Acting on a Dodd-Frank mandate, the SEC adopted regulations requiring that hedge fund and private fund advisers with $150 million assets under management register with the Commission. Given the $150 million asserts under management trigger for registration, the fair valuation of a fund's assets is a critical element of the new regime. The SEC said in Adopting Release No. IA-3222 that hedge fund and private fund advisers must determine the amount of their assets under management based on the market value of those assets, or the fair value of those assets where market value is unavailable. They must calculate the assets on a gross basis, that is, without deducting liabilities, such as accrued fees and expenses or the amount of any borrowing. If a fund does not have an internal capability for valuing illiquid assets, the SEC expects it to obtain pricing or valuation services from an outside administrator or other service provider. The SEC noted that many private funds already value assets in accordance with U.S. GAAP or other international accounting standards that require the use of fair value. While sensitive to the costs of the new requirement, the SEC believes that this approach is warranted in light of the unique regulatory purposes of the calculation under the Investment Advisers Act. The SEC declined to mandate a fair value standard for advisers to use in order to provide advisers with greater flexibility in calculating the value of their private fund assets. But the Commission conceded that not mandating a fair value standard will result in valuations that are not as comparable as they could be if the SEC had specified a fair value standard While many advisers will calculate fair value in accordance with GAAP or another international accounting standard, other advisers acting consistently and in good faith may use another fair valuation standard. Consistent with this good faith requirement, the SEC expects that an adviser that calculates fair value in accordance with GAAP or another basis of accounting for financial reporting purposes will also use that same basis for purposes of determining the fair value of its regulatory assets under management. While these other standards may not provide the quality of information in financial reporting, the SEC expects that these calculations will provide sufficient consistency for the purposes that regulatory assets under management serve in the new rules, including Rule 203(m)-1. In addition, the fair valuation process need not be the result of a particular mandated procedure and the procedure need not involve the use of a third-party pricing service, appraiser or similar outside expert. An adviser could rely on the procedure for calculating fair value that is specified in a private fund's governing documents. The fund's governing documents may provide, for example, that the fund's general partner determines the fair value of the fund's assets. Advisers are not, however, required to fair value real estate assets only in those limited circumstances where real estate assets are not required to be fair valued for financial reporting purposes under accounting principles that otherwise require fair value for assets of private funds. For example, in those cases, an adviser may instead value the real estate assets as the private fund does for financial reporting purposes. The SEC noted that FASB has a current project related to investment property entities that may require real estate assets subject to that accounting standard to be measured by the adviser at fair value. See FASB Project on Investment Properties. In addition, international accounting standards currently permit, but do not require, fair valuation of certain real estate assets. See International Accounting Standard 40, Investment Property. To the extent that an adviser follows GAAP or another accounting standard that requires real estate assets to be fair valued, this limited exception to the use of fair value measurement for real estate assets would not be available. The SEC has noted that many, but not all, advisers to private funds value assets based on their fair value in accordance with GAAP or other international accounting standards that require the use of fair value. Some advisers to private funds may not use fair value methodologies, which may be more difficult to apply when the fund holds illiquid or other types of assets that are not traded on organized markets. Nevertheless, the SEC believes that the requirement to use fair value would not result in significant costs for these advisers, particularly in light of the decision to require annual, rather than quarterly, valuations. Also, private fund advisers, including those that may not use fair value methodologies for reporting purposes, perform administrative services, including valuing assets, internally as a matter of business practice For example, a hedge fund adviser may value fund assets for purposes of allowing new investments in the fund or redemptions by existing investors, which may be permitted on a regular basis after an initial lock-up period. An adviser to private equity funds may obtain valuations of portfolio companies in which the fund invests in connection with financing obtained by those companies. Advisers to private funds also may value portfolio companies each time the fund makes or considers making a follow-on investment in the company. Private fund advisers could use these valuations as a basis for complying with the fair valuation requirement applicable to private fund assets.
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