Redundant Independent Valuations

Here's another insightful article on private equity valuations from Rudi Prozesky.

Private equity funds invest in difficult-to-value investments, otherwise known as Level 3 investments. Investment Managers of private equity firms experience great headaches every year valuing these portfolio companies for financial reporting purposes, and even greater headaches trying to persuade the auditors that these valuations are reasonable.

Private equity funds try to provide the auditors with easy to audit, neatly packaged investment valuations. Auditors, however, often tell me that while private equity firms are capable of doing the calculations, their calculations are usually incomplete and lack sufficient support for the auditors to sign off on an opinion.

To solve this problem, Investment Managers often obtain independent investment valuations from outside valuation experts. This process, however, results in a duplication of tasks between the private equity firm and the valuation firm. Most of these tasks are redundant when all the Investment Managers really need is some help with improving their own valuations and putting it all together in a robust and tailored valuation support package for the auditors.

Helping the Auditors Gain Comfort with Level 3 Investments

Independent opinions provided by external valuation firms are valuable, but there is a less costly, and even more effective approach. By looking at the prominent reasons why independent valuations are usually obtained, we can identify only the outcomes that private equity firms require and find a more effective alternative.

There are two main reasons why private equity firms obtain independent valuations from outside valuation firms:

The first reason is that GPs expect an independent valuation to be more credible to auditors than their own valuation because it comes from an independent party. I say "expect" because this notion is only partly true. The truth is that auditors consider any Level 3 investment valuation to contain significant risks of material misstatement, irrespective of who prepared them. Therefore these valuations are almost always audited to death. The auditors could even consider the risk of material misstatement in an independent valuation to be higher, because the valuation firm usually knows less about the investments than the private equity fund's own investment advisors. This can result in even more audit procedures, which results in greater audit costs.
The second reason is that an independent valuation report contains ample valuation support for the auditors. External valuation firms know how to provide well-documented support for their calculations, assumptions and inputs used. This is worth its weight in gold, but it also costs an arm and a leg. When preparing independent opinions, valuation firms are required to start from scratch and do all their work un-influenced. In the process, a lot of tasks are duplicated between the valuation firm and the private equity firm's investment advisors.

the solution for private equity firms is to request only value-added services from external valuation experts

A More Effective Solution

Is there a way to obtain higher quality support for valuations without having an independent appraiser duplicate the tasks already performed by the private equity firm? Could the knowledge of the private equity firm's in-house staff be combined with that of external valuation experts to prepare higher quality and well supported valuations? I believe so.

Rather than obtaining independent valuation opinions, the solution for private equity firms is to request only value-added services from external valuation experts. Valuation firms can provide consulting services or loaned staff arrangements. For both of these options, the private equity firm retains ultimate responsibility for the valuations, but can tap the brains, experience, and resources of the external valuation experts. Under such arrangements, the private equity firm and the external valuator can work together to ensure that the private equity fund provides the auditors with a neat and tidy, audit-friendly valuation package.

Ask your valuation firm about this alternative approach, and the best way to structure such a service.

In the next article, we will look at exactly which value-added services private equity funds should request from external valuation experts to supplement their in-house work.