Ask any GP, and they’ll argue that no third-party valuation expert knows more about a given portfolio investment than they do. After all, who did more due diligence on an asset than the firm that bet its capital and reputation on it? And in a world of fee compression, no investment manager is looking to increase their costs at the fund level by paying for a second opinion.
Such costs may not be negotiable for much longer.
LPs are demanding greater rigor in valuations, due to their increasing sophistication and their own regulatory pressure. Today’s third-party experts can offer greater independence and robust regulatory expertise, though GPs need to find a service provider with experience and capabilities tailored to their asset class and their own investment focus.
Some investment managers have already embraced the practice. “They are a necessary stepping stone in the world of transparency,” says Ronald Dickerman, president of real estate private equity firm Madison International Realty. “As we continue to launch funds and raise larger amounts of money with more institutional investors around the world, it’s become more expected to utilize some third-party valuation benchmark.”
Until recently, it was common that private equity real estate firms might use outside valuation experts every two or three years, but now, industry participants might use third-party valuations annually, and for certain special situation vehicles, such as open-ended funds, quarterly.
Private equity and infrastructure funds won’t use them that often, but independent valuations are on the rise across the alternative asset universe, driven most often by investor request.
That change of heart among institutional investors may be rooted in their experience in the hedge fund industry, according to several market participants. “Open-ended hedge funds have been using them for a decade,” says Chris Franzek of valuation firm Duff & Phelps. “And as they increase their operational due diligence into private equity, they think the use of outside valuation experts makes sense for a GP that may have their money for almost a decade.”
The secondaries market also feeds the need for rigor. “Investors are more frequently buying and selling their LP interests and valuation is critical in determining the value of the underlying investments held in a fund, which ultimately supports the net asset value price transacted by the investor,” says Cindy Ma of Houlihan Lokey, a financial advisory firm which provides valuation services. Perhaps the biggest driver for third-party valuations is the same thing that keeps GPs up at night: regulatory scrutiny.
“LPs today are obligated to take a harder look at the data they receive from GPs for a range of reasons, including statutory requirements and evolving industry standards,” says Jennifer Choi, the managing director of industry affairs at ILPA. “For instance, the Securities and Exchange Commission has brought valuations into sharper focus, including the question of whether methodologies are appropriately disclosed and reviewed.”
With the recent release of Government Accounting Standards Board Rule 72, public plans are now faced with complying with a fair value measurement standard for their investments. “The new rule broaches the question of whether LPs from state and local governments following GASB 72 can accept the NAV from GPs without having to form an opinion on whether those valuations conform to the GP’s stated valuation policy,” says Choi. “Meeting such a standard could prove difficult for organizations with limited resources or inconsistent access to the underlying metrics to inform those valuations.”
No doubt this can make third-party validation of valuations an attractive facet of a GP’s operations. In lieu of hiring their own experts, those valuations can help inform their judgement.
Cost and competence
It may be tempting for a GP to select a valuation firm on the basis of cost alone, but every market participant we spoke with cautioned against it. Valuations have become their own discipline, which means there’s a growth of new, untested service providers and new complexities to manage.
So, what value does the best kind of third party bring?
For one, there’s real regulatory expertise. The number of audit boards and regulators investigating valuation practices is only multiplying. “From the SEC to regulators in Europe, Asia and South America, valuation is top of mind,” says Franzek. “So it’s a matter of staying atop what’s new, what matters most today and what the view is going forward.”
Franzek recalls working with a global regulator in discussions over codifying the use of a third-party valuation firm. “They were exploring the option, based on what they were seeing from the Alternative Investment Fund Managers Directive in Europe, so it’s useful to know that’s on the table as a possibility.”
A few industry conferences may not be enough for the in-house team to stay informed of the broader audit and regulatory landscape that governs every valuation. The right expert can offer that kind of knowledge, along with the kind that might not be as welcome: independence.
“Private equity firms may have their own valuation bias,” says Ma. “They may be too conservative or too aggressive in their valuation, which would result in an over-allocation or under-allocation, respectively, of investment in a particular industry sector within an investor’s own asset and risk diversification strategy.” With a growing secondaries market, such bias matters more to LPs looking to accurately value their holdings on a more regular basis.
Regulatory scrutiny also finds auditors happy to have their work vetted by an “independent” third party. “Internationally, this is less the case, but in the wake of [US anti-fraudulent accounting law] Sarbanes Oxley, the big four accounting [firms] are increasingly working through independence issues and we can help them help their clients,” says Franzek. Even if the auditors are happy with their involvement, valuation experts can clash with deal teams.
“A valuation firm shouldn’t be a rubber stamp,” says Franzek. “Deal guys can bluff, and we challenge that, but they respect us for enforcing best practices.”
Besides a willingness to be contrary, what should managers be looking for in a valuation expert to make them worth the cost? Real estate, private equity, secondaries and infrastructure all have their own unique issues in selecting a third party, but there are some general issues that are relevant to all.
Contrary to popular belief
As with any service provider, turnover is a concern. It can be time-consuming to get new people from an outside firm up to speed with the unique elements of a given portfolio investment. “Look at the efficacy of the platform and the stability of the people you interact with,” says Dickerman. “You want to choose service providers on their demonstrated track record of retaining talent and delivering quality work product, but there will always be a bit of musical chairs.” Most experts suggest a good, not great, record of keeping talent will suffice.
Having a senior point of contact at the service provider can help limit the impact of this. It’s important that the valuation firm be willing to have an experienced staffer to manage the relationship, and be responsible for getting lower-tier valuation staff updated with the account.
One GP who interviewed a slew of third-party experts couldn’t get comfortable with the junior valuation staff, admitting it was hard to tell if they were the firm’s A-team or not. Senior members of staff lend the stability and institutional knowledge that can help make a third party feel like an extension of the back office.
Lastly, the valuation firms should introduce at least some procedures that contradict current practices. “Almost 99 percent think they’re in the top 10 percent in terms of best practices, but that’s not possible,” says Franzek. Again, the contrarian service provider might be the one worth their fee.
That’s not to say there isn’t room for collaboration. Every valuation expert we spoke with admitted that, yes, the deal team knows more about any portfolio investment than they do. Instead, they see themselves as bringing broader industry expertise to the process. “For example, we might see 500 to 600 portfolio investments in the energy space every quarter, so we bring that knowledge to the valuation at hand,” says Franzek.
In this way, the third-party expert knows the forest from the trees, and the conversation results in a perspective that understands both the investment and its broader context. The argument is never that the GP’s opinion is wrong, but that in today’s world, every number needs to be checked twice. ?
PE valuations: know thy sector
For private equity GPs looking to hire valuation firms, they should find experts that have serviced private equity firms of similar size and industry focus. “When we perform valuations in energy, healthcare or technology, we consult with our own industry experts actively doing both transactions and valuation work in those areas,” says Ma.
Market participants suggest if the choice is between a valuation firm with sector experience and one that’s serviced a similar-sized fund, the former should win.
However, at times there is complexity at the fund level that may inform valuations and the service provider should be comfortable with that task. One GP avoided third-party experts precisely due to the complex nature of their fund structure.
Infrastructure: experience is an asset
In an ideal situation, the third party conducting infrastructure valuations will have had some experience in the sector. “If you’re investing in energy assets, you need someone with experience in long- term power purchase agreements and other idiosyncratic value drivers,” says Franzek.
Geography is not key. One valuation expert suggests someone with experience in airports should be chosen to evaluate Heathrow, rather than a local UK firm with no such expertise.
Each kind of infrastructure asset has its own set of circumstances to evaluate. However, firms should bear in mind that valuations are relatively new to this asset class so there may not be a host of providers to choose from.
Secondaries: two steps removed
While the criteria for hiring a secondaries valuation expert are the same as private equity, third-party valuations of secondaries funds are not common, as most managers rely on net asset values they receive from their underlying GPs to tabulate their own valuations. However, firms may engage a third party to perform periodic reviews on specific assets.
A major challenge to conducting valuations is whether the auditor can obtain accurate information from portfolio companies on a timely basis. As secondaries funds typically hold fund stakes, whether the managers of the underlying funds are willing to share information about the assets is a key question. “Ultimately, the level of the deep dive depends on the GP and what kind of information they’re willing to share,” Ma says.
Real estate: seek a sound structure
For private equity real estate firms looking at third-party experts, it’s key that the appraisals are conducted by local firms, even if that means foregoing larger, global entities. “There are not many global valuation firms, but more funds are investing globally,” says Franzek.
However, steep fines can be levied if firms don’t have local licenses to make such appraisals. “Not infrequently, the local firm will know the market better than a national or global firm will,” Franzek adds.
On the other hand, while the appraisals should be done locally, the firm may still need a larger firm to translate those appraisals into relevant valuations.