Insight Analytical Note

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Improper Evaluation of Permanent Impairment

Background:

  • On June 20th, 2023, the U.S. Securities and Exchange Commission (“SEC” or “Commission”) charged Insight Venture Management, LLC (“IVP”) with conduct related to improperly calculating a fund management fee attributable to impaired investments in four portfolio companies.
  • IVP’s issue arose from the firm’s implementation of a complex set of impairment criteria which were not disclosed to investors.
  • Additionally, IVP calculated impairment on a portfolio company rather than on an investment basis.
  • IVP refunded more than $4.6 million in disgorgement, self-remediation and interest and agreed to violations of Rules 206(4)-8, 206(4)-7 and Section 206(2) of the Investment Advisers Act. IVP also paid a $1.5 million penalty.

Key Facts and Allegations:

  • Undisclosed Complex Impairment Criteria – IVP’s Limited Partnership Agreement (“LPA”) required IVP to not charge management fees on permanently impaired investments for funds in their post-commitment period. To determine whether an investment was “permanently impaired” IVP implemented 4 criteria which were not disclosed to investors. Specifically, IVP’s criteria were: (a) the valuation of the Fund’s aggregated investments in a portfolio company was currently written down in excess of 50% of the aggregate acquisition cost of the investments; (b) the valuation of the Fund’s aggregated investments in a portfolio company had been written down below its aggregate acquisition cost for six consecutive quarters; (c) the write-down was primarily due to the portfolio company’s weakening operating results, as opposed to market conditions, comparable transactions, or valuations of comparable public companies; and (d) the portfolio company would likely need to raise additional capital within the next twelve months.
    • Analysis:
      • IVP’s impairment criteria were very specific but lacked a clear linkage to permanent impairment. This combination enabled the SEC to challenge IVP’s impairment decisions more easily and to make the claim that these criteria constituted a material fact which was required to be disclosed to investors.
      • This type of criteria-based approach is sometimes used by venture capital firms to determine value in a pre-revenue company, but IVP seems to have applied the approach in an overly broad manner.
  • Impairment Applied to Portfolio Companies Rather than Investments – IVP appears to have applied its “permanent impairment” criteria to portfolio companies rather than to each investment individually. IVP’s LPA, however, required that impairment be evaluated on an investment-by-investment basis rather than on a company-by-company basis.
    • Analysis – IVP’s investing style often involves investing in multiple tranches of equity securities with later investments being senior to earlier investments. If companies struggle, later investment rounds may have punitive liquidation preferences and valuations making recoveries from earlier investments unlikely. In this not uncommon scenario, it is possible for earlier investments to be permanently impaired while the portfolio company itself still has value.

Takeaways:

  • Impairment Procedures and Pre-Determined Criteria – Many managers are currently considering whether to adopt policies, procedures and pre-determined criteria around the detection of permanent impairment. We believe that while larger managers should have a written process to assess impairment, smaller managers may not need a formal approach. Further, we do not believe that it is prudent to define specific impairment criteria because it is impossible to capture such a complex analysis with predefined factors. Instead, managers should periodically review their portfolios for impaired securities and document their impairment decisions, especially for securities valued at or near zero but not permanently impaired.
  • Venture Style Investing and Capital Stack Risks – Venture and growth companies are often the first to be impacted in a dislocated market. At the same time, venture and growth investors may continue to fund struggling companies with senior securities which would carry lower valuations and contain significant liquidation preferences. These types of “down-round” financings can quickly impair common equity and other junior securities even if the portfolio company still has value. Venture-style investors should be aware of that dynamic and evaluate each situation accordingly.
  • Impairment in the Current Market – The Commission continues to demonstrate its knowledge of and interest in company impairment and valuation. We expect this trend to intensify in the future.
  • Examination Remediations – IVP remediated during the SEC examination but was nevertheless referred to enforcement resulting in a settlement. Despite this, we continue to believe that proactively identifying and remediating compliance issues lowers regulatory risk and aligns with the SEC’s view of fiduciary duty.