Originally published in the American Bar Association's Commercial & Business Litigation: Summer 2012, Vol. 13 No. 4 – Delaware Corporations & Private Equity - August 16, 2012.

It has been widely reported that in late 2011, several leading private equity funds received informal inquiry letters from the Division of Enforcement of the Securities and Exchange Commission (SEC). G. Zuckerman, “SEC Launches Inquiry Aimed at Private Equity,” Wall St. J.,Feb. 11, 2012; P. Lattman, “Private Equity Industry Attracts S.E.C. Scrutiny,” N.Y. Times, Feb. 12, 2012. Although these informal inquiry letters were broad in their scope (as is often the case in such inquiries), the SEC staff is understood to have requested production of documents concerning the valuation of private equity fund assets, the manner in which those valuations are reported, and details of agreements between the private equity fund and third party valuation service providers. Such requests suggest a concern among regulators about the manner in which the funds that comprise the $1.2 trillion private equity industry value their investments and present performance data to current and prospective investors. In light of the SEC’s focus on private equity valuation, as well as a number of private civil litigations directed to the issue, it is worth considering the standards governing the valuation of private equity assets and recent developments in the law on those valuations.

Valuation of any portfolio asset—private equity or otherwise — begins with the concept of fair value. Statement of Financial Accounting Standards (SFAS) 157 (now known as Accounting Standards Codification (ASC) 820) defined and established a framework for measuring fair value under United States Generally Accepted Accounting Principles, or GAAP. “Fair value” is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” SFAS 157, ¶ 5 (also known as ASC 820 in the updated Financial Accounting Standards Board codification). In the context of highly liquid, publicly traded securities (such as equities trading on a national securities exchange), fair value is relatively easy to calculate: It is typically the current trading price of the security, multiplied by the size of the portfolio position...