Questionable values

Will there be a backlash to third-party valuations in private equity? asks David Snow.

There are two trends unfolding in the finance world that are related but appear to be headed in completely different directions.

From one direction comes a backlash against the rating agencies, which have become one of several sin-eaters among the scattered corpses of the debt market.

Market participants have been shocked, shocked to discover that debt raters did not actually have all the information, resources, judgment and political leverage necessary to ensure that, for example, a triple-A rating was always assigned to a true triple-A security. How could such an important function as risk assessment have been outsourced to agencies that lacked the wherewithal to truly measure risk? How could a vast market for these debt products have been built on ratings that now appear to have got it all wrong?

In another corner of the finance world comes a separate backlash against GP valuations.

This is driven more by an almost unstoppable institutional policy than by collective wisdom. GPs are being told that they really shouldn’t simply hold their fingers to the wind in determining the value of their portfolio companies. Instead they need to turn to standards of fair value accounting in creating their reports to investors. In order to avoid the moral hazard of a GP valuing his own portfolio companies, many are employing outside valuations services to do the measuring for them.

This outsourcing makes sense for many reasons, including the benefit of GPs removing themselves from any accusations that they are gaming the valuation process. But it also raises the possibility that at some point down the line, investors will be stung by “inflated” or “undervalued” interim reporting and shout: “How could you let an outsider place a value on a portfolio that you know best?”

Sadly, it may be more damaging for the GPs to be accused of gaming the valuation system and to be accused to relinquishing this necessary task to underqualified outsiders. The parade of bankers who now claim to be so disappointed in the ratings agencies is testament to the convenience of having a third-party scapegoat.

Just as a CDO issuer can now say, “Don’t look at me – Moody’s gave those babies an Aa3!” a private equity GP may at some point have to say, “Don’t look at me – that billion-dollar value came from a valuation specialist, as per our LPs’ wishes!”