Third-Party Valuation Opinions and Private Equity: A Conversation with Houlihan Lokey Managing Director Cindy Ma –Private Equity Manager

Private Equity Manager reports that with regulators looking over their shoulders, some GPs are playing it safe by hiring third-party valuation advisors to check their numbers. However not all third-party opinions are equal, warns Cindy Ma, managing director at advisory-focused investment bank Houlihan Lokey.  PE Manager’s Nicholas Donato talked with her recently.  Here are excerpts: 

There was a feeling of unease in the industry when the US Securities & Exchange Commission (SEC) announced an informal inquiry into private equity portfolio valuations. Many wonder, how do I stay off regulators’ radar screen?

The SEC has developed a number of analytical tools that now allow them to perform analysis of the investment portfolio. And so if you have a portfolio that is consistently at the top tier among peer groups, or if performance considerably improves just before a fundraise, that’s going to raise some red flags. Another thing is pricing: If you hold investments where the marks have been unchanged from period to period, questions will be asked given the volatile risk. Or if other companies in a portfolio company’s industry are being priced down and yours are going up, that may gain regulators’ attention.

Is it viable to mark fair value at cost of acquisition?

It may be, but not necessarily. If the reporting date is close to the acquisition date, then it should be sufficient so long as you can provide models or market evidence that supports the fair value at cost and can demonstrate no unexpected meaningful changes at the company since acquisition. However as you move further from the acquisition date, it becomes less likely that the fair value would remain at cost. In short, the industry should soon expect auditors to request supporting documents for valuations marked at cost.

Is there any risk in a firm playing it too safe with their numbers?

Most firms get the point that the SEC does not want firms overestimating their performance to impress investors or make fundraising easier. But it goes the other way too. If you’re too conservative in your numbers it might appear suspicious later on if you have to suddenly ratchet up your numbers when marking to market or exiting.

And it can be bad for investors too. Valuations that are too conservative can harm LPs looking to sell their interests in the secondary market. Many investors need to trust the valuations they are provided so that they can assess their allocations, commitments to new funds and other types of financial planning.

Should firms be worried if two funds with the same portfolio company arrive at different valuations for that business? 

Not necessarily. For club deals and similar arrangements it is not unusual for firms to arrive at different valuation conclusions. Different investors may have different views about a company, depending on whether they think the market would view the investment optimistically or pessimistically.

And there are also fundamental reasons why an investment in the same company may be properly valued at different levels. The first is control premium. Perhaps one fund may have more of an ability to influence management, the company’s capital structure, or ability to exit compared to another fund with a smaller interest that cannot capture the value of control. A second reason could be information asymmetry, where perhaps different funds have different levels of access to information which could lead to different valuations.

What might regulators want to see when reviewing a firm’s valuation practices?

There are three common types of valuation opinions: negative assurance, positive assurance, and full valuation.

It’s interesting because the situation private equity funds are in today is similar to the situation hedge funds were in about five years ago. The whole valuation process now needs to become more transparent at private equity firms. And what’s more is that the SEC is concerned about the independence of the parties evaluating valuations. One result is that the SEC is asking much tougher questions. Before they might have asked a firm: Do you have a third party valuing the fund? And if so, they would check the box and move on. But now they might ask what type of valuation opinion is being provided. There are three common types of valuation opinions: negative assurance, positive assurance, and full valuation. And each one has its own pros and cons (see boxout for details) that it may expect firms to consider.

GPs should also consider the documentation of their valuation policies and procedures. They should ask themselves whether or not the valuation method they use is broadly accepted by the industry. They should also make sure they use a consistent methodology used for each asset alongside sufficient supporting documentation.

What kind of costs should a firm expect in going to a third-party valuation advisor?

Depends on the firm, the types of assets they invest in and how big the portfolio is. There are lots of factors to consider, including whether the assets are being valued once a year or once a month. Obviously a discount will apply the more frequently the valuation service is used. And if a firm has very good internal valuation procedures, we can more easily work with them to learn their models and documentation, and that may allow us to reduce our fee.

 Find the full discussion here (free registration required).

Cindy Ma