On February 25, the SEC fined Madison Funding, a Chicago-based private fund manager, $900,000 for violations related to the valuation of its private credit portfolio.
During 2020, when the Firm had approximately $3.7 billion in AUM, the SEC found that the Firm priced principal trades with its own underlying funds (the “Funds”) without reasonably determining whether those trades were at fair market value.
Specifically, the Firm originated certain senior loans for private equity sponsors and sold portions of those loans to its underlying Funds, typically after holding them for thirty to sixty days. For valuation purposes, Madison’s practice was to use the par value less the unamortized loan fee as the fair market value and sale price of these recently originated loans.
Yet, between March 2020 and May 2020, at the start of the COVID-19 pandemic and during a period of significant disruption in U.S. financial markets, Madison continued to sell performing loans it had originated before the market disruption at par value less the unamortized loan fee. In doing so, Madison failed to determine the effect of the market disruption on the fair market value of those loans.
Previously, pursuant to a 2021 SEC exam, Madison had voluntarily reimbursed the Funds as compensation for the sale of loans at the purchase price less the unamortized loan fee. Madison also made certain enhancements to its disclosures and policies regarding its loan transfer practices. Nevertheless, the SEC still levied the $900,000 fine as part of its enforcement action.
Background
Per the SEC, Madison offered lending to companies being acquired by private equity firms, primarily to facilitate leveraged buyouts of middle-market companies. The sponsors would provide equity financing, and Madison would provide senior debt financing to facilitate the buyout.
Madison would sell portions of the loans it originated to private funds, including its own underlying Funds. As a general matter, Madison retained approximately 40-50% of the underlying loan, and the remaining portions of each loan were allocated to the Funds in accordance with Madison’s Investment Practices and Allocation Policy.
Madison assigned each loan it underwrote an internal credit rating ranging from “A” to “F,” which helped Madison monitor the overall portfolio based on the performance of the underlying assets. Madison would originate only loans that received a “B” credit rating, meaning that Madison deemed the underlying company a stable and performing business. These ratings were subject to subsequent adjustment by the firm.
During the early days of the 2020 COVID-19 pandemic, the firm issued an update to Fund investors which acknowledged the market disruption and stated that “we anticipate the private credit market could see widening of interest rate spreads, reflecting global instability and the dynamic news cycle . . . In the near term, we do expect a slow-down in private equity transaction volume. Investment banks and potential sellers will likely wait to see how the current macro environment impacts valuations and underlying company performance before transacting.”
Consequently, in response to market uncertainty and increased risk to lenders during the coronavirus pandemic, borrowers, including Madison’s borrowers, paid higher interest rates on any new originations relative to the rates on loans originated earlier in late 2019 and the beginning of 2020.
In response to the market disruption, Madison took steps to increase monitoring of its existing portfolio companies and implemented a day-ahead check to confirm that loans being sold still maintained a “B” credit rating or better according to its proprietary rating system. However, it did not perform other analyses to determine whether the fair market value of those loans declined as a result of the changing market conditions.
All the related loans were subject to downward price pressure, and certain borrowers’ operations were directly affected by market conditions, such as a franchisee of a national fitness center chain that temporarily paused in-person operations. For example, Madison executed 143 sales to the Funds between March 2020 and May 2020 at par value less the unamortized loan fee, without any market adjustments in light of then-current market conditions. For each of these transactions, Madison represented to the Funds’ third-party independent review agent that the price was fair market value based on current market conditions.
While the loans sold during this 2020 period either continued to perform or were fully repaid by the borrowers, Madison failed to determine the effect of the market disruption on the fair market value of those loans at the time of purchase by the Funds.
Principal Transactions
The SEC deemed the Firm’s sales to its underlying Funds as principal transactions. While the Firm’s policies and practices contemplated the use of the third-party review agent, Madison knew that this review agent a) relied on Madison’s certification that the sale was made at fair market value, and b) was not responsible under its agreements with the Funds for making its own independent determination of fair market value.
Salus GRC Takeaways
- Per its 2026 exam priorities, we expect the SEC to continue to focus on private credit managers in both its exam and enforcement initiatives. https://www.sec.gov/newsroom/press-releases/2025-132-sec-division-examinations-announces-2026-priorities
- A firm’s valuation practices, particularly during periods of market stress, will continue to be a cornerstone of SEC examinations.
- While Madison had undertaken substantial remedial efforts to make its Funds whole following its SEC exam findings, these efforts were not sufficient to avoid a referral to the SEC’s Division of Enforcement, nor to avoid a significant fine resulting from the enforcement action.