Reed R. Kathrein, partner, leads Hagens Berman’s San Francisco office. He focuses on financial fraud and securities litigation.

In a case that should catch the attention of institutional investors who invest in the private equity industry, federal regulators and the Massachusetts Attorney General are investigating whether a fund that was part of Oppenheimer Holdings Inc. overstated the value of one of its holdings, according to a February 24, 2012, Wall Street Journal article.

The investigation centers on the potential exaggeration in the fund valuation as the fund was reaching out to potential investors in the fall of 2009, which may have helped push the fund’s reported internal rate of return to 38 percent, after fees, from a loss of 6.3 percent. The fund subsequently raised more than $55 million from individuals and various institutions, such as Bradley University and the Massachusetts cities of Quincy and Brockton.

The private equity industry is vast and, according to some sources, manages over $1.2 trillion in assets. Private equity portfolios, however, are usually not part of an observable market – they do not have market trading prices. Unlike the valuing of publicly traded stocks, valuing private equity investments — largely in private companies that are not listed on an exchange — can be an opaque and subjective process. In order to arrive at a value for these potentially illiquid investments, firms often employ best estimates that are based on models and internal information.

Importantly, an inherent conflict may exist within the private equity firm’s fee structure. If they are compensated based upon a percentage of the amount under management, or increased valuation of the assets, they have every incentive to inflate these valuations.

The possibility of exaggerated valuations by private equity firms, fee structures, and fund raising have become a major concern of regulators. The Securities and Exchange Commission’s enforcement division, led by Robert Khuzami, is focusing on whether private equity firms may be inflating returns to help raise money from investors.

On December 8, 2011, the SEC sent letters to about a dozen private equity firms as part of an “informal inquiry.” The 16 page letters include questions about how the funds value their investments, asking for details on fund investments and the valuation of assets, as well as communication with clients, according to the copies of the letters obtained by Bloomberg News and The Wall Street Journal. Firms were asked to produce the documents by the end of last year.

Institutional investors need to find ways to monitor private equity valuations, or take action when valuations look to have been suspect, such as when there is a sudden unexpected drop. Even the largest funds have admitted that “there are no current industry standards for valuations, reporting, and performance benchmarking” and have thus turned to industry associations, such as the Institutional Limited Partners Association and AIMR, for help. Some funds retain specialty consultants and receive a specialized performance report, periodically, on the asset class. One role that should be considered and assigned to such consultants is the red-flagging of suspicious performance or valuations based on their performance reviews. Monitoring and securities litigation counsel should also be brought into that process early, when issues arise. Here at Hagens Berman, we stand ready to help, to bring our legal and litigation strategy expertise to bear, and to bring in valuation experts when suspicious activity arises.