Private Equity Trends: Valuation’s Rising Role in PE’s Drive for Deals

By: John Czapla

(Estimated reading time: 3 minutes 30 seconds)

The article in brief:

  • Traditionally, private equity firms rely heavily on the involvement of their deal teams to conduct investment valuations.
  • An excess of private equity dry powder means deal competition is heating up, leaving less time for deal teams to focus on financial reporting due diligence.
  • With audit season on the horizon, valuation scrutiny will become a critical, top-of-mind issue for PE firms.
Private Debt Dry Powder Trends, 2008 to 2018
Source: Preqin Ltd. Dry Powder Statistics

Private equity dry powder in 2018 has continued its climb to record levels, bolstered by sustained economic growth, historically low interest rates, deal financing from a supportive credit market, and abundant fundraising opportunities. In the face of this growth, PE firms find themselves grappling with an abundance of capital to find and deploy in a market where competition has never been greater.

Recent market reports and PE client surveys all point to an industry victimized by its own fundraising success, as firms flush with fresh capital struggle to strategically and creatively gain a competitive edge.

Valuation is one area in which we are already experiencing this shift.

Outsourcing Trends, Then

Private equity firms tend to rely heavily on the involvement of their deal teams to conduct investment valuations, considering they are closest to the intrinsic value of their investments. A shift in recent years resulting from the massive push for transparency and enhanced governance around valuations, firms began to involve external valuation specialists alongside internally conducted analyses. The partnership with an independent valuation firm, however, tended to focus on the valuation in connection with a particular transaction or issue within a portfolio company.

Outsourcing Trends, Now

We are now seeing a new trend emerge as our PE clients weigh the opportunity cost of asking deal professionals to focus the valuation work versus dealmaking. As a result, firms have begun to engage with independent valuation experts specializing in portfolio valuation and alternative, illiquid assets for fund level analyses and financial reporting requirements.

Fund managers are choosing between two distinct paths in this partnership:

  1. An entirely outsourced portfolio valuation engagement, or alternatively,
  2. Positive assurance

As one fund manager describes it, “Using a third party [valuation firm] is a little like using the navigation unit in your car – once it becomes part of your process, it is hard to live without.”

Another key reason fund managers are relying more heavily on a third party valuation firm is for the purpose of managing investor reporting requirements that must be completed on a periodic basis (e.g. quarterly or semi-annually.) Investors have come to expect transparency into valuation estimates including information on methodologies, key market inputs, valuation models, and accurate markets for performance measurements (e.g. unrealized gains.)

This topic is especially pressing for limited partners and asset managers who focus heavily on non-traded, illiquid assets, which can be difficult to value and can have a material impact on reported figures.

LP’s major concerns are that erroneous valuation can lead to overpayment of management fees, an inappropriate asset allocation mix, inaccurate performance measurements, and inaccurate prices. Obtaining positive assurances on performance measurements is the leading interest of a PE fund investor – particularly considering record fundraising levels – they demand assurances on accurate fund returns and values to be determined on a frequent basis to set prices before buying into or exiting PE funds.

"Using a third party [valuation firm] is a little like using the navigation unit in your car - once it becomes part of your process, it is hard to live without."

Audit Season Is Coming

While price remains a consideration, the quality, timeliness, and internal staff’s ability to focus on their dealmaking pursuits have presented the most compelling reasons to hire an outside firm.

Additionally, audit season is in the near view and, undeniably, valuation scrutiny will be top of the priority list for all auditors. They will demand more and more detailed support of figures used in financial statements, including valuation estimates for a fund’s assets as reported under GAAP ASC 820 fair value measurements, along with documented support for the various “red flag” inputs such as EBITDA adjustment levels. Fund clients know they need to spend much more time and effort providing this support to receive auditor sign off on their asset values.

Benefits of External Valuation Support

Given the existing competitive deal environment, it is difficult to deny the benefits presented when leveraging an external resource to focus on delivery of a well-documented, consistent value conclusion and, in turn, allow the deal team to focus on finding and making deals.

With capital stores nearly bursting at the seams and constant pressures surrounding valuation practices, private equity firms need to balance their resources to the most efficient end. It is mission critical for PE fund managers to focus and balance resources toward valuation-related work at the cost of resource allocation to dealmaking-related work.

A third party firm can provide an independent perspective because they are not vested in the ultimate valuation conclusion. Dedicated valuation firms see many securities and companies across numerous industries as opposed to an internal investment team who may only perform a few valuations per year.

PE firms have begun to engage with independent valuation experts specializing in portfolio valuation and alternative, illiquid assets for fund level analyses and financial reporting requirements.

Also, valuation firms often have access to databases as well as their own vast proprietary data sets. Valuation firms generally have large teams with diverse experiences and, when there is a gray area, can tap professionals with the specific knowledge to help with critical judgment.

On behalf of the private equity fund, an external valuation firm will also stand up to questioning around derived valuations by auditors, boards of directors, or even the SEC, rather than requiring the fund’s employees to do so.

Most often, the realized value is cost savings from efficiency and more effective staff utilization. Investment professionals focus on higher margin investing. Private equity funds can reduce time spent on lengthy audits and reduce the potential for litigation over disputed measurements when the cumbersome valuation process is outsourced.

For an in-depth conversation on how VRC’s portfolio valuation practice team can work with your private equity firm, we welcome you to contact article author, John Czapla, or your VRC professional.