Demand for capital in credit-hungry times has led many a small- to mid-cap company to turn to private investment in public equities (PIPEs).

PIPEs can promise a small company a quicker, less regulated way to raise money. They are also a natural for hedge funds because of the potential favorable terms that can be negotiated for convertible and warrants, as well as the potential for hedging the bet by shorting the company’s stock. Hedge funds were the most active investors in PIPEs in the third quarter of 2010, according to PrivateRaise, a service of DealFlow Media. The asset class did 191 PIPEs deals worth about $1.7 billion in Q3.

Overall, PIPEs were down in the third quarter of 2010 mostly due to choppy markets, PrivateRaise said. In Q3 there was about $6.4 billion raised in 244 private placements, as compared to 299 placements worth about $8.4 million the year before.

These vehicles are not without their risk. Besides that the companies involved are often small and under-capitalized, the question of how to value PIPEs portfolios, which usually involve thinly traded securities is one that can bedevil these funds, especially when regulators come to call.

The Securities and Exchange Commission has brought a number of cases recently that charge fraud in valuation of PIPEs funds.  In the most recent case, filed Monday by the SEC and the Connecticut state banking commission, Southridge Advisors and founder Stephen Hicks were charged with misvaluing one transaction.  Earlier this month, the SEC charged that Georgia hedge fund managers Paul Mannion and Andrew Reckles valued a portfolio of bridge loans in now-defunct medical staffing company World Health Alternatives at $6 million.

The SEC’s claim is that, since the hedge fund manager’s firm PEF Advisors had already sued the company on the loans, it had to know that they worth nowhere near their valuation.  The managers and the hedge fund have denied any wrongdoing.

Vision Capital, Yorkville Advisors and Corey Ribotsky’s NIR have all been said to be under SEC scrutiny for PIPEs portfolios.  Douglas Scheidt the SEC’s chief counsel of the investment management division, tells HedgeFund.net that the question of valuation, at least as far as the regulator is concerned, is not a science.

“Valuation is an estimate of what a willing buyer would pay,” Scheidt says.

The problem with PIPEs, however, is that there isn’t the kind of price discovery process that a buyer and seller can get in an open market.  One measure that can be used to help the valuation process, Scheidt says, is to look to the issuer’s publicly traded securities as a reference point.

“Of course, you also have to take into account if the security can’t be publicly sold, then the value of that restricted security may be less to a willing buyer,” he says.

Valuing a portfolio where the price of an individual security isn’t readily available requires managers to have a process in place, but to be aware that circumstances may change, says Espen Robak, president of Pluris Valuation Advisors.

While the definition of value is always “fair value,” Robak says, “It doesn’t matter if it’s Coca Cola or a little private company or an illiquid warrant in a small micro-cap stock. There is a market for every one of these things.”

Robak says managers should follow a four-point process in valuing hard-to-mark PIPEs securities:

“No. 1. Managers should have a serious internal valuation process. Meaning a management committee; someone who isn’t paid two and 20 who decides on the value or at least signs off on the value, in other words, someone who doesn’t have a vested interest.

No. 2. There should be a real, solid auditor; if not one of the Big Four, then, at least, a good, solid auditor.

No. 3. Serious internal work papers so the manager can produce a big file that shows they did their due diligence including a stack of documents that shows their analysts have done the evaluations once a quarter, or once a month with a full survey once a year.

No. 4. External validation. You need somebody who produced a report; either they reviewed your own valuation or they produced their own independent report. You present that, with your internal work, to your auditors.”

If a manager follows these recommendations, Robak says, “You can present it to the SEC and they can knock on your door all they want.”

Scheidt agrees with that assessment, up to a point.

“The more rigorous the valuation policies and procedures are, the less basis we have to challenge a particular validation,” Scheidt says.

However, being a regulator, Scheidt also points out, “For some funds that have a higher percentage of their assets in hard-to-value assets, our staff might think that’s a higher risk and they might focus more heavily on it when conducting an examination.”