Data & Intelligence
EMPEA’s Submission on the Treatment Mandate Process for 3rd Party Price Providers
Posted On: 09 Mar 2015
EMPEA respects the SFC’s mission to gather input on the key issues that will determine the orientation of the SFC’s opinion on the question of whether the requirement for fund managers to hire third party price providers for portfolio company valuations is consistent with international practice or whether it deviates from the standards and best practices in operations in both mature and emerging markets.
EMPEA has been asked to participate in the advisory process related to the subject SFC regulations. EMPEA member firms have noted that the regulations require Colombian private equity and venture capital funds to hire third party price providers to approve the methodology for valuation of the fund’s investments in portfolio companies and to value those portfolio companies.
This letter is to confirm that standard practice in emerging markets private equity is to leave it to the parties to enter into an agreement setting the terms of the relationship including overseeing valuation and resolving valuation disputes. This is also true in mature markets. Consistent with LAVCA’s submission (and the exception LAVCA noted), EMPEA is not aware of any supervisory authority in an emerging market or mature market that mandates the engagement of third party price providers to either perform independent valuations of portfolio companies or to approve the methodology a fund manager employs.
We are aware that LAVCA and ColCapital have provided extensive discussion and deep analysis of both international standards and practices in Latin America for the valuations of private equity and venture capital portfolio assets and reporting. We are aware that both ColCapital and LAVCA recommend against implementation of regulations that would force fund managers to hire third party price providers to value a private equity fund’s portfolio companies. EMPEA endorses their recommendation for reasons set forth below.
Emerging Markets and Supervisory Authorities
We note that the supervisory authorities in emerging markets, like those in developed markets, are interested in regulation that provides a framework for a resilient and dynamic financial system while fostering growth in their real economies. They see the participation of private equity in their markets as having a positive effect on sustainable economic and social development. (See Appendix I, Southern African Case Study Compendium 2015 attached.) We note that supervisory authorities also recognize the need to maintain an even playing field for participants in their markets with those in neighboring markets (See quotes in ‘Agreement Between the Parties.’) They recognize the efficiency of having the private equity parties address issues and valuation-driven terms in the agreement governing their relationship.
Valuation Background and Cost Imbalances
It is almost universal in private equity that when valuation of assets has an actual economic impact on the LP investors/GPFMs, as opposed to affecting only the valuations shown in interim reports, independent valuations are already required. For example, it is standard practice for the agreement governing the relationship between the parties to require independent valuations where:
- An investment is to be written down below cost/written off and this will result in a reduction in the GPFM’s management fee;
- A GPFM has been dismissed and is to be paid its carried interest based on the value of the fund’s assets at the time of its dismissal;
- Assets are distributed in specie/cash to LPs and this has some impact on the carried interest calculation.
It is also increasingly common for LP advisory committees to be able to query a GPFM’s valuation at any time and demand an independent comparison, at the cost of the fund or often at the cost of the GPFM if the initial valuation is found wanting by the expert. It should be noted that, because of the additional costs and impacts on returns for a mandatory price provider in Colombia, the playing field is not even. It is economically detrimental to LP investors and competitively detrimental to Colombian GPFMs trying to raise new funds in a market where the LPs are not required to bear these costs. The LPs can simply choose to invest in a fund domiciled elsewhere and the LP will have a higher return in non-Colombian funds which do not have the mandated valuation cost.
Agreement between the Parties
An agreement between the parties to provide when and how valuations will occur is the best practice for several reasons including the following:
1) Nature of the Parties. The nature of the private equity investor base is highly sophisticated, pre-qualified, subject to intermittent re-certification and uniquely positioned to determine what is in its interest. Qualified investors typically include financial institutions, pension funds, foundations and endowments, funds of funds or very high net worth individuals. Investors generally have substantial in-house expertise and/or are well advised. The parties understand that the process of valuation is critical to private equity and venture capital, and contractually stipulate for advisory committees to oversee, among other things, the valuations of assets. (See Valuation Background above.)
2) Nature of the Agreement. The agreement governing the private equity and venture capital relationship (most commonly a partnership) recognizes that the parties are able to negotiate, extensively and at arms’ length to enter into contractual relationships reflecting and balancing their respective interests over the long-term (commonly 10-year) life of an investment. Actual exit values drive the distributions to investors in a contractual “waterfall”. Agreements not only provide for the duties of the partners and advisory committees, but also, for conflict and dispute resolution, including those that may arise surrounding asset valuation described above.
3) Presence of Auditors. Private equity and venture fund auditors have the primary responsibility for overseeing the maintenance of a private equity fund’s books and records and preparation of a fund’s audited financial statement. This means that an independent, external auditor reviews and certifies the accuracy of the financial statement of the fund not less than annually. Advisory committees can request more frequent reviews. In addition, the investors themselves are required to report to their own stakeholders and are frequently subject to audit, e.g. pension funds, endowments, etc. It is unclear what the contribution of a third party price provider, whose own methodology and practice would require auditing, would contribute to the accuracy of the financial statements and reports.
4) Nature of the Private Equity Asset Class. Because of the long-term nature of the partnership relationship between sophisticated investors and the expert fund managers they select, the illiquidity of the fund’s portfolio companies and the shared understanding that fund assets will respond to known and unknown variables many times over the life of the fund, the parties are all interested in accurate portfolio company performance and value. The investors seek clarity, consistency and conservatism to ensure they are allocating their assets correctly. Fund managers are expert in the value of their portfolio companies. Their reputations for fair and accurate valuations will impact their ability to raise future funds or renew investor commitments.
For the reasons above, SFC’s peers and colleague supervisory authorities in the International Organization of Securities Commissions (IOSCO) recognize these factors and they are equally concerned about a level playing field. For example, the Financial Services Board of South Africa, specifically notes that “the portfolio valuation remains the responsibility and function of the [fund] manager, as part of its administration functions.” The Polish Financial Supervision Authority, consistent with its peers and with the developed markets does not mandate that funds hire third party price providers for valuations. Related to assuring a level playing field, the Financial Supervisory Authority of Norway states that it operates on the premise that, “Norwegian enterprises must be afforded competitive conditions which are…in line with those enjoyed by institutions in other …states.” For another voluntary approach through the bylaw structure, we also note that the Brazil, Instruction CVM No. 391, issued by Comissao de Valores Mobiliarios to regulate private equity funds, provides that the by-laws of private equity funds must state the “methodology for the determination of the accounting value of the assets of the fund, including criteria for the provisioning and writing-off of investments.”
Summary and Recommendation
EMPEA thanks the SFC for this opportunity to participate in the advisory process and respects the SFC’s accomplishments in creating an enabling environment that is efficient, transparent, fair and inviting to the private equity asset class which, in turn contributes to sustainable economic growth and development in Colombia.
EMPEA endorses and supports the recommendation of our industry partners, ColCapital and LAVCA, that the SFC consider reversing the mandatory requirement for third party valuations of private equity portfolio companies.
Additionally, the EMPEA Guidelines produced by EMPEA’s Legal & Regulatory Committee (please see Appendix II) identify the key elements of legal and tax regimes optimal for the development of private equity and EMPEA believes the Guidelines include a framework that provides for investor protection. EMPEA stands ready to provide whatever further contribution to this work the SFC might find helpful, including attending meetings and contributing further materials in writing.
Rashad Kaldany | Executive Vice-President and Growth Markets, CDPQ
David Rubenstein | Co-Founder and Managing Director, The Carlyle Group