SEC’s New Rules on Valuation and Fairness Opinions: Ensuring Transparency in Private Equity Continuation Funds

The financial world is constantly evolving, and so too are the regulations that govern it. The Securities and Exchange Commission (SEC) has recently introduced new rules under the Investment Advisers Act of 1940, which have gone into effect, as of November of 2023. These rules are poised to redefine industry standards and require things that were, until now, more considered to be best practices in the realm of private equity continuation funds.

Continuation Funds

Private equity funds have finite investment horizons, typically 10 to 15 years based on fund strategy and limited partner (LP) agreements. Unlike public investments, private equity involves a lengthy process for acquiring portfolio companies, resulting in a typical holding period of around five years. However, as funds mature, extensions may be needed to tap into unrealized value. Some extensions are expected and allowed in contracts, but to go beyond the “normal” extensions usually requires unanimous LP approval, and this can be challenging, forcing general partners (GP) to balance contractual obligations while still optimizing returns.

One strategy is selling investment holdings into a new fund, giving LPs the choice to cash out or roll over their investments for a longer horizon. This is most often legitimate but poses manipulation risks, as GPs initiate and handle transfers between their managed funds. Undervalued sales harm selling investors while inflating carried interest in the new fund, while overpricing can artificially inflate carried interest in the existing one. The performance of the existing fund and management fees further complicate matters. Oversight of transaction pricing is essential, providing LPs a safeguard against potential GP abuses, as existing LPs may cash out or roll over their investments in this process.

New SEC Rules

In this landscape, the SEC’s new rules take center stage, aiming to enhance transparency and investor protection in private equity continuation funds. The regulations mandate that advisors must obtain a third-party valuation or fairness opinion for transactions where an investor is given the option to either receive cash proceeds or roll over its investment, these rules coming into effect as of November of 2023.

Valuation and fairness opinions are at the heart of these rules. Advisors must obtain this independent opinion to ensure that these transactions, which are amongst and between related parties, are conducted fairly and transparently. The regulations underscore the importance of these opinions in instances where conflicts of interest may appear to compromise the integrity of investment decisions.

Fairness opinions, which assert that transaction prices are fair and reasonable from a financial standpoint, tend to be relatively expensive due to the associated liability. Valuation opinions, offering a range of values, are a less expensive alternative. The SEC’s rules require opinion providers to disclose their relationships with the fund advisor, empowering investors to scrutinize potential conflicts of interest.

Impact of the SEC Rules

These rules make obtaining third party opinions part of the regular course of business and require that the opinions be obtained well in advance of a transaction date, giving investors adequate time to evaluate the facts as they consider the two alternatives.  This should add consistency and credibility to the process of establishing a continuation fund.

The SEC’s new rules align with good fiduciary practices and are indicative of improvements in transparency and investor protection. By standardizing the use of valuation and fairness opinions, these regulations not only bolster investor confidence but also promote ethical conduct within the industry.

The private equity landscape is inherently complex, with interests and objectives evolving over the course of a fund’s lifespan. As the SEC’s rules come into effect, they provide a regulatory framework that bolsters the ability of LPs to make informed decisions. Embracing these practices should not merely be a regulatory requirement; when done, it stands as a testament to the industry’s commitment to responsible and informed financial decision-making.

In this ever-evolving financial world, the SEC’s emphasis on transparency and investor protection ensures that private equity continues to thrive as an investment strategy and balances the needs of limited partners as they make major financial decisions.