On January 31, it emerged that Deer Park Road Management Company (“Deer Park”) – “a multi-fund investment manager primarily focused on investing in distressed real estate and asset-backed fixed-income securities for both high-net-worth individuals and institutional investors”^[1] – is currently under investigation by the Securities and Exchange Commission (SEC) for the firm’s alleged practice of valuing infrequently traded bonds “below market norms.”^[2] While SEC scrutiny over the valuation of assets held by investment funds is certainly nothing new, many in the investment community are wondering “Why on Earth would Deer Park want to undervalue its assets?”^[3]

It is true that for years the SEC has been hunting down firms that do not follow their own documented valuation-related policies and procedures, or improperly value their assets.^[4] Furthermore, over the last several years, the SEC has publicly stated that valuation will be an area of focus.^[5] Traditionally, however, and also somewhat logically, the SEC has been critical of practices that ultimately result in the overvaluation of assets. Undeniably, there are several incentives for a fund to “aggressively” (i.e., over-) value assets including, but not limited to, a higher reported fund net asset value (NAV), ^[6] elevated rates of return,^[7] and increased management fees.^[8] Accordingly, when it comes to Deer Park, the SEC is clearly bucking the trend with allegations of undervaluing assets. But while intentionally undervaluing assets may appear counterintuitive, there are several incentives for a fund manager to do so.^[9]

How and Why Do Investment Funds Value Assets?

Funds can follow a variety of investment strategies, which determines not only what types of assets the fund invests in, but also how the fund trades – i.e., risk and diversification, and the buy, sell, and hold strategy. Regardless, the strategy a fund implements should be found in the fund’s offering materials and periodic disclosures to investors. 

Many strategies focus on investing in highly liquid securities, such as stocks listed on major exchanges. Because these types of strategies involve investing in widely traded and liquid securities, the fair values are readily determinable. Other strategies, however, may involve more complex or illiquid investments such as distressed debt and private equity. Additionally, further strategies encompass investing in ventures such as start-up companies or real estate. For funds that invest in these more complex and illiquid securities, it may be more complicated to accurately measure the fair value of the underlying assets because the fund has to implement a valuation process to estimate the fair value, which in turn is used to calculate the fund’s NAV.

As background, all investment companies must follow the same financial reporting standards in determining their NAV. Those standards generally require that a fund’s investment assets be measured at “fair value.”^[10] The standards also establish a framework that financial statement preparers are required to follow to determine the fair value of each security held by a fund. Nevertheless, for an unscrupulous fund manager, there is always an opportunity to bend the rules or even to break them if there is sufficient incentive coupled with the belief that they will not be caught.

For financial reporting, fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” ^[11] In an effort to increase consistency and comparability among reporting entities, a fair value “hierarchy” was established that categorized the inputs used to value assets into three levels. ^[12] The three levels are prioritized based on how readily available market prices are for the same or comparable assets – i.e., observable inputs used in the valuation process to place value on a fund’s own assets. ^[13] Regardless of whether a fund invests in Apple Computer or a small closely-held business, investment companies must adhere to the fair value hierarchy, which gives the highest priority to quoted prices (unadjusted) in active markets for identical assets (Level 1) and the lowest priority to unobservable inputs (Level 3). Assets are also categorized for disclosure purposes based on the fair value inputs used to measure them (e.g., Level 1, 2, or 3 assets). More details on the three levels are as follows: 

• Level 1 inputs (the highest priority) are quoted prices (unadjusted) in active markets for identical assets.^[14] According to accounting standards, a quoted price in an active market provides the most reliable evidence of fair value and shall be used without adjustment to measure fair value.^[15] Examples of Level 1 assets include U.S. government bonds and listed equities. 
• Level 2 inputs are other significant observable inputs, such as quoted prices for similar securities, interest rates, prepayment speeds, credit risk, etc.^[16] Examples of Level 2 assets include corporate bonds (investment grade, high yield), mortgage-backed securities, bank loans, less-liquid listed equities, and municipal bonds.
• Level 3 inputs are unobservable inputs for the asset or liability.^[17] Examples of Level 3 assets include distressed debt, private equity, and certain derivatives. 

Accordingly, both the classification and the valuation of assets is a critical topic, especially for those investment funds that invest in assets that rely on Level 2 or Level 3 inputs. That is because the aggregation of the fair values of each of a fund’s securities is a key factor in the computation of a fund’s NAV. The NAV is then used by the investment manager for a variety of reasons, including:

• Periodic reporting to investors, creditors, and the SEC.
• To calculate the fund manager’s fixed management fee, which is calculated as a percentage of the fund’s NAV. For example, a “typical” hedge fund charges a fixed management fee of 2% of the average NAV for the period.
• To calculate the fund manager’s performance-based fee, which is usually calculated as a fixed percentage of the fund’s annual return over a particular “hurdle” rate. For example, a “typical” hedge fund charges 20% of all annual returns over a rate of 5%.
• To calculate the purchase price for investors who are investing in the fund, which is calculated as the total net assets in the fund divided by the number of “shares” in the fund.^[18]
• To calculate the redemption price for investors who are exiting the fund, which is also calculated as the total net assets in the fund divided by the number of “shares” in the fund.^[19]

All of the valuation techniques and methods used for these harder-to-value assets require the application of judgement and use of estimates. Even though they are based on some observable inputs, these estimates remain subjective. Additionally, the calculations involved are often complex, and there are a variety of methods a fund can select to determine value. These factors result in an increased chance for error in calculating the fund’s NAV, or even the opportunity for intentional manipulation.

Why Might an Investment Manager Intentionally Understate the Value of Fund Assets?

While the specific facts and circumstances surrounding the allegations in Deer Park are yet to be known, there are several reasons why an investment manager may be incentivized to intentionally understate the value of assets held in its fund(s). These reasons may include:

• Creating “cookie jar” reserves 
• Luring investors into a fund
• Manipulating management fees
• Reducing risk of regulatory scrutiny

The undervaluing of fund assets in effect creates a type of “cookie jar” reserve that could be used in later periods to help protect the security and the overall fund from loss, in the case that unforeseen events occur and market conditions change in a way that negatively impacts the value of the security. These reserves can also be used to smooth out earnings; after all, if a fund’s return exceeds expectations during the year, saving some of these returns aside to ensure that expectations are again surpassed in the next year will help keep investors in the fund happy.

Those same undervaluing measures, however, could be an incentive to lure additional investors into the fund, thereby increasing the pool of investors and resulting, eventually, in additional management fees for the fund manager. In addition, fund managers are typically among the largest investors in a given fund, so these measures allow them to buy shares in the fund at an artificially low price. These same fund managers are typically also those investors who stay in the fund longest, while those who exit early may be harmed by artificially deflated exit prices.

Fund managers may also have personal incentives to defer their fees to future periods, such as tax avoidance or other personal circumstances (e.g., divorce). Although the saying is “what goes up, must come down,” in this case what goes down, must go up – at a later time, when the benefits are ultimately reaped, and fewer questions are likely to be asked.

As stated above, the SEC has brought numerous enforcement actions against funds that either do not have or do not follow their documented policies and procedures, and/or funds where the valuation is fraudulently overstated.^[20] Because the SEC has, in the past, been primarily focused on the potential overvaluation of assets, it is reasonable to believe that a fund manager may want to take a conservative approach to valuing Level 3 assets, simply because of the perception that a conservative valuation will receive less scrutiny by SEC examiners. That belief would be perfectly reasonable and rational – and such conservatism is indeed the practice of many fund managers. In practice, there is nothing inherently inappropriate with being conservative.

For an unscrupulous manager, however, the perception that the SEC is only concerned with overvaluation may result in the belief that an opportunity exists to intentionally and drastically understate asset values with little or no scrutiny by the SEC. Accordingly, they may feel that they have a better chance of “getting away” with their nefarious conduct. Their incentive for doing so would likely be one of the reasons discussed above.

A One-Off Sighting or the Sign of Things to Come?

It is incontrovertible that the SEC will continue to hunt down funds that fail to follow documented valuation-related policies and procedures or that are overly aggressive with their underlying asset valuations. What remains to be seen, however, is whether the investigation into Deer Park for undervaluing assets is simply a one-off sighting or the beginning of a herd of similar cases. What seems clear at present is that the SEC will continue to track down funds where the valuation of assets indicates either an intentional over- or undervaluation and there are additional facts and circumstances that are spotted that indicate intentional, nefarious behavior.

1. Deer Park Road Management Company
2. Simone Foxman and Matt Robinson, “Deer Park Road Draws SEC Probe Over Bond Valuations,” Bloomberg News, January 31, 2018 (emphasis added)
3. While the issue of valuation is applicable to both investment funds and public companies, the focus of this article relates to investment funds. Accordingly, from this point on the article will only refer to funds or investment managers.
4. See, e.g., In the Matter of KPMG LLP and John Riordan, CPA; In the Matter of Enviso Capital, LLC, Ryan Bowers, and Jeffrey LaBerge, CPA; In the Matter of Covenant Financial Services, LLC and Stephen Shafer; In the Matter of Pacific Investment Management Company LLC; In the Matter of Calvert Investment Management, Inc.; In the Matter of RD Legal Capital, LLC and Roni Dersovitz.
5. See, e.g., Simpson Thacher, Registered Funds Alert, February 2017, stating that the “asset management priorities [the SEC’s OCIE and Division of Enforcement] cited included valuation.”; Joe Eisenberg, “SEC Actions Against Investment Advisors in 2016: Part 2,” Law360, Dec. 19, 2016, stating that “[t]he [SEC] will carefully scrutinize the methodology firms use to value difficult-to-value securities.”; Charlie Marlow, “Former Senior SEC Attorneys Offer Insight on Chair Clayton’s Priorities and the Current Enforcement Climate (Part One of Two),” The Hedge Fund Law Report, December 7, 2017, stating that “enforcement priorities will remain largely unchanged . . . [and] examiners continue to look for traditional hot-button issues such as . . . questionable valuation practices.”
6. The net asset value is the value of a fund’s assets less the fund’s liabilities.
7. The reported rate of return for a fund, disregarding purchases and redemptions, is calculated as a fund’s net assets at the current period measurement date less the fund’s net assets at the prior period measurement date, divided by the fund’s net assets at the prior period measurement date.
8. See infra.
9. Foxman and Robinson, “Deer Park Road SEC Probe”: “Marking down bonds could lower the value of an entire hedge fund, which would mean less money for fund clients who redeem their investments. The practice could also allow a manager to inappropriately smooth returns or realize a bigger year-end payout. A trader might cause a bond’s valuation to be low-balled at the beginning of the year, and then increased later to offset losses on other holdings in his or her portfolio. By year-end, the proper price would be used to calculate fees and bonuses.” While these are certainly possibilities that are recognized and discussed in this article, we believe there are also other incentives as detailed in the article.
10. Financial Accounting Standards Board (FASB), “946: Financial Services—Investment Companies,” in FASB Accounting Standards Codification. While generally accepted accounting principles require the initial measurement of the purchase of securities at their transaction price, the subsequent measurement is generally at fair value, which is the focus of this paper. The source cited here is the source of authoritative generally accepted accounting principles recognized by the FASB to be applied to nongovernmental entities. See FASB, “About the Codification” in Accounting Standards Codification (v 4.10) at 4.
11. FASB, FASB Accounting Standards Codification 820-10-20, Glossary.
12. FASB, FASB Accounting Standards Codification 820-10-35-37.
13. Id.
14. FASB, FASB Accounting Standards Codification: 820-10-35-40.
15. FASB, FASB Accounting Standards Codification: 820-10-35-41. There are limited exceptions to this principle.
16. FASB, FASB Accounting Standards Codification: 820-10-35-47.
17. FASB, FASB Accounting Standards Codification: 820-10-35-52.
18. The actual calculation is more complicated since funds typically do not have a set number of “shares” available for purchase, but instead calculate the amount pro rata based on the amounts invested by other investors, taking into consideration the gains or losses of the fund less all management fees and other expenses. Again, this example has been simplified for illustrative purposes and simplicity.
19. Id.
20. See cases notes in supra fn 4.