Articles Tagged with Valuation

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The relentless attention being paid to cyber-attacks is driving companies to increase cyber security budgets and purchases. In turn, this has led institutional investors and asset managers to see potentially massive returns associated with companies in the cyber security market. Indeed a number of companies that have gone public have had phenomenal success, and the constantly morphing nature of cyber-attacks means that purchasing trends are not likely to slow down any time soon.

However, it is critical to keep in mind that just as cyber security capabilities can be a very attractive component in evaluating a potential investment; it also could lead to potentially negative consequences. Ignorance of some key legal and policy considerations could lead to an improper assessment of the value/future earnings potential of technology investments. These considerations are true regardless of whether or not the technology or service has a core “security” component.

Below are some key issues to consider when making cyber security investment decisions:

  • Cyber security matters in every investment
    • It is a simple fact that every company faces cyber threats. Multiple studies have  demonstrated that essentially every company has been or is currently subject to cyber-attack and that most if not all have already been successfully penetrated at least once. This leads to a key consideration: every company’s cyber security posture should be considered when making investment decisions. For example, a company selling information technology that is less prone to cyber-attacks should be viewed as a better investment than competitors who pay little to no attention to how their products can be breached.
  • Cybercrime is cheap
    • The cost of conducting cyber-attacks is depressingly cheap: $2/hour to overload and shutdown websites, $30 to test whether malware will penetrate standard anti-virus systems, and $5,000 for an attack using newly designed methods to exploit previously undiscovered flaws. Indeed it is now so cheap to create malware that the majority of malicious programs are only used once – thereby defeating many existing cyber security systems which are designed to recognize existing threats. This all adds up to a cost/benefit analysis that is irresistible for cyber-attackers, and essentially guarantees that the pace and sophistication of attacks will not let up any time soon.
  • Cyber security should be in the company’s DNA
    • Whether a company is offering a service or a technology, a critical factor to consider is its approach to security. Companies that consider security a key functionality that needs to be integrated from the start of the design process are far more likely to go to market with an offering that has higher degree of security. Security as an afterthought is just that – an afterthought. Weaving security into the DNA of a service or technology will be extremely helpful in decreasing security risks. Just remember though that no security program or process is flawless, and no one should expect perfection.
  • Is there a nation-state problem?
    • An R&D or manufacturing connection to countries known for conducting large-scale cyber espionage causes heartburn for companies and governments alike. Too many instances have occurred where buying items from companies owned by or operated in problem nation states have resulted in cyber-attacks. In some cases, Federal agencies are prohibited from buying IT systems from companies with connections to specific governments. Investors and managers need to stay abreast of problem countries, and also examine whether the product or service has a connection to such countries. Failure to do so can lead to investments in companies that have limited market potential.
  • Do your homework and forensic analyses
    • There’s nothing like buying a trade secret only to find out it really isn’t a secret. Before investing in any company, conduct due diligence to determine how good the security of the company is and whether IP or trade secret information has been compromised.
  • If the government cares, so should you
    • The Federal government is stepping up its requirements regarding cyber security in procurements. That means that all federal contractors (not just defense contractors) are going to have to increase their internal cyber security programs if they want to win government contracts. Failure to have a good cyber security program could lead to lost contracts, and thus decreased growth. 
  • Words matter
    • Companies have been too lax in negotiating terms that explicitly set forth security expectations for IT products as well as who will be liable should there be a breach/attack. Judicious reviews of terms and conditions can help avoid liability following a cyber-attack. For example, companies should not accept boilerplate language regarding the following of “industry standards” or “best practices” with respect to cyber security. Instead, specific obligations and benchmarks need to be agreed upon before signing any agreement. Further agreements should be drafted to that make clear that security measures are the obligation of the other party. That way the investor has set up a stronger argument for recovering losses as well as shifting liability away from itself.
  • Insurance isn’t everything
    • Companies may be tempted to think that if a company has a cyber-insurance policy, they are protected in the event of a cyber-attack. The reality is that there is an enormous chasm between buying coverage and having claims paid. Cyber policies are increasingly being written and interpreted to cover fewer types of attacks, and so do not be tempted to think that cyber insurance can fully protect an investment.
  • SAFETY Act
    • Under the Support Anti-Terrorism by Fostering Effective Technologies Act (SAFETY Act), cyber security services, policies, and technology providers are all eligible to receive either a damages cap or immunity from liability claims. The SAFETY Act also protects cyber security buyers, as they cannot be sued for using SAFETY Act approved items. Possessing SAFETY Act protections should be considered a positive sign and indicative of potential earnings growth.

There is no doubt about it; cyber risks are here to stay. Addressing those risks should be a core component of any business or investment strategy, because even if “today’s problem” is solved the introduction of new technologies will just mean a new threat vector for adversaries to exploit.

It is not all doom and gloom, however. Paying attention to cyber security trends and doing some simple due diligence will go far in minimizing digital risks. Make no mistake: defenses will always be incomplete and successful attacks will happen. However, with the right processes and approach, the bad outcomes can be minimized and investments will be protected.

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Written by: Jay B. Gould

On December 12, 2013, the Securities and Exchange Commission (SEC) charged a London-based hedge fund adviser and its former U.S.-based holding company with internal controls failures that led to the overvaluation of a fund’s assets and inflated fee revenue for the firms.  The investigation came out of the SEC’s Aberrational Performance Inquiry, pursuant to which the Enforcement Division’s Asset Management Unit identifies suspicious performance through risk analytics.  The SEC searches for performance that is inconsistent with a fund’s investment strategy or other benchmarks and then conducts follow up inquiries.  In this case, the SEC worked with the United Kingdom’s financial regulator, the Financial Conduct Authority.

According to the SEC’s order instituting settled administrative proceedings, the GLG firms managed the GLG Emerging Markets Special Assets 1 Fund.  From November 2008 to November 2010, GLG’s internal control failures caused the overvaluation of the fund’s 25 percent private equity stake in an emerging market coal mining company.  The overvaluation resulted in inflated fees to the GLG firms and the overstatement of assets under management in the holding company’s filings with the SEC. 

The SEC order also stated that GLG’s asset valuation policies required the valuation of the coal company’s position to be determined monthly by an independent pricing committee.  On a number of occasions, GLG employees received information calling into question the $425 million valuation for the coal company position.  The SEC found that there were inadequate policies and procedures to ensure that such relevant information was provided to the independent pricing committee in a timely manner or even at all.  There also appeared to be confusion among GLG’s fund managers, middle-office accounting personnel, and senior management about who was responsible for elevating valuation issues to the independent pricing committee.  

The SEC’s order found that GLG Partners L.P. violated and GLG Partners Inc. caused numerous violations of the Federal securities laws.  It also required the GLG firms to hire an independent consultant to recommend new policies and procedures for the valuation of assets and test the effectiveness of the policies and procedures after adoption.  The GLG firms agreed to pay disgorgement of $7,766,667, prejudgment interest of $437,679, and penalties totaling $750,000.

The SEC has been targeting valuation cases recently as evidenced by the recent enforcement action against the Morgan Keegan fund directors and in the Ambassador Capital case.  Fund managers should review their valuation policies and procedures to make sure that such policies and procedures address current regulatory concerns, and to make sure that the disclosures in their fund documents are consistent with actual practice.

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Last month, the Securities and Exchange Commission (the “SEC”), published its examination priorities for 2013.  As we suggested in our Blog posting at that time, the SEC is fixated on examining and bringing enforcement against its newest class of investment adviser – managers of private equity funds.  Fast forward four weeks, and we should not be surprised to see that the SEC is doing what they said they would do.  Today, the SEC charged two investment advisers at Oppenheimer & Co. with misleading investors about the valuation policies and performance of a private equity fund of funds they manage.

The SEC investigation alleged that Oppenheimer Asset Management and Oppenheimer Alternative Investment Management disseminated misleading quarterly reports and marketing materials, which stated that the Oppenheimer Global Resource Private Equity Fund I L.P.’s holdings of other private equity funds were valued “based on the underlying managers’ estimated values.”  The SEC, however, claimed that the portfolio manager of the Oppenheimer fund actually valued the Oppenheimer fund’s largest investment at a significant markup to the underlying fund manager’s estimated value, a change that made the performance of the Oppenheimer fund appear significantly better as measured by its internal rate of return.  As part of the Order entered by the SEC, and without admitting or denying the regulator’s allegations, Oppenheimer agreed to pay more than $2.8 million to settle the SEC’s charges and an additional $132,421 to the Massachusetts Attorney General’s office.

In its press release, the SEC reiterated its focus on the valuation process, the use of valuations to calculate fees and communicating such valuations to investors and to potential investors for purposes of raising capital.  The SEC’s order also claimed that Oppenheimer Asset Management’s written policies and procedures were not reasonably designed to ensure that valuations provided to prospective and existing investors were presented in a manner consistent with written representations to investors and prospective investors. This claim gave rise to an alleged violation of Rule 206(4)-8 (among other rules and statutes) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), the rule that the SEC passed after the Goldstein case permitted many funds to de-register as investment advisers from the SEC.

This case illustrates the new regulatory landscape for private equity fund managers.  Many private equity fund managers have not dedicated the time and resources to bringing their organizations in line with the fiduciary driven rules under the Advisers Act.  Many of these managers have not implemented the compliance policies and procedures required by the Advisers Act, nor have their Chief Compliance Officers been empowered to enforce such compliance policies and procedures when adopted.  Much of this oversight goes to the fact that many private equity fund managers do not have a history of being a regulated entity nor have they actively sought out regulatory counsel in their typical business dealings.  Private equity fund managers generally use outside counsel to advise them on their transactional or “deal” work and they often do not receive the advice that a regulated firm needs in order to meet its regulatory obligations.  Oppenheimer serves notice that failing to meet these regulatory obligations can have dire consequences.

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Written by Jonathan J. Russo and Meredith Ervine

At first glance, Southern Peru Copper Corporation (Southern Peru) and its special committee (Committee) appeared to do what they were supposed to do when considering a controlling stockholder transaction—form a special committee of disinterested, sophisticated directors, engage separate, independent financial and legal advisors, request a fairness opinion and obtain super-majority stockholder approval. So why did the Chancellor of the Delaware Court of Chancery (Court) hold that the transaction was unfair and award $1.3 billion in damages—one of the largest derivative monetary awards in the Court’s history? This Advisory discusses In re Southern Peru Copper Corporation Shareholder Derivative Litigation and suggests specific practices that a special committee should consider when evaluating a controlling stockholder transaction.

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As we have previously discussed here, the Securities and Exchange Commission’s Asset Management Unit has been investigating whether hedge fund managers overvalue illiquid assets so as to generate higher management fees. Most recently, on October 25, 2010, the SEC charged hedge fund manager Stephen M. Hicks and his investment advisory businesses with defrauding investors in funds managed by Southridge Capital Management LLC and Southridge Advisors LLC by overvaluing the largest position held by the funds.

According to the SEC’s complaint, the largest holding of the Southridge funds was an investment in Fonix Corporation, which was valued at $30 million. The Southridge funds had acquired Fonix securities in exchange for securities of two telecommunications companies owned by the Southridge funds – LecStar Telecom, Inc. and LecStar DataNet, Inc. (collectively, “LecStar”). Southridge and Hicks valued the Fonix securities at their cost of acquisition, which they determined to be equal to the appraised value of the LecStar securities at the time of the exchange. The SEC alleges that the defendants knew or should have known that this appraisal did not reflect the “real” acquisition cost of the Fonix securities because it was based on erroneous information indicating that LecStar was profitable and assumed that an earlier transaction in LecStar securities had been negotiated at arm’s length when in fact it was a transaction between affiliates.

Even if Southridge and Hicks had properly calculated the acquisition cost of the Fonix securities, they would not have been permitted to use this as the basis of a valuation. The offering materials for the Southridge funds indicated that such investments would be valued based on a valuation provided by a clearing broker or independent pricing service rather than acquisition cost.

The SEC is seeking injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.

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The Investment Fund Law Blog has been selected as one of the LexisNexis Top 25 Business Law Blogs for 2010. You can read the full announcement and list of honorees here. We are in very good company in the Top 25, which includes such highly regarded blogs as thecorporatecounsel.net, the Harvard Law School Forum on Corporate Governance, and the M&A Law Prof Blog.

As you’ll note, voting for the top blog begins today and will last one week so please feel free to visit the site and vote to show your support. Thanks to all our readers who supported our nomination for this award.

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The Securities and Exchange Commission’s Asset Management Unit has been investigating whether hedge fund managers have overvalued assets in “side pockets” and then charged investors higher fees based on those inflated values. A side pocket is a type of account that hedge funds use to separate certain illiquid investments from the rest of their portfolio. Investors are typically not permitted to redeem their interest in a fund with respect to assets allocated to a side pocket until such assets have been liquidated or reallocated to the general portfolio by the investment manager.

Recent charges brought by the SEC highlight the need for hedge fund managers to establish reasonable policies for the valuation of illiquid assets and carefully adhere to such policies when valuing assets allocated to a side pocket. On October 19, 2010, the SEC charged two hedge fund managers and their investment advisory businesses with defrauding investors by overvaluing illiquid fund assets they placed in a side pocket. According to the SEC complaint, Paul T. Mannion, Jr and Andrews S. Reckles, through their investment adviser entities PEF Advisors Ltd. and PEF Advisors LLC, caused certain investments made by Palisades Master Fund, L.P. to be overvalued by millions of dollars.

Beginning in August 2004, the fund, at the direction of Mannion and Reckles, invested millions of dollars in World Health Alternatives, Inc. By July 2005, World Health was the fund’s largest single position and constituted at least 20% of the fund’s assets. As World Health (now bankrupt) began to experience financial difficulties, Mannion and Reckles became concerned about the value of the fund’s World Health assets and the potential for any report of substantial losses in relation to such assets to cause investors to redeem their interests in the fund. Recognizing the risk of large scale redemptions, Mannion and Reckles decided to place the World Health assets in a side pocket.

Palisades had adopted specific policies on how it would value different categories of securities and communicated those policies to prospective investors in its offering memorandum and financial statements. Mannion and Reckles allegedly valued the World Health assets contrary to the disclosed valuation policies, which resulted in such assets being significantly overvalued. Mannion and Reckles then charged management fees that were improperly inflated by their overvaluation of fund assets.

Robert B. Kaplan, Co-Chief of the SEC’s Asset Management Unit, commented:

Side pockets are not supposed to be a dumping ground for hedge fund managers to conceal overvalued assets. Mannion and Reckles deceived investors about the fund’s performance and extracted excessive management fees based on the inflated asset values in a side pocket.

The SEC is seeking injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.