Category: Valuation

The One with Valuation Malfeasance

After a hiatus for the heat of the summer, here is a compliance case of valuation malfeasance. It comes from the biggest collapse of a private equity fund manager. The Abraaj Group and its CEO, Arif Naqvi, were vanguards in emerging markets investments. After some early success buying and transforming Inchcape Shipping Services and Jordanian Express Mail, Mr. Naqvi became a prolific fundraiser. The Abraaj Group at one point managed almost $14 billion, with holdings in health care, clean energy, and real estate across Africa, Asia, Latin America and Turkey.

The Abraaj fundraising was based on the purported success of the prior funds’ private company investments which were very illiquid. Mr. Naqvi also claimed that his investments were doing good for people while making money for the investors.

It turns out that wasn’t true. There are currently many pending actions against the Abraaj Group, Mr. Naqvi and the firm’s personnel in several countries.

The latest action is a case brought by the Securities and Exchange Commission against Mark Alan Bourgeois who was responsible globally for fundraising and investor relations and was a member of Abraaj’s Management Executive Committee. Mr. Bourgeois recommended that Abraaj not apply write-downs (or delay doing so) for investments made by prior funds to avoid the negative impact on the fundraising for its sixth fund. Abraaj did delay applying the write-downs. The result was that investors and potential investors in its sixth fund received an inflated performance track record while Abraaj and Mr. Bourgeois actively solicited investments for the sixth fund.

Mr. Bourgeois agreed to pay a $2 million fine in this case. Mr. Naqvi is currently free on bail in London while contesting extradition for financial fraud charges.

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Weak Valuation Procedures Result in Private Fund Fine

An SEC investigation found that Colorado-based investment adviser Deer Park Road , in connection with one of its funds, failed to have policies and procedures to address the risk that its traders were undervaluing securities and selling for a profit when needed.  The SEC fined a hedge fund $5 Million, and its Chief Investment Officer another $250,000, for failing to properly value portfolio securities.

In the order, the SEC maintains that the firm failed to sufficiently address how to conform the firm’s valuations with GAAP. In addition, they were not designed for its own business practices, given the firm’s models and potential conflicts.

Even worse, Deer Park Road didn’t follow its existing, yet deficient, policy. The policy was important because the fund focused on thin-traded mortgage-backed securities.

Another aspect of its deficiency was the membership of the firm committee that was responsible for making sure valuations were in compliance with the firm’s pricing source protocol. The members were:

  • CCO – a former geochemist with no relevant experience in bond valuation
  • CFO – former bookkeeper and tax accountant with no experience in bond valuation
  • Untitled person – an attorney with no experience in bond valuation.

Of course there are messages noting the failure to mark assets to the market price.

“we are fundamental oriented, and price them based on future cash flow . . . . Mkt seems to be willing to buy at lower yield, which is only a technical issue, but we may sell our bonds at mkt price, only to take realized profits then rather than mark them up to book unrealized profits.”

and

“don’t you know me at all / I don’t mark stuff up / stay as conservative as possible.”

and

“[w]e mark it low. it can trade much higher . . .” and “undervalued, can trade low60s…. can sell it for profit if needed.”

Wait a second…. This is a different type of valuation case. Based on the order, the manager was staying conservative with fund valuations. The assets were not over-valued; they were UNDER-VALUED.

The SEC order does not allege any harm to investors. The SEC does not accuse the firm of making extra money by keeping the values low. The SEC accuses the firm of allowing its traders to “mark assets up gradually instead of marking them to market.”

Of course, valuation is important. You can’t ignore obvious market indicators on value.

I have to assume there are other matters that didn’t make it into the Order that caused the SEC to pursue this case and seek a $5 million fine.

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Vindication for Yorkville (mostly)

Back in 2012, the Securities and Exchange Commission filed suit against Yorkville Advisors for valuation failures.  According to the SEC complaint, the failure was two-pronged: one of misstatements and a second failure to follow the funds’ own policies and procedures on valuation. Yorkville denied the charges.

Legal action has continued and Yorkville has been largely vindicated in a motion for summary judgement.

The SEC lost virtually all claims in the asset valuation case brought against a fund and two of its officials.

As with most private fund managers, Yorkville’s ability to understand the valuation of its investments is critical to its strategy and results. So you would expect some discretion to be granted to the manager, without the SEC second-guessing the valuation. The SEC second-guessed the values and lost.

The key should be precision ahead of accuracy. Precision is getting close to the same result consistently. Accurate is getting close to the right target. You can be precise and inaccurate, and you can be accurate but imprecise.  With a hard to value asset, where its hard to know the correct target, precision is more important.

The SEC case was focused on 15 privately negotiated, customized securities in its portfolio that had little to no market activity.

Yorkville was using GAAP in calculating the net worth of each fund and marking the funds’ investments to fair value. It used one valuation adviser to help value some of those 15 positions. Yorkville ended up rejecting most of the first attempts because it thought the valuations were too high. Yorkville hired a second valuation company to help with some of the investments it had to foreclose on. Yorkville’s audit form signed off on the valuations. The auditor re-examined the work after the SEC was filed, discovered that it did not have some the draft valuation work, but concluded that it could still stand behind the audits.

Prior to 2008, the firm marked positions at the lower of cost or market value until gains were realized. The firm would recognize unrealized losses but not unrealized gains. Yorkville adopted FASB Statement 157 in 2008 which changes to the treatment to always be fair market value accounting.

The SEC claimed that Yorkville overvalued the 15 investments by at least $50 million as of December 2008 and $47 million as of the end of December 2009. The over valuations inflated the value of the funds which attracted investors and increased the fees that Yorkville charged.

The opinion starts with precluding a big chunk of the testimony of the SEC valuation expert. The court found that the Uniform Standards of Professional Appraisal Practice call for a review to be one of the quality of the of the valuation process and not to create a new value based on the review.

Then the court moves on to deciding if there was evidence to support a finding of scienter or intent to deceive. The SEC used three theories as to why the Yorkville principals had the motive and opportunity to commit fraud.

First, the court rejected the claim that motive and opportunity could be established from the Yorkville’s compensation structure. The court refers to established law that the mere desire to earn management fees is not sufficient to allege a concrete and personal benefit resulting from the fraud.

Second, although Yorkville was in a tough financial position (it was 2009-2009) and would be better off it could raise more funds from investors, it was not enough to prove an intent. The SEC was claiming that Yorkville kept the valuations high to attract more investors. That did not meet the test.

Thirdly, the principals redemption of interests in the fund did not have the facts to show fraud. Yorkville was actively marking the Fund down by $33 million at the time of the redemption request. .

The Court also rejected the SEC’s claim that the Yorkville principals had fraudulent intent because they failed to disclose key documents to the outside auditors and made affirmative misrepresentations regarding the 15 positions to the investors and auditors. The court rejected that, noting that the auditors still stood behind their audits. Although, the audit partner claims that a dozen documents, out of hundreds of others, were not provided to the auditors.

It looks like Yorkville was a bit sloppy in its statements regarding its use of outside consultants to help in valuations. Some of these sloppy statements were in investors’ DDQs. Some of those charges survived the summary judgment order and ill have to be contended. So, Yorkville did not come out of this case completely vindicated.

The Yorkville case  was one of several brought as part of the Commission’s Aberrational Performance Inquiry which was tied to about a half dozen cases.The Inquiry is supposed to use performance metrics to identify outlying performance and use that to suggest suspicious conduct.

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A Focus on Valuation Sources

Private funds are often dealing hard-to-value assets. Real estate funds are overwhelmingly dealing with hard-to-value assets. For purposes of GAAP reporting those will be the Level 2 and Level 3 assets. For these assets, valuations can be manipulated if you have a wiling participant in the process.

For thinly-traded securities, like some bonds, private funds will often rely on quotes from a broker for a potential sale. For the fund manager, the source was usually a broker that was in the circle of those trading for the fund.

A potential conflict exists, with the broker hoping to get more business from the fund and the fund hoping for a higher valuation. There is not much for the broker to lose by quoting a slightly higher sales price for thinly-traded bond in a hypothetical sale. Especially if the broker knows that she or he will not be required to actually trade that bond. In return, the broker may get additional business from the fund.

The Securities and Exchange Commission has been looking at conflicts and potentially illegal practices in this area.

In May, a former broker named Frank DiNucci Jr., said under oath that he provided bogus quotes to a trader at a mortgage bond fund. DiNucci  plead guilty to conspiracy and fraud and has been cooperating with a criminal probe by New York prosecutors. The DOJ has charged at least seven bond traders since 2013 with lying to customers about prices. Now the focus has widened to also include the buy-side of the market and is staring at practices at private funds.

Level 2 and Level 3 assets are by definition hard-to-value. A fund can not prove that the value is accurate. But it can be precise, by being consistent in its valuation procedures and ensuring that the pricing indications it receives are unbiased. Accurate and precise is the best result. But following procedures and being precise is the most important.

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SEC Views on Valuation

The Securities and Exchange Commission regulations for investment advisers does not contain any specific requirements on how valuations should be conducted. That means operating under the general anti-fraud provisions. That is, valuations should not be misleading, deceptive or fraudulent. Although there are no specific regulations, there are enforcement actions from the SEC against advisers that the SEC found to have failed in their valuations. Here are four recent cases.

In the Matter of Pacific Investment Management Company LLC (December 1, 2016)
www.sec.gov/litigation/admin/2016/ia-4577.pdf

PIMCO Total Return-Exchange-Traded Fund (“BOND”) was one of PIMCO’s first actively managed exchange-traded funds. PIMCO employed an “odd lot” strategy
using non-agency mortgage-backed securities. This strategy involved (1) purchasing odd lot positions that traded at a discount to the round lot prices; (2) valuing those positions in BOND at the higher pricing for institutional round lots; and (3) as a result, obtaining immediate positive returns for BOND.

The securities as a pool should all have the same value. But on exit, PIMCO would have to sell at a discount because part of the sale would be odd lots. I find this a tough call. The problem is that the SEC discovered an email that said “[We] can find you several odd lot positions in the coming days that trade well below round lot levels and therefore pricing marks which will help with performance out of the gate.” I assume the SEC found this statement to indicate an intent to be manipulative.

In the Matter of Equinox Fund Management LLC (January 19, 2016)
www.sec.gov/litigation/admin/2016/ia-4315.pdf

An SEC investigation found that Equinox Fund Management LLC calculated management fees contrary to the method described in registration statements for a managed futures fund called The Frontier Fund (TFF), and the firm also deviated from its disclosed valuation methodology for some TFF holdings.

TFF’s registration statements disclosed that Equinox charged management fees based upon the net asset value of each series.  But Equinox actually used the notional trading value of the assets, which is the total amount invested including leverage.  Equinox consequently overcharged the fund $5.4 million in fees from 2004 to 2011.

SEC v. Summit Asset Strategies Investment Management, and LLC Chris Yoo (September 2015)
https://www.sec.gov/litigation/complaints/2015/comp-pr2015-178.pdf

Summit and its owner Yoo were entitled to a share of profits from an investment fund that Summit advised. Yoo falsely claimed that the fund had purchased 500,000 shares of an entity called Prime Pacific Bank in December 2012 when in reality, the fund did not own this security. Because the Prime Pacific Bank security was purportedly illiquid, Yoo developed a financial model to value this asset. This model showed that the fund’s interest in Prime Pacific Bank had more than tripled in value from the shares’ purchase price of $1.00 per share on December 28, 2012, to $3.81 per share on December 31, 2012. Yoo revised the model to reflect that Prime Pacific Bank had slightly decreased, but still generated a gain from its initial purchase price. Yoo relied on these cumulative gains to justify taking over $2.5 million in fees from the fund.

In the Matter of Alpha Bridge Capital Management (July 1, 2015)
https://www.sec.gov/litigation/admin/2015/ia-4135.pdf

When the Alpha Bridge fund was started in 2001, the adviser told the funds’ investors, administrator, and auditor that the adviser obtained independent, market-grounded price quotes for the securities at issue from registered representatives of two reputable broker-dealers. AlphaBridge’s written valuation policy, stated that AlphaBridge obtained monthly price quotes for certain types of less liquid securities from two independent and reputable broker-dealers and used the arithmetic average of these quotes as AlphaBridge’s price for these securities. However, by 2010, AlphaBridge was providing its valuations to those registered
representatives of the broker-dealers who in turn provided those valuation to the fund’s administrator.

SEC Brings a Real Estate Valuation Action

Real estate is the standard for hard to value assets. But there are plenty of models to help reach a reasonable value. The Securities and Exchange Commission has apparently taken the position that it will not challenge absolute valuations, but will challenge flaws in the models that get to the value. A recent SEC case for improper valuation flaws was brought against a real estate company.

field of schemes

The St. Joe Company is Florida’s second largest private landowner, holding over 500,000 acres of land in the state. The developments in question are known as Victoria Park, Southwood, and WaterColor.

The SEC order states that St. Joe deviated from GAAP and had a flaw in its impairment testing for its real estate developments. The model failed to include some necessary non-capitalized cash outflows. If St. Joe had used the correct model, those developments would have seen impairments of $55 million in Q1 2009 and $19 million in Q4 2009. The blame seems to be on the company for using two different models.

St. Joe also failed to take the pending sales price into consideration for one of the developments. The company had a development for sale at $15 million, but it fell through and went to the second place bidder at $11 million. The company failed to reflect that change in the likely realized price as an impairment. The company also told its auditors that the chance of sale was close to nil.

St. Joe’s problems came to light when David Einhorn of Greenlight Capital thought there was a problem with St. Joe’s accounting and began shorting the stock. His take: “Field of Schemes: If you Build It, They Won’t Come.” Mr. Einhorn then began releasing presentations that St. Joe was overvaluing its real estate developments.

Once the company realized there actually was a problem, it changed its models. But, it failed to go back and review prior periods. That would have resulted in a material restatement.

St. Joe also failed to disclose changes in business strategies for its Windmark II and Southwood real estate developments. The company was halting development and planned a future bulk sale of the sites. Unfortunately, St. Joe booked the value in its 2010 10-K as if it were still planning to develop both sites.

These were big issues. When finally recorded in Q4 2011 St. Joe had a 50% reduction in the value of its real estate and reduction of its total assets of more than 35%.

The order has some exact numbers which I assume are taken from St. Joe’s new valuations. The challenge by the SEC was that the company’s procedures were flawed. That lead to the improper valuations.

St. Joe is a public company so there are some differences with the private real estate fund model. However, it seems consistent with what the SEC is saying about private fund valuations.

The SEC was not fighting over small differences in valuations with St. Joe. There were big discrepancies in values. The SEC was not charging that the values were wrong, but that the way the company got to the values was wrong.

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Private Fund Is Sanctioned for Valuation Issues

SEC Enforcement Logo

The Securities and Exchange Commission brought another case out of its Aberrational Performance Inquiry initiative in the Enforcement Division’s Asset Management Unit. That initiative identifies funds with suspicious returns and flags performance that is inconsistent with a fund’s investment strategy or other benchmarks forms a basis for further investigation and scrutiny. The initiative nabbed GLG Partners for overstating its stake in an emerging market coal mining company.

This case’s headline caught my attention because it’s a challenge of a hard-to-value asset.  A private equity stake in a company is a Level 3 asset that can’t be determined by outside data sources. I would expect that a fund that used a thoughtful process and could justify its assumptions in a valuation should not have the value challenged by the SEC.

For private funds, valuation is a key area of focus for the SEC. I’ve heard from examiners that they are looking for consistent valuation process with justified assumptions for hard to value asset.

GLG appears to have a few red flags on its valuation that would raise questions. GLG bought the 25% stake in Sibanthracite for $210 million March 20, 2008. Just 11 days later, GLG wrote up the value to $425 million on March 31. That’s a big jump in value.

The asset stayed at the $425 million valuation until December 2010. That’s a long time for an asset to stay at the same value. According to the SEC order, there was a failure in GLG’s process to determine the fair value of the investment.

I hope one of the reasons that the action was taken was because of the resulting impact the valuation failure had on the management fees earned by GLG. The inflated valuation resulted in GLG earning extra management and administration fees of about $7.8 million.

GLG was a hedge fund and earned its management based on valuation. That is unlike the private equity fund model where the fund does not typically earn a management on an increased valuation, but instead earns a promote on a realized value.

The investment happened just before the financial crisis in the fall of 2008 and the improper valuation occurred during the turmoil of 2009 and 2010. According to news reports, GLG created a side pocket for the Sibanthracite holding, limiting investors’ ability to redeem from the fund.

The SEC also piled on and faulted GLG for improper statements of AUM on its Form ADV filings.

The reports are not clear on how GLG came to the attention of the SEC. The press release credits the Aberrational Performance Inquiry initiative. I’m skeptical that GLG was flagged for over-performance when the investment was not subject to market pricing. Perhaps the Aberrational Performance Inquiry initiative it just running all of the cases where there are valuation issues.

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