Estimated reading time: 3 minutes

The article in brief:

• PE firms are increasingly using external valuation specialists at the fund level, driven by factors such as resource constraints, best practices, and auditor encouragement.
• The use of external valuation specialists can provide a more defensible valuation process, improve transparency, and bring confidence to the valuation process, which is particularly important for institutional limited partners.
• There is no standardized approach to using external valuation specialists, and the valuation approaches and results are highly customizable based on the specific needs and preferences of the private equity firm.

The use of external valuation specialists at the fund level is becoming more prevalent—and, in many cases, more formalized—in the private equity space, consistent with the established practices of the private credit industry. PE firms historically have been reluctant to outsource limited partner (LP) fund valuations, partly because they are so closely tied to portfolio companies with respect to understanding of their business, the subjectivity in the valuation and cost. 

Whether it’s a fairness opinion for a transaction or a formal Section 409a-driven valuation of a portfolio company related to a deferred compensation plan, PE firms have traditionally used an external valuation specialist at the portfolio company level. But for many of them, that’s still the full extent of their use of outside valuation professionals.  

For several reasons, however, more and more general partners (GPs) are embracing outside valuation specialists at the fund level as part of their regular fund valuation process: 

• Resource Constraints With the explosive growth in private capital fundraising, some PE firms are finding it challenging to maintain internal valuation capabilities, leading to an increased reliance on outside valuation specialists. We’ve seen this on both ends of the spectrum in terms of fund size, where major multibillion-dollar fund sponsors have trouble growing their internal valuation capability to match their fundraising prowess and small start-up funds with just a few portfolio companies can’t justify the expense of standing up an internal valuation team, so they outsource the job entirely.  

• Best Practices The AICPA Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (PE/VC Guide), provides a framework for PE and venture funds that generally includes a role for third-party opinions and has been influential for many funds. 

• Auditor Encouragement Fund auditors are increasingly encouraging clients to seek third-party valuation specialists as they can bring a depth of knowledge particularly when considering the PE/VC Guide and the growing complexities of PE transactions, which includes an increase in GP-led secondary transactions, dividend recaps, and rollups. The use of external valuation specialists can lead to more defensible valuations. 

• LP Pressure Institutional LPs, especially lead LPs in new funds, are requiring regular third-party valuation assessment of internal marks, and the demand for GP transparency is growing. Internal valuations can lack independence, especially if conducted by the same team making the investment decision. Third-party valuation specialists can provide an independent opinion, improve valuation policies, and bring confidence to the valuation process. While the International Limited Partners Association has not sought to impose a strict requirement for regular valuation processes, it has generally encouraged the use of third-party valuation specialists and has been especially vocal about the desirability of third-party fairness opinions in the context of GP-led secondaries. 

• Fundraising Advantage In a crowded and professionalized marketplace, funds are leveraging their operational practices, including valuation approaches, as a differentiator in capital raising programs.  

The different tactics to approaching PE firm external valuations

There is no standardized approach in the use of external valuation specialists in terms of processes, frequency or methodology. Rather, the valuation approaches and results are highly customizable based on the specific needs and preferences of the PE firm.  

GPs with their own internal valuation teams might seek positive assurance on their own marks on a quarterly or annual basis, while funds with limited internal resources might engage a specialist to fair value the entire investment portfolio at year-end, or investments in the fund more frequently. 

Similarly, valuation methodologies vary. While internal valuation teams rely almost exclusively on market-based approaches, including revenue and EBITDA multiples, external valuation specialists are more likely to use multiple methodologies, both market and income based approaches, to calculate and corroborate fair value. 

Summary

We are seeing a notable increase in private equity funds seeking external valuation specialists on investment values across their portfolios, and as outlined herein, the shift is being driven by a range of factors. VRC’s team has extensive experience in providing valuation services to private equity funds and can help you navigate the complexities of outside opinions on asset values. If you would like to learn more about how we can assist you, we welcome you to contact any of the article authors or Contact Us with general details about your next valuation engagement requirements.