This article originally appeared January 11, 2002 on PrivateEquityCentral.net
A common accounting practice of the venture capital industry may be put on trial.
According to a clutch of class action lawsuits filed this month against the Van Wagoner Emerging Growth Fund, a hybrid mutual fund that invests in both public and private companies, the practice of holding a private investment at cost in the midst of a collapsing public stock market constitutes fraud. In holding these investments at cost, the lawsuits allege, Van Wagoner "materially inflated" the value of the fund, thereby luring unsuspecting investors onto a sinking ship. Investors in venture capital funds will find these suits particularly interesting, as they essentially proclaim that reports issued by nearly every venture capital firm on the planet over the past 18 months have been fraudulent. Even if these suits are ultimately dismissed, they highlight the perils of mixing public and private investing. They also put on display the inherent squirreliness of private equity valuations.
Van Wagoner is far from alone in finding itself the subject of class action suits. These days, it seems any company that experiences a precipitous decline in the value of its shares invariably becomes the target of law firms that operate what amount to class-action factories. These cookie-cutter suits always allege that the managers of the target companies conspired to obscure accounting data in order to hide deteriorating earnings. To date, four separate law firms have organized class action suits against Van Wagoner. One of these firms, Schiffrin & Barroway, lists a total of 47 class action suits on its Web site, which allows angry shareholders to join up with the click of a mouse.
The Van Wagoner suits stand out because of the nature of the "fraud" alleged. A statement from Schiffrin & Barroway asserts that Van Wagoner, its managers, along with accounting firm Ernst and Young, issued to Van Wagoner Emerging Growth Fund shareholders "false and misleading statements concerning the Fund's net asset value. . . and performance." Specifically, the defendants, allegedly, materially overstated the value of certain private placement holdings.
That Van Wagoner, a mutual fund, even has private securities is a legacy of the mania for venture capital that gripped the investment world during the late 1990s. Seeing the incredible returns that venture capital firms enjoyed as a result of their investments in pre-IPO tech companies, a handful of mutual funds decided to get into the act. Under provisions of a 1980 amendment to the Investment Company Act of 1940, open-ended mutual funds, like Van Wagoner Emerging Growth, are allowed to invest up to 15% of their net asset values in illiquid securities. Closed end-mutual funds may invest any amount in private deals. Not surprisingly, the period between 1996 and 2000 saw the formation of a number of mutual funds that touted their ability to capitalize on pre-IPO opportunities. Among the mutual fund firms to offer these types of vehicles were Munder Capital, Putnam Investments, OppenheimerFunds, Amerindo Investment Advisors and J.W. Seligman & Co. Van Wagoner, in fact, became increasingly serious in its commitment to venture capital-style investing. The Emerging Growth fund started life in 1996 structured as a standard, open-end mutual fund. A year ago, Van Wagoner launched a $150 million closed-end mutual fund called the Private Opportunities Fund to invest in private and public expansion-stage tech companies. The fund was limited to accredited investors and had a minimum investment of $250,000.
The move to venture capital was not fortuitously timed. Van Wagoner's Emerging Growth fund, like the rest of the tech world, has seen a serious erosion in value over the past year-and-a-half. In Sept. 2000, shares in the fund were trading near $60. The fund now trades near $13. While the value of most mutual funds can be accurately ascertained simply by adding up the value of the underlying stocks they own, the accounting wasn't as simple with the Emerging Growth fund. Like many venture capital firms, Van Wagoner held at cost the value of many of its private investments. At the same time, the rest of the fund's positions tanked. This apparent discrepancy was first reported in a Dec. 11 Wall Street Journal article, which was no doubt read with glee by the class action specialists. The complaints submitted by Schiffrin & Barroway, as well as by other law firms suing Van Wagoner, extensively quote the Journal article.
The article described 23 private placements in the Emerging Growth fund, many of which were made near the end of 2000, but some of which dated as far back as Sept. 1999. On Dec. 31, 2000, Van Wagoner reported the value of these investments at $271 million and the value of the overall fund at approximately $2 billion. The lawsuits allege that these private investments should have been valued at far less, and that this inflated NAV gave investors the impression that the fund was doing better than it really was. In addition, the suits claim that when Van Wagoner did eventually write down the value of these investments, the write-downs were arbitrarily round percentages, such as 50% and 75%.
Of course, no one familiar with the world of venture capital will be surprised at this approach to valuations. One of the most talked-about issues among industry insiders last year was the reluctance of venture capital firms to write down or write off struggling tech investments. A cynic might view the practice of keeping an investment at cost as unwillingness to accept reality, or, even worse, an attempt to mask dreary fund performance. But there are also entirely responsible reasons for keeping an investment at cost. Writing a company's value down, or off, severely impairs that company's ability to secure additional financing. A year ago, many venture capitalists hoped the market swoon was a temporary problem, and were in no rush to slash the value of their portfolio companies simply because comparable public companies were down in the dumps. "It takes discipline not to write something down, as well," says an accounting professional who works exclusively with private equity firms. "A year ago, I was telling my clients to only write something off if it was really, really, really dead."
If the public markets had returned to health, as they had numerous times over the past half-decade, premature write-downs could have been construed as mismanagement on the part of venture capitalists.
Investment Company Act rules require fund managers to use "sound judgment" in determining the "fair value" of their funds. If a venture capitalist firm studies all the relevant data, and, after struggling mightily with the issue, decides that keeping a portfolio company at cost is the best course, that's sound judgment. "It is very difficult to challenge someone's judgment," the accountant says. "The only way a person can be accused of not doing a good job is if they don't attempt to find the proper valuation."
In other words, the class action law suits must prove that Van Wagoner either determined that valuations should be written down, and then deliberately chose not do so out of a desire to defraud, or that the folks at Van Wagoner didn't even bother to figure out what the true value of the private deals should have been. Either way, proving fraud or neglect on the part of Van Wagoner will be an uphill legal battle.
The plaintiffs have also taken exception with the seemingly arbitrary nature of Van Wagoner's eventual write-downs. A passage in the Schiffrin & Barroway complaint reads, "[The fund managers] on June 30, 2001. . . marked down an additional 12 holdings by precisely 50% or 75%, reducing their values dramatically."
Again, round-numbered write-downs are not unusual to venture capital veterans. As the accounting source puts it: "Fund managers clearly disclose to investors that valuations are based on large judgments and estimates, and those estimates may in fact change and be proved not to be accurate. It is fairly normal practice to round the amount of a discount. You don't want to give the appearance of a level of precision that doesn't exist. It would be misleading, for example, to write something down 73.27%, because that level of precision simply does not exist."
Clearly, Van Wagoner, in not reducing the value of its private placements as the market fell, was behaving exactly like a venture capital firm. The lawsuits it faces, however, stem from the fact that Van Wagoner is not, in fact, a venture capital firm, but a mutual fund company. It mixed private and public securities in the same vehicle, and exposed public shareholders to the dynamics of illiquid securities. The most compelling argument of the class action suits may be this ? as a mutual fund, Van Wagoner Emerging Growth is required to facilitate shareholder redemptions, and should the demand for redemptions surge dramatically, the fund may be forced to sell some of its private deals. As anyone active in the secondaries market knows, interests in early stage tech companies are certainly not changing hands at cost, but rather at unbelievable discounts. Should a mutual fund suddenly sell its private securities, those discounts would take many shareholders by surprise. On this topic, the Journal article quotes a former SEC attorney as saying, "Carrying any security at cost, especially a private placement, is a violation of the Investment Company Act, unless the cost just happens to be the price at which they could sell those securities in the market."
If this standard were applied to the private equity industry, then the past two years have seen an astonishing amount of violations go unchecked.