Failure to Base Valuation on Reasonable Assumptions May Lead to SEC Charges
An adviser may believe in the value of a portfolio company. But when the adviser managing private funds with an interest in that company seeks investors for that company by overstating the portfolio company’s and therefore the funds’ value, expect the SEC to come knocking.
That is the situation that San Diego-based adviser Enviso Capital found itself in, according to the settlement the advisory firm signed with the agency last month. The advisory firm, from 2012 through 2014, materially overstated the value of two of its private funds in financial statements sent to fund investors, according to the SEC’s administrative order instituting proceedings against Enviso, its managing principal who also served as chief compliance officer, Ryan Bowers, and another principal, Jeffrey LaBerge, whose responsibilities included portfolio management and valuation formulation.
Both private funds held an interest in a non-publicly traded company, Bluefin Renewable Energy, which between 2011 and 2014, according to the agency, had only one asset, a renewable energy project that was under development in Tecate, Mexico.
"Although the respondents were aware that Bluefin never reached certain milestones necessary to building the project, such as obtaining financing or potential customers, they used unreasonable assumptions when applying the discounted cash flow method to value Bluefin," the SEC said. Among these were that Enviso and its two principals "assumed that Bluefin would sell significant amounts of energy within 24 to 30 months, even though no financing for the project had been obtained, no construction had ever started, and Bluefin had no contracts with potential purchasers of energy."
In addition, the agency alleged that Enviso failed to properly value a loan from one of its funds to the other, "despite the fact that it was probable that the full outstanding amount would never be collected," the agency said.
Violations and penalties
Enviso, Bowers and LaBerge were all charged with willfully violating Section 206(2) of the Advisers Act, which prohibits fraud; and Section 206(4) and its Rule 206(4)-8 for making untrue statements of material fact to investors or prospective investors. In addition, Enviso was charged with willfully violating, and Bowers and LaBerge with causing the advisory firm’s violation of, Section 206(4) and its Rule 206(4)-2, the Custody Rule. Separately, Enviso was charged with willfully violating, and Bowers causing its violation of Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule. Finally, Enviso and Bowers were both charged with willfully violating Section 207, which prohibit the making of any untrue statements of material fact on a registration application.
Each of the three respondents was ordered to pay a $50,000 civil money penalty. Enviso itself was censured, and Bowers and LaBerge were barred from the securities industry for at least two years. LaBerge was also barred from appearing or practicing before the Commission as an accountant for at least two years. An attorney representing the three respondents did not respond to an email or voice mail seeking comment.
"The industry bars appeared disproportionate to the monetary penalties," said Paul Hastings partner Nicolas Morgan. "This suggests that the SEC may have a greater interest in keeping specific individuals out of the fund advisor space than in sending a deterrence message through heavily punitive fines."
Investments and the loan
Each of Enviso’s two funds – Heritage Opportunity Fund (HOF) and Heritage Dividend Fund (HDF) - had skin in the game when it came to Bluefin. HOF, in fact, had between 51 percent and 88 percent of its total assets in the energy company, the agency said. HDF had a smaller percentage of total assets at risk with Bluefin – between 11 percent and 17 percent, according to the SEC.
In addition, according to the agency’s administrative order, both Bowers and LaBerge took an "active role" in Bluefin’s business and served as board members.
As for the loan, the SEC said that HDF issued a line of credit to HOF that was secured by HOF’s assets – which were primarily in Bluefin. "The line of credit was issued in September 2008 for $1.5 million with a maturity date of December 31, 2010," the agency said. "The maximum loan amount was increased three times and the maturity date was extended four times. As of December 31, 2014, HOF owed HDF $6.1 million in principal and accrued interest on the loan. HOF never made, and did not have the liquid assets to make, any payments on the loan."
"Another notable aspect of this case is the SEC’s willingness to second-guess valuation judgments relating to ‘realizable value’ of certain loans," said Morgan. "Specifically, the agency cited several extensions to a borrower’s line of credit and the borrower’s inability to satisfy certain liabilities without any corresponding recognition of impairments on the loan until the entire loan was deemed worthless. When and how to recognize impairments involves a large measure of judgment, and this case demonstrates that the SEC will not shy away from critiquing those judgments with the benefit of hindsight."
A question of valuation
Despite the above, Enviso, with LaBerge performing the calculations and Bowers approving them, provided valuations for the funds’ financial statements (which were sent to investors) and which were used to calculate advisory fees, since they are based on net value of assets under management.
"Notwithstanding the fact that the Tecate project had not yet started construction, obtained financing or potential customers, the respondents represented to fund investors in financial statements for the years ending December 31, 2011 through December 31, 2013, that Bluefin was worth between $10.8 and $12.7 million," the SEC said. As of the end of December 2014, however, "the Bluefin investment was written down to zero."
As for the loan, the agency said, "despite HOF’s inability to make payments on HDF’s outstanding loan from 2011 through December 31, 2014, respondents never wrote down the value of the loan. In 2015, Enviso Capital wrote off the entire value of the HDF loan as uncollectible while preparing the 2014 financial statements."
Then there are the advisory fees. From 2012 through 2014, according to the SEC, Enviso chose to "accrue but not collect" any investment advisory fees from either of the funds. Afterward, Enviso wrote off all related accrued advisory fees, the agency said.
A question of assumptions
How did Enviso value Bluefin the way it did? It used "unreasonable assumptions," the SEC said.
Under each fund’s valuation policy, "interests in fund portfolio companies without readily available market quotations would be valued in good faith by the investment advisers," the agency said, and from 2011 through 2013, "the funds’ audited financial statements disclosed that the valuation of certain securities may be based on discounted cash flow from projected income and Bluefin was specifically identified as valued under this approach."
Not to get too deep into the accounting weeds, but it is important to understand the discounted cash flow method means projecting expected future economic benefits (net cash flow) and discounting each expected benefit back to present value at an approximate risk-adjusted rate of return. "In using the discounted cash flow methodology – which at its core entails projecting cash flow – reasonable assumptions and estimations of future cash flows must be used.," the SEC said.
But the agency’s administrative order argues that Enviso did not use reasonable cash flow assumptions from 2011 to 2013, and provides a chart showing
assumptions the adviser made to buttress its point.
The examiners’ concerns
"At least as early as January 2012, Bowers and LaBerge were aware that the Commission’s examination staff had concerns about the assumptions underlying the discounted cash flow method used to value Bluefin," the SEC said. "Specifically, the Commission’s staff sent Bowers, as CEO of Enviso Capital, a deficiency letter on January 19, 2012 regarding the results of an investment adviser examination."
In the letter, according to the agency, the examiners expressed concerns regarding some of the revenue assumptions underlying the discounted cash flow method to value two alternative energy plants that preceded the Tecate project, and that these assumptions may have been used in 2010.
"Generally speaking, the Enforcement Division is more likely to take interest in an issue raised during an exam that remains unremedied," said Morgan.
Separately from the valuations themselves, the SEC, in its administrative order, expressed concerns in other areas, including:
Custody. Enviso, which the agency said had custody of client funds or securities, allegedly did not undergo a surprise examination conducted by an independent accountant at least once a year. It did not do so, the SEC said, because it intended to rely on an exception within the Custody Rule for pooled investment vehicles that, among other things, distribute to their investors annual audited financial statements prepared in accordance with GAAP. "Because Enviso Capital distributed to HOF and HDF investors financial statements that were not prepared in accordance with GAAP, this exception did not apply," the agency said. The SEC’s use of GAAP violations in the case "used to be the domain of actions against public companies," noted Pasquarello Fink partner William Haddad. "With this action, the Commission appears to be taking tried and true approaches from that world and applying it to advisory firms."
Misrepresentations. Enviso, according to the administrative order, sent management discussions and analyses, as well as other communications, to fund investors in 2011 and 2012 that "misrepresented the nature of Bluefin’s relationship with a Mexican company as a partnership, even though the contractual relationship that existed at the time was not a legal partnership." This was an important point, the agency argued, because without a legal partnership, Bluefin had no legal claim to land and certain permits upon which the Tecate project was based.