with the SEC, 2,586 of which were advising hedge funds.

Coming to Light

SEC officials “are now in a position to oversee how the funds are doing these valuations,” so more abuses are coming to light, says Jay Dubow, a partner in the Philadelphia office of law firm Pepper Hamilton LLP.

The 2008 financial crisis put greater focus on the importance of regulatory scrutiny and due diligence generally. In 2012, the Financial Accounting Standards Board clarified its existing rules for measuring assets’ fair value and put additional disclosure requirements in place.


FASB rules now require assets to be classified in three levels, from Level 1, which are assets such as listed stock and bonds that are easiest to value, to Level 3, which are assets for which there isn’t observable market pricing.

The aim with an illiquid asset is to figure out “what would it get in a sale between a willing buyer and a willing seller,” says Stephen Culhane, a partner at New York law firm Kaye Scholer LLP. Such a determination can involve significant judgment, and it is “susceptible to abuse,” says Mr. Culhane, who represents private-fund managers and advises institutional clients on theirinvestments.

SEC Allegations

One area of focus for the SEC has been the potential overvaluation of assets when funds are being marketed. Regulators are concerned that some managers are exaggerating the performance or quality of holdings by boosting their reported values during a fundraising period, then writing them down after that period closes.

Because in some cases it’s difficult to prove whether a valuation is accurate or fair, the SEC has tended to pursue allegations that an adviser isn’t adhering to SEC valuation practices, says Jonathan Green, counsel with Kaye Scholer in New York.

Last March, for example, Oppenheimer agreed to pay $2.8 million to settle, without any admission of wrongdoing, allegations by the SEC that two company units misled investors about the valuation policies and performance of a private-equity fund one managed. The two business units involved were Oppenheimer Alternative Investment Management, which managed the fund, and its parent, Oppenheimer Asset Management. (Neither has corporate ties to OppenheimerFunds.)

Oppenheimer Asset Management says that it cooperated fully with the SEC and has put in place additional policies and procedures designed to ensure that valuations of portfoliopositions in its marketing documents are determined in a manner consistent with its obligations to investors.

Also in March, the SEC announced charges that Houston hedge-fund manager George Jarkesy Jr. and his firm, John Thomas Capital Management, since renamed Patriot 28 LLC, defrauded investors by inflating valuations on assets held by two hedge funds. “We vigorously contest the allegations that were brought by the SEC against Patriot 28 LLC and Mr. Jarkesy,” says Karen Cook, the firm’s attorney in Dallas.

In October, a judge in U.S. district court in Manhattan refused to dismiss a valuation-related lawsuit the SEC brought in 2012 against Yorkville Advisors LLC, a Jersey City, N.J., hedge-fund firm. The SEC alleged that the firm, its president, Mark Angelo, and its chief financial officer, Edward Schinik, didn’t adhere to the fund manager’s stated valuation policies and ignored negative information about some investments. Yorkville Advisors didn’t return a call seeking comment.

In reaction to the increased scrutiny, many funds now hire third-party independent-valuation specialists to ensure compliance when valuing illiquid assets, and are adding in-house talent, says Michelle Keyes, a senior manager at accounting firm Rothstein Kass in New York. Ms. Keyes conducts audits of hedge and private-equity funds for financial-reporting purposes.

Over the past five years, increasing numbers of research services have been used for pricing more-esoteric holdings, says Kenneth Heinz, president of Hedge Fund Research Inc., a company that tracks industry performance and is based in Chicago.

Red Flags for Investors

Pension plans and other institutional investors generally hire consultants when investing in these private funds. Those who don’t should scour funds’ financial statements for red flags, says Jason Scharfman, a managing partner at Corgentum Consulting LLC in Jersey City, N.J.

In their offering documents, funds may disclose such items as whether there are limits on the amount of the portfolio that managers themselves may price; who is on the valuation committee; whether the fund administrator has interaction with the committee; and the administrator’s role and valuation approach.

Investors should compare what they read with information they learn from other documents and conversations with the manager and administrator, says Mr. Scharfman. “If I know a manager is pricing 10% of a book himself, I don’t want to see that jump up to 40%,” he says.

Also look at the overall level of difficult-to-value assets. “If you are investing in a global macro fund that’s supposed to be in liquid positions, and you look at its audit and it has a lot of Level 3 assets, that’s doesn’t make sense,” Mr. Scharfman says.

Mr. Dubow says investors should also check out the fund’s auditor. On the website of the Public Company Accounting Oversight Board, investors can see which accounting firms are registered with the board and view registered firms’ disciplinary proceedings and inspection reports.


About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: