Valuation compliance is not simply a regulatory requirement; it can be a critical component of an investment manager’s operations and also a reflection of the firm’s efficiency and organization. Having a strong valuation process that works well and addresses SEC concerns and requirements is appealing to potential investors, and the lack of a good system could give both new and current limited partners (LPs) reasons for concern. It should also be consistent with the investment underwriting process, and can sometimes even provide support and feedback to that process. Below are five key elements an organization should consider when conducting a valuation.

#1: Vigilance Against Fraud

While often seen as a problem at the highest levels, fraud is a threat that can appear across all sectors and levels of an organization. When caught, fraud can result in a level of damage to a company’s reputation and value, but even without reputational damage, fraud can cause damage to a company’s profitability.

Valuations can require both subjectivity and detailed financial models, and the technical skillset required to “unpack” an analysis means that manipulation can be obscured. Inaccurate or unreliable information, including portfolio company forecasts, add to the opportunities to influence valuation outcomes. Firms should implement rigorous procedures for testing and verifying, as well as documenting, the data that goes into a valuation.

The textbook example of this is the 2015 case in one of the world’s leading VC investment managers, where a general partner intentionally added a zero to a valuation, to turn a $2 million investment into a $20 million investment, and misappropriated the difference. Regulatory authorities do not tolerate this type of behavior, and have consistently penalized the manager for lack of oversight in similar cases.

#2: Eliminating Operational Sloppiness

Errors and mistakes are not always the result of deliberate misconduct. Mistakes that arise from carelessness and inadequate oversight can result in the same reputational damage, and similar punishment from regulatory bodies. Examples of such unintentional errors include neglecting to update capital market data, relying on figures from outdated reports, or the proverbial “fat-finger”. Such lapses in a valuation can erode confidence among regulators, resulting in heavier scrutiny, fines, and other penalties.

By establishing clear review protocols, fostering a culture of accountability, and prioritizing detailed verification through the valuation process, managers can easily ensure that these unintentional errors are caught prior to any final valuation being reported to investors or regulators.

#3: Ensuring Policy & Practice Alignment

While robust written policies are a fundamental component of any compliance program, regulatory bodies like the SEC are quick to scrutinize dissonance between officially documented procedures and actual practices. Organizations must ensure that policies are not only well-crafted but feasibly operationalized and embedded in day-to-day operations.

Management must actively monitor operations, providing training to new and current employees, and address any departure between “aspirational” policies and practical execution. When policies become too difficult to implement at a practical level, organizations should err towards alignment in policy and practice, rather than risk maintaining official policies that are disregarded in practice. This is an easy target for the SEC, as both the policy documents and the valuation documentation are easy to compare and highlight contradictions, and there are many examples in exam findings of exactly this type of discrepancy.

#4: Instituting Robust Review & Oversight

A thorough review process is crucial for detecting errors, preventing fraud, and maintaining valuation accuracy. At least some of the individuals involved in the review process should have a similar skill set to those performing the analysis, as without knowledgeable peer review, misstatements or manipulations can go unnoticed.

While valuation committees should be composed of members with diverse skill sets, and in practice often include legal and compliance specialists to ensure all regulations are accounted for, it is essential that those committees also include sufficiently senior financial and investment professionals, who can challenge valuation assumptions and conclusions.

#5: Timely Market Evaluations

Market conditions can shift rapidly, especially during periods of instability – as we have been seeing in recent months. Valuations based on outdated market data risk misrepresenting asset values. For instance, during the initial onset of the COVID-19 pandemic, some private equity firms delayed adjusting valuations in hopes that market conditions would stabilize. This delay resulted in a mismatch between private and public market valuations at critical reporting dates.

A company should establish protocols for prompt market assessments and avoid valuation lag, particularly when market volatility threatens the relevance and accuracy of existing estimates. Fair value is an exit price – that is, what it could be sold for – as of the valuation date. It doesn’t mean it must be sold at this valuation, but it is helpful for investors to understand where their investment portfolio is at a given point in time.

In today’s complex regulatory and investment environment, valuation compliance cannot be treated as a formality. It demands vigilance, rigorous oversight, and proactive market engagement. By addressing the risks of fraud, operational errors, policy misalignment, inadequate review, and market lag, firms can strengthen their valuation practices, further build stakeholder trust, and enhance their position as industry leaders.