Private Equity, Mutual Funds and Valuation
Wall Street Journal reporter, Eleanor Laise recently wrote that an increasing number of mutual funds are "venturing into the risky world of private-equity investments", "because of the prospects for higher returns." While SEC rules limit assets to no more than fifteen percent in illiquid holdings, Ms. Laise describes potential problems. Higher legal expenses for more complex deals, difficulty of unwinding a position and valuing private investments are far from trivial challenges. She cites one SEC investigation of a mutual fund that allegedly undervalued its private company positions to give the impression that it had not breached the fifteen percent limit. "The SEC also has charged funds with inflating the value of illiquid investments. Mutual-fund managers have an incentive to overestimate the value of these holdings because they collect fees that are calculated as a percentage of total assets in the fund." (See "Mutual Funds Delve Into Private Equity" by Eleanor Laise, Wall Street Journal, August 2, 2006.)
Applying a version of the transitive property from mathematics, the implication is clear. Some pension funds have increasing exposure to private equity investments that do not trade in a ready market.
1. Pension funds allocate money to mutual funds.
2. Mutual funds buy private equity.
3. Pension funds are exposed to private equity as an asset class. (This is in addition to any direct allocation by pension funds to private equity.)
The message is clear. For those pension funds investing more money in private equity (indirectly or directly), the valuation issues are real and cannot be overlooked.
