Outsourcing valuation – why and how many?

Michael Athanason, managing director and head of alternative investment valuations, and Federico Jost, managing director, alternative investment valuations of BRG Corporate Finance, analyze the trends driving the rise in portfolio valuation outsourcing.

Mike Athanason

As the alternative investments asset class continues to develop and mature, investment professionals are required to deliver performance that continues to appeal to their investors. Private equity and private real estate funds have delivered returns above those of their listed equivalents for many years and investors’ expectations for continuing these superior returns have pushed them to increase their allocation to alternatives in their efforts to boost returns. Many market observers are concerned that the record amount of dry powder awaiting investment will drive fierce competition for deals and drive asset valuations even higher, at best reducing future returns for LPs and at worst creating asset bubbles. As the burden of regulatory complexity and the high demand of time from deal teams and CFOs creates more demand for outsourcing certain functions to generate cost efficiency, enhance independence and demonstrate transparency. Outsourcing is now a growing trend borne out of necessity and, furthermore is encouraged by investors. It is currently estimated that approximately 12 percent of GPs now fully outsource their valuations, while more than 50 percent hire third-party firms to do positive assurance.

A recent survey presented at the PEI CFOs and COOs Summit in New York showed that approximately 55 percent of CFOs want to decrease the time spent on valuations, yet understand their valuation reporting will increase over time. Also, approximately 94 percent of firms participating in the survey who outsource valuations are satisfied with the product and its quality.

Valuation outsourcing is an industry trend

Outsourcing valuations is increasing, driven by five clearly identifiable trends.

Federico Jost

CFOs seeking operational improvements. Operational improvements often involve hiring staff to work directly in certain areas that require specialization such as valuation. This is usually treated as a manager expense. Outsourcing valuations transfers the cost out of the manager and into the fund. Additionally, smaller funds that lack operational scale and seek to demonstrate best practice should consider partnering with a valuation service provider rather than relying on deal teams that are not trained in financial reporting valuation. This does not eliminate investment professionals’ critical input into the process, rather it backstops and formalizes it.

Managers require high quality valuations. Industry and geographic expertise is an added benefit coming from hiring a capable external provider. Leading third-party valuation firms often sit within a platform that has close ties to industry experts across multiple geographies, allowing these firms to tap into operating expertise and transaction knowledge, adding value to the assumptions going into the valuation models. Also, methodology from external providers tends to be refreshed frequently based on their broad exposure to industry, accounting, tax and deal exposure through their client base. A clear example is the impact of the tax act recently passed by the US Congress which impacts the valuation methodologies and models. There are a large number of technical adjustments being implemented now to correctly value 2017 year-end positions.

Flexibility is key. Having a large number of in-house staff on board to do the valuations has risks, primarily employee turnover. Outsourcing valuations, while maintaining internal oversight, has the benefit of institutional support every period, allowing funds to access valuations on a turnkey basis.

Investor demands. Investors are increasingly demanding valuation governance and segregation of duties when it comes to calculating the fund’s net asset value. Data derived from fundraising activities in 2017 reveals that most investment consultants and placement agents agree that a well-defined set of policies and procedures and an independent valuation process are high-priority concerns for many investors.

Regulatory demands. At the January 2018 PEI CFOs & COOs Summit in New York, panelists discussed the planned increase in the number of SEC examinations and their continuing focus on valuations and expenses. SEC examiners and the Alternative Investment Fund Managers Directive specifically ask whether the manager has an independent valuation committee in place, a formal valuation policies and procedures document and the involvement of a third-party valuation provider, either preparing or reviewing (positive assurance) valuations.

The outsourcing trend has continued beyond private equity sponsors. Limited partners now routinely outsource valuations for their direct investments for many of the same reasons as general partners. Moreover, LPs are now routinely checking valuations provided by GPs in order to maintain an independent view. Many are motivated to seek third-party valuation support in order to gain geographic and industry expertise. Those that rely on quality external valuation firms can rely on a deep and stable bench, mitigate key-man risk and expect a timely delivery of results.

Real estate funds and business development companies have been doing this for years, hiring multiple valuation firms based on geographic footprint, asset type and specialty. Hedge funds have moved beyond their administrators’ management of positions to external specialist valuation providers for their illiquid books. Private equity is following suit – they have embraced independence as a best practice attractive to investors – rather than sticking with internal controls heavily dependent on the investment teams’ inputs and giving them the ability to focus on financial reporting tasks.

One valuation provider is not enough any more

Fund governance often requires an independent valuation agent and there are various reasons why managers should not depend on only one provider and why the trend is clearly moving towards multiple providers.

Depth of perspective: As portfolios can be extensive and expertise is key, most investors with large portfolios tend to have two to three valuation firms for financial reporting valuations. Multiple providers having a diverse client base and transaction experience extends the knowledge network an investor can tap into. Service provider exposure to multiple clients, assets and jurisdictions ensures that evolving best practices are always considered.

Value and quality: Employing multiple service provider is a proven method to ensure that pricing remains competitive with market rates and service quality consistently meets expectations

Gregory Hunt, CFO at Apollo Investment Corporation with $72 billion committed to private equity, said: “A second (or third) valuation provider offers the CFO an ability to compare market pricing ‘keeping providers honest and competitive’ and provides assurance that the fund is paying a market rate.”

Conflicts: When conflicts arise that prevent a service provider from providing a valuation, the CFO can be placed in a tough situation at crunch time – no independent marks and no time to engage a new provider. Having a diversified set of valuation specialists avoids potential disruption.

Outsourcing to multiple service providers appears to be the safest and most efficient solution to fund managers and investors. Management of these relationships must be simple and cost-efficient to be truly worth it. Service providers bring many benefits to the fund managers and investors that otherwise would have to be obtained by increasing headcount and strengthening talent retention incentives, both of these are expensive.