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The private equity industry faces increasing scrutiny

Improving transparency of equity valuation methods

How will valuation be the cornerstone of private equity industry performance in the future? Discover why the equity valuation methods a firm employs, the objectivity and transparency of its approach, and the ability to stand up to demanding operational due diligence will become increasingly important for organizations.

Valuation and private equity firms: Ready for growing scrutiny?


Recent attention from several quarters has cast a bright light on the private equity (PE) business. From accounting treatments and returns to political rumblings for industry overhaul, the private equity industry has faced the scrutiny of its performance and practices.

Beyond the headlines, private equity’s role across the financial landscape continues to grow. PE deal activity has more than doubled in the past 10 years. Meanwhile, the number of companies listed on US stock exchanges has fallen by 50 percent over two decades.

As private equity industry activity expands, so too does investor and regulator interest in how firms establish the value of their portfolio companies. Valuation—what a company is worth today—is arguably the single most important component of PE financial reporting. And it will remain preeminent as the longest US economic expansion in history continues or, sooner or later, wanes. Transparency into how fund managers establish, govern, and carry out their equity valuation methods will be increasingly important to the spectrum of PE stakeholders for the next several years.

Valuation comes to the fore


As an alternative to public listing, a PE firm provides portfolio companies with needed capital and ownership opportunities. It also delivers the firm’s business experience, insights, and guidance to help those businesses pursue growth.

Further fueling interest in the private equity industry, the US Securities and Exchange Commission has signaled it will seek public comment on whether to lower the $200,000 annual income and $1 million net worth requirements for investors in PE funds. While these changes may be years away, or may not even come to fruition, such consideration acknowledges PE firms’ interest in greater access to retail investors.

Whatever the arc of such a shift, firms would face new disclosure, inspection, and review requirements. And if the investor base expands in this manner, over the next three to five years valuations will likely continue to be the most important metrics of PE performance. How will leading firms be setting them?

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Valuation: A cornerstone of private equity industry performance


PE firms can expect increased scrutiny as they expand their portfolios, pursue returns, and cultivate new investors. Valuation provides a clear measure of how well a firm identifies investment opportunities, recruits investors, elevates portfolio company performance, and, ultimately, delivers value. The equity valuation methods a PE firm employs to arrive at its valuation, the objectivity and transparency of its approach, and the ability to stand up to rigorous operational due diligence will become increasingly important in the next two to three years.

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.

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