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How to make sure your private equity valuation withstands scrutiny

 

How to make sure your private equity valuation withstands scrutiny

Feb 06, 2020

Growth in the private equity market continues to make headlines. Private equity deal activity has more than doubled over the past 10 years. PE firms now manage $3.4 trillion in investor commitments worldwide, up from $500 billion in 2000, and companies backed by private equity employ an estimated nine million Americans.

This evolution marks a significant shift in our modern capital markets — one that’s too big for regulators to ignore. The SEC has consistently named valuation practices as a key area of focus, but with the industry’s continued growth, that scrutiny is likely to increase.

Valuations are inherently complex and subjective. And the process of valuing assets gets even more difficult as a portfolio firm’s capital structure becomes more complex. Selecting and applying valuation methodologies, across myriad scenarios and applications, is an ongoing challenge for private equity.

To assist, the AICPA recently released their new accounting and valuation guide for the private equity and venture capital industries. The guide is intended to address the subjectivity associated with valuing illiquid assets and determining fair value.

While the guidance is “non-authoritative” and does not change existing standards, it could become a benchmark by which future valuation efforts are measured. Regulators will likely look to the guidelines as they examine a firm’s valuation procedures, and firms will have a harder time defending a non-standard approach.

Standing up to scrutiny

To avoid extra investor or regulatory scrutiny around valuations, private equity funds should follow several best practices to improve consistency, oversight and transparency:

1. Adopt written valuation policies

Develop written policies to help ensure valuation practices are applied consistently from one valuation to the next. Policies may also address valuation frequency, oversight, how to address potential conflicts of interest, and considerations that outside valuation firms should be using as they conduct valuations on your behalf.

2. Set up an internal pricing committee

When pricing investments, an internal committee (with the appropriate background and skills) should periodically evaluate pricing recommendations and review the accuracy and consistency of pricing methodologies applied over time.

3. Establish an advisory board

An advisory board, comprised of professionals from both inside and outside the firm, can provide additional oversight and support, particularly when conflicts of interest occur. The board should pay close attention to valuation processes in order to advance consistency and transparency.

4. Secure third-party valuations

As private equity firms are pressured to improve their valuation processes, many are turning to third-party valuation providers. This helps alleviate the burden from deal teams and back-office staff who are already pressured to keep pace with the competitive state of the M&A market.

Outsourcing valuations to a third-party firm alleviates some of the workload while having the dual benefit of providing outside perspective and objectivity to the process. Independent valuation professionals can help protect everyone’s interests — both investors’ and the firms’ — by ensuring valuations adhere to GAAP standards and sound industry practices.

Be aware, though, even if you outsource your valuations, your fund manager is still responsible for the fair value determination. So, your team needs to understand how a valuation was arrived at and whether or not your valuation provider is adhering to industry guidelines.

AICPA guide helps standardize the process

You can determine if your firm is following best practices by reviewing the recent AICPA guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies.

The 14-chapter guide is over 600 pages and includes 16 case studies that provide application examples across a range of valuation scenarios. Despite its size, the guide is highly accessible with easy-to-read guidance on a variety of valuation issues.

In addition to the case studies, investment company managers and valuations specialists may find the sections on calibration, back-testing and factors to consider at transaction time to be particularly relevant.

The guide includes background on the industry as well as an FAQ section that users may find to be a helpful starting point.

SEC scrutiny shows signs of increasing

In 2018, the SEC issued its first penalty over valuation in a private-equity secondary sale, fining Veronis Suhler Stevenson for allegedly concealing valuation details from LPs during a deal. Several hedge funds and other private funds have been penalized in recent years over valuation problems.

One such case included a $5 million settlement with Deer Park Road Management Company over valuation inaccuracies. Reportedly, the firm had an unqualified committee overseeing valuations.

More recently, the SEC charged SBB Research Group with a complaint stating that executives misled investors by using an internal valuation method that artificially inflated the value of structured notes. Other charges are also pending against West Mountain, LLC for allegedly overvaluing assets relating to investments in two privately held companies.

Overall, private equity firms can expect greater scrutiny as they secure new investors and expand their portfolios. Consistency, objectivity, transparency and the ability to stand up to rigorous examination must become a vital part of operations. 

How Wipfli can help

In addition to valuation services, Wipfli provides independent, cost-effective solutions for private equity firms in the middle market.

Visit our web page for more information on how we can assist you.

Or to learn more, check out these articles:

How to value your business

Why a private equity backed company should leverage data analytics tools — and how

How do the new revenue recognition standards affect private equity funds?

Author(s)

Lisa Cribben
Lisa M. Cribben, CPA/ABV, ASA, CMA
Partner, Business Valuation and Transaction Support Services
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