Private Equity Valuation: A Significant Decision

Insiders (and others) in the private equity business are accustomed to seeing a good deal of discussion ' academic and trade ' on the question of the appropriate methods of valuing private equity positions and securities which are otherwise illiquid. An interesting recent decision in the Southern District has been brought to our attention by Carl Kaplan, who (while confessing he is a cynic, claims he is not the ultimate cynic). The case is In Re Allied Capital Corp., CCH Fed. SEC L. Rep. 92411 (US DC, S.D.N.Y., Apr. 25, 2003). Judge Lynch's decision is well written, the Judge reviewing a motion to dismiss by a business development company, Allied Capital, against a strike suit claiming that Allied's method of valuing its portfolio failed adequately to account for i) conditions at the companies themselves and ii) market conditions. The complaint appears to be, as is often the case, slap dash, content to point out that Allied revalued some of its positions, marking them down for a variety of reasons, and the stock price went down – all this, in the view of plaintiff's counsel, amounting to violations of Rule 10b-5.

The Court first noted that the SEC has provided “some guidance” to business development companies, which are closed end mutual funds organized under special provisions of the Investment Company Act of 1940 and operating as if they were private equity funds. Presumably Judge Lynch was applying a bit of irony when he mentioned “some guidance” since he quoted the SEC's interpretation in Accounting Series Release 118 as follows:

“No single standard for determining 'fair value' … can be laid down, since fair value depends upon the circumstances of each individual case. As a general principle, the fair value of restricted securities [is] the amount which the owner might reasonably expect to receive for them upon their current sale.”

If Release 118 provides “some” guidance, I would be interested in seeing what “no” guidance would consist of. Allied in turn elected to state its valuation policy from which the Judge excerpted as follows:

“[e]quity interests in portfolio companies for which there is no liquid public market are valued based on various factors, including cash flow from operations and other pertinent factors such as recent offers to purchase a portfolio company's securities or other liquidation events. The determined values are generally discounted to account for liquidity issues and minority control positions.”

Throwing cold water on the conclusory nature of the complaint, the Judge went on to make some interesting statements reflecting his reasoning. Thus, one of the items pointed out by the plaintiff's lawyers was that Allied maintained a particular investment at a higher value than Cisco Systems did, which (to the plaintiff) proved that Allied's valuation was deficient. This is a big deal these days, as critics compare differing valuations of the same security in the portfolios of two or more private equity funds – one fund holding the position at, say, cost while another has written it down materially. In rebuilding the plaintiff's argument in this instance, however, Judge Lynch pointed out the obvious, that plaintiff had failed to allege the facts that “would lead to the conclusion that Cisco's value was the correct one. That some other company reached a different valuation is no reason to believe that its valuation was correct and Allied's wrong.” The Judge then imposed a pretty significant on burden the plaintiff; he stated that “Even if plaintiffs had pleaded sufficient facts to support an inference that Allied may have overvalued some of its investments, plaintiffs have not alleged the extent of any such overvaluation. In order to plead fraud with particularity, plaintiffs must state by how much Allied overvalued the investments ….”

To be sure, a fair analysis of the opinion in the case suggests that much of what Judge Lynch wrote is dicta; the nature of the pleadings themselves were conclusory, causing him to cite a Second Circuit case, Grandon v. Merrill Lynch & Co., Inc., 147 F.3d 184, 193-94 (2d Cir. 1998), in which the Court wrote: “A plaintiff's conclusory allegation that markups are excessive is similar to a barroom generality; it is insufficient to state a securities fraud claim.”

Moreover, the Second Circuit is more conservative than several of the other Circuits on the standards for 10b-5 pleading. And, Allied's stock price, which dropped when a hedge fund manager publicly criticized them (shorting the stock?) in fact recovered, which took a lot of the sting out of the damage claim. However, the decision is well-reasoned and, if it holds up on the appeal which I assume will ensue, could prove to be helpful to the defending side when 10b-5 and related claims based on inappropriate valuations are made.

Forum Invitation

Much learning on this subject is based on results in proceedings that do not reach the dignity of a reported court opinion. One and all are invited to contribute their thoughts, and particularly examples of disputes and their resolution (whether reported or unreported), to a new Forum on the VC Experts Web site, http://www.vcexperts.com/, entitled Private Equity Valuation.

Insiders (and others) in the private equity business are accustomed to seeing a good deal of discussion ' academic and trade ' on the question of the appropriate methods of valuing private equity positions and securities which are otherwise illiquid. An interesting recent decision in the Southern District has been brought to our attention by Carl Kaplan, who (while confessing he is a cynic, claims he is not the ultimate cynic). The case is In Re Allied Capital Corp., CCH Fed. SEC L. Rep. 92411 (US DC, S.D.N.Y., Apr. 25, 2003). Judge Lynch's decision is well written, the Judge reviewing a motion to dismiss by a business development company, Allied Capital, against a strike suit claiming that Allied's method of valuing its portfolio failed adequately to account for i) conditions at the companies themselves and ii) market conditions. The complaint appears to be, as is often the case, slap dash, content to point out that Allied revalued some of its positions, marking them down for a variety of reasons, and the stock price went down – all this, in the view of plaintiff's counsel, amounting to violations of Rule 10b-5.

The Court first noted that the SEC has provided “some guidance” to business development companies, which are closed end mutual funds organized under special provisions of the Investment Company Act of 1940 and operating as if they were private equity funds. Presumably Judge Lynch was applying a bit of irony when he mentioned “some guidance” since he quoted the SEC's interpretation in Accounting Series Release 118 as follows:

“No single standard for determining 'fair value' … can be laid down, since fair value depends upon the circumstances of each individual case. As a general principle, the fair value of restricted securities [is] the amount which the owner might reasonably expect to receive for them upon their current sale.”

If Release 118 provides “some” guidance, I would be interested in seeing what “no” guidance would consist of. Allied in turn elected to state its valuation policy from which the Judge excerpted as follows:

“[e]quity interests in portfolio companies for which there is no liquid public market are valued based on various factors, including cash flow from operations and other pertinent factors such as recent offers to purchase a portfolio company's securities or other liquidation events. The determined values are generally discounted to account for liquidity issues and minority control positions.”

Throwing cold water on the conclusory nature of the complaint, the Judge went on to make some interesting statements reflecting his reasoning. Thus, one of the items pointed out by the plaintiff's lawyers was that Allied maintained a particular investment at a higher value than Cisco Systems did, which (to the plaintiff) proved that Allied's valuation was deficient. This is a big deal these days, as critics compare differing valuations of the same security in the portfolios of two or more private equity funds – one fund holding the position at, say, cost while another has written it down materially. In rebuilding the plaintiff's argument in this instance, however, Judge Lynch pointed out the obvious, that plaintiff had failed to allege the facts that “would lead to the conclusion that Cisco's value was the correct one. That some other company reached a different valuation is no reason to believe that its valuation was correct and Allied's wrong.” The Judge then imposed a pretty significant on burden the plaintiff; he stated that “Even if plaintiffs had pleaded sufficient facts to support an inference that Allied may have overvalued some of its investments, plaintiffs have not alleged the extent of any such overvaluation. In order to plead fraud with particularity, plaintiffs must state by how much Allied overvalued the investments ….”

To be sure, a fair analysis of the opinion in the case suggests that much of what Judge Lynch wrote is dicta; the nature of the pleadings themselves were conclusory, causing him to cite a Second Circuit case, Grandon v. Merrill Lynch & Co., Inc. , 147 F.3d 184, 193-94 (2d Cir. 1998), in which the Court wrote: “A plaintiff's conclusory allegation that markups are excessive is similar to a barroom generality; it is insufficient to state a securities fraud claim.”

Moreover, the Second Circuit is more conservative than several of the other Circuits on the standards for 10b-5 pleading. And, Allied's stock price, which dropped when a hedge fund manager publicly criticized them (shorting the stock?) in fact recovered, which took a lot of the sting out of the damage claim. However, the decision is well-reasoned and, if it holds up on the appeal which I assume will ensue, could prove to be helpful to the defending side when 10b-5 and related claims based on inappropriate valuations are made.

Forum Invitation

Much learning on this subject is based on results in proceedings that do not reach the dignity of a reported court opinion. One and all are invited to contribute their thoughts, and particularly examples of disputes and their resolution (whether reported or unreported), to a new Forum on the VC Experts Web site, http://www.vcexperts.com/, entitled Private Equity Valuation.