The capital market regulator is taking a close look at how private equity houses (PE) and venture capital funds (VCF) value the startups and unicorns they bankroll.
A propped-up valuation gives a rosy picture of the portfolio to a fund’s investors and paves the way for the fund manager to attract more money from new as well as old investors when it goes for the next round of fund-raising.
Probably driven by complaints from investors and recent reports of opaque accounting of a few unicorns, the Securities & Exchange Board of India (Sebi), in a communication on September 6, asked a large number of funds to disclose their valuation practices and share details like the qualification of the valuer, whether the valuer hired is an associate of the fund or its manager or sponsor, and if there was a significant change in the valuation methodology in the past three years among other things, two persons aware of the matter said.
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“Sebi clearly wants to understand the credibility of the valuation exercise undertaken by funds,” said Richie Sancheti, founder of the law firm Richie Sancheti Associates. According to Tejesh Chitlangi, senior partner, IC Universal Legal, “While the regulator is trying to get a sense on the performance of the AIFs (alternative investment funds), it may also wish to understand the valuation practices prevalent in the industry as the same may vary across funds in absence of any regulatory prescription.
This may be a precursor to forthcoming valuation policies, enhanced disclosures norms etc. which Sebi may prescribe for the AIF Industry to achieve consistency in the way valuations are carried out and increase transparency in the investor interest.”
Most AIFs-the regulatory parlance for PE and VCFs-are close-ended funds having large exposure to unlisted stocks. While open ended funds have to publish every month the net asset value (NAV), which is the market value of the securities held by the fund or the scheme, close-ended funds may announce the NAV twice a year, or even annually if investors agree.
Though closely-held companies and unlisted securities are outside its purview, Sebi regulates pooled vehicles like PE, VCF, mutual funds and portfolio management schemes.
According to the Sebi directive, the funds have to also share the following information-the date of latest valuation, cost of cumulative investments made, latest valuation of investment portfolio, whether the valuation exercise is based on audited or unaudited data of the investee companies, whether the valuation is done by an independent or internal valuer, if additional valuation exercise was carried out during a financial year, details of valuation methodology and if there were any deviations from the said methodology, and whether the scheme has a valuation committee.
“The actual economics for the manager only comes at the basis of cash distributions under a structured waterfall construct. The current exercise seems to be to ensure that a fund projects an accurate state of health to investors on an on-going basis,” said Sancheti.
Under the waterfall mechanism, cash generated from sale of stocks and dividend paid out by investee companies first goes to investors in the fund with fund managers receiving their `carry’ only if the fund performance crosses the hurdle or the preferred rate of return. For instance, if the hurdle rate is 14% and a fund records a return of 18%, then the extra 4% (above the hurdle) is shared between fund investors and the fund manager in the ratio of 80:20.
With AIFs having emerged in recent years as a preferred investment vehicle for many wealthy Indian investors, Sebi has been tightening the rules for the funds. A year ago, the Sebi had said that AIFs must have independent trustees having no connection with the sponsor and managers of the funds. A few months ago, at a meeting of the Alternative Investment Policy Advisory Committee, Sebi officials had proposed that the schemes of PE and VC funds should be ring-fenced from each other so that any stress and liabilities in one pool of money do not spill over into another.