A range of valuation approaches for PE fund

Through the years, equity valuation methods have undergone many queries regarding the modeling of PE investments for valuation purposes. While audit reports for publicly traded companies must comply with standards set by the Public Company Accounting Oversight Board, no such strictures exist for private company valuation.

Without such requirements, PE firms value their investments in various ways:

• The guideline public company (GPC) method values similar companies using financial metrics such as price-to-earnings and price-to-book ratios.T
• he discounted cash flow (DCF) takes a more forward-looking, subjective view in which valuation is assigned based on the company's expectations for business growth.
• Comparable transaction is commonly used to value companies that are M&A targets and examines transactions that involve companies with similar business models to that of the target.

Firms can also employ a combination of these and/or other equity valuation methods. For example, GPC, DCF, and comparable transaction could be calculated, with each assigned a 33 percent weighted value.

An overarching consideration for firms in setting valuations is the need and stakeholder expectation for firms to apply a consistent process, period after period. This approach presumes that the outcome shouldn't be a predetermined number. Instead, if the process is solid, the number is simply the number.

For PE firms wanting to strengthen their value processes, help is on the way. In August 2019, the Association of International Certified Professional Accountants announced the release of its new guide. Although this is a nonauthoritative document, the guide does provide a framework of acceptable practices for valuing PE investments. Adherence to these protocols could serve a company well when, for example, a fund's limited b1 seeks assurance that valuations are well-founded rather than the product of a cursory drive-by analysis.

Benefits of and barriers to third-party valuation

Publicly traded companies are hyperaware of the need to accurately value their third-level assets that are illiquid and difficult to assess, including PE investments. Since level three assets can be major balance sheet items, income generators, and carried interest sources, public companies want to avoid any suggestion or appearance to investors that valuations are being manipulated. For that reason, they routinely outsource valuation to a third party, in some cases alternating the work between multiple providers to strengthen confidence in the numbers.

In contrast, PE firms rarely seek such outside support. The contrast is somewhat ironic, in that public companies are compelled to keep valuations in line because of regulatory requirements, while private firms, which face no such demands, might benefit from the third-party view. That said, the typically high percentage of PE investors that stay with a firm as it rotates from fund to fund reduces the urgency for fresh valuations.

The importance of operational due diligence

Potential and current limited b1s could pose several operational questions when conducting their due diligence on a potential PE investment. What are the firm's valuation policies? Does it conform to industry practice and literature? Does it employ a third-party administrator for accounting services? Does it hire an outside firm to help conduct valuations?

How private equity industry leaders answer these questions can be a key factor in earning and maintaining the confidence of limited b1s and portfolio company operators over the life of a fund.