Last month, we broke news that Oppenheimer & Co.’s private equity team had spun out into an independent firm called Roc Resources. Just two weeks later, the WSJ reported that Oppenheimer was under investigation by the SEC and other government agencies for inappropriately changing the valuation of one of its investments, perhaps to make a new Roc-branded fund more attractive to prospective investors.

Upon first hearing about the investigation, I wondered four things: (1) Was the underlying accusation legitimate? (2) Where were the outside auditors? (3) Why would Oppenheimer (OPY) have allowed the group to spin out while it was under federal investigation? (4) How has all of this affected fundraising for Roc Resources?

So I’ve done some digging and uncovered some, albeit not all, of the answers. What follows is based on numerous interviews, including with former members of the Oppenheimer private equity team, a series of internal emails and investor documents. None of those interviewed were willing to be named. Oppenheimer itself declined comment, as did Brian Williamson (former alternatives boss at Oppenheimer, and current head of Roc Resources).

For the uninitiated, Oppenheimer’s private equity unit primarily focused on energy and energy-related investments. This included a fund-of-funds that committed to invest a total of $7 million into a special purpose vehicle for holding shares in SC Fondul Proprietatea SA, a closed-end Romanian fund that owned “minority stakes in most Romanian energy and infrastructure companies.” At the time, Fondul was trading OTC (it would later list in Bucharest).

In October 2009, Oppenheimer sent its fund-of-funds investors a quarterly report through the end of Q2. It reported the Fondul investment at cost, which was how it was valued by the underlying manager (private equity firm Cartesian Capital). This worked out to a net asset value of just over $6 million. In a footnote, Oppenheimer said that “Net Asset Values are based on the underlying managers’ estimated values as of June 30, 2009.”

From the document:

By November, however, Oppenheimer was distributing marketing materials to prospective investors that painted a very different picture. Fondul’s net asset value suddenly was $9.27 million through the end of Q2. Oppenheimer arrived at this figure by valuing the investment at par, without amending its footnote about basing NAV on “the underlying managers’ estimated values.” To be clear, the underlying manager was still valuing at cost.

From the document:

The change increased the fund’s overall net IRR from -6.3% to +38.3%. Investigators reportedly are most concerned about the misleading footnote and if “at par” should have ever been accepted by auditors, but I’d think the existence of two sets of books – for the exact same period – is even more troubling.

So how did this happen? Well, it seems that Oppenheimer’s private equity group only used an outside auditor (Rothstein Kass) for year-end reports. As such, it was free to change its valuations through the year as it saw fit, so long as they were reconciled by December 31. Not surprisingly, the year-end report for existing investors marked Fondul at par.

Once authorities began investigating in mid-2011, a campaign of finger-pointing began inside of Oppenheimer. Group head Brian Williamson allegedly told colleagues that the mark-up had been the work of a former employee who later was terminated, and that the ex-employee had turned whistle-blower in an effort to exact revenge. The only problem, however, is that the ex-employee wasn’t yet working at Oppenheimer when the mark-up occurred.

From an email sent by another former group employee, to Oppenheimer deputy general counsel Jack McGuire in July 2011:

“At this point, I am troubled from my personal opinion, and belief in practicing the highest standard of care for our clients, that the OGR marketing materials and/or financial statements may have potentially been misleading to investors. Further, during the meeting [with Williamson and a colleague], I was told that my cooperation… was to be kept secret. That it was inferred not to be shared with others within our team or anybody else at Oppenheimer, implying that others could not be trusted. This has put me in a difficult situation, as I understand there is currently an investigation pertaining to a recent inquiry regarding the valuation of Fondul – an investigation in which I prefer not to interfere… I wish to be loyal to Oppenheimer, preserve my integrity and respect the investigation process, yet I fear that my desire to abstain from interfering may lead to retaliation from Brian.”

By the time that Williamson formed Roc Resources at the beginning of 2012, at least seven Oppenheimer employees related to the private equity group had resigned. Another would join Roc Resources, but leave shortly thereafter.

The spin-out had been in the works for several months (if not longer), and Oppenheimer apparently did not believe that the ongoing investigation was reason to prevent it from happening. The firm had done its own internal investigation, determined everything was on the up-and-up and let Williamson move forward. In fact, it continued having its advisors pitch a new Oppenheimer/Roc fund to its clients.

Fundraising for Drilling Partners began prior to the spinout, but was suspended when the SEC investigation began last summer. It then resumed, and secured around $40 million of its $200 million target (investors were informed of the SEC issue). A second close was scheduled for this month, but was delayed once the WSJ story was published. No word yet on when (or if) that second close will occur.

What’s important to understand here is that Oppenheimer continues to maintain a very close relationship with Roc. This is no arms-length spinout. Drilling Partners charges a 2/20 structure, plus another 2% of any oil royalties from underlying investments. If Oppenheimer brings in an LP via its adviser network, it receives 70% of the management fee and 50% of the carry. All of the oil royalties remain with Roc.

I cannot, for the life of me, understand why Oppenheimer didn’t either delay the spinout or cut its ties with Roc – pending the outcome of federal and state investigations. Conducting an in-house analysis is fine, but doing things in-house (like valuations) is kind of what got them into this mess in the first place. Moreover, Oppenheimer had to know what would happen when an outlet like WSJ got their hands on this. Was it simply hoping to get that second close done before news leaked?

Again, Oppenheimer isn’t commenting. Not certain if it feels the mark-up was an honest mistake, or not a mistake at all.

“That’s what I’ve been wrestling with since last summer,” a former employee tells me of the mistake vs. deception question. “Either way, it shouldn’t have happened and it really blew up the entire group. I’m glad I’m not there anymore.”

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