In-House Portfolio Valuations: Is the Reward Worth the Risk?

In-House Portfolio Valuations: Is the Reward Worth the Risk?

March 21, 2022

Portfolio Valuations Under a Microscope

After the global financial crisis, the introduction of Dodd-Frank and new fair value accounting regulations made it more difficult for banks to lend money. In addition, private equity firms shifted their focus to distressed companies and consolidation opportunities, leaving a lending gap for small and mid-sized companies. Business development companies (BDCs) and other non-bank lenders stepped in to fill the void. In the ensuing years, these BDCs and non-bank lenders flourished in a receptive U.S. economy by providing capital to small and mid-sized companies.

Typically, BDCs and non-bank lenders raise money through public funding, which in turn creates more demand for transparency from both investors and government regulators, such as the SEC. In fact, there are numerous examples of companies that have been formally cited by the SEC for making unreasonable assumptions when valuing their own assets. These companies have been subject to warnings or action letters, fines, and in extreme cases, criminal action. In addition to the repercussions stemming from a formal punishment, the damage to a company’s reputation after a negative SEC interaction can potentially be catastrophic.

Case in point: In one case, the SEC found that the BDC materially overstated the values of its interest in certain portfolio companies in reports filed with the SEC. Moreover, the SEC found that the BDC misrepresented its valuation policies in filings with the SEC and had deficient internal accounting controls. Among other things, the CEO of the BDC was found to have failed to properly implement the BDC’s valuation policies.1

BDCs and non-bank lenders continue to feel pressure to prove that they’ve fulfilled their regulatory responsibilities regarding fair valuation and have acted in good faith by the Board of Directors, especially when Level 3 investments are in play. Specifically, there are new SEC rules (2a-5 and 31a-4) that have been published and became effective on March 8, 2021, to help ensure that they are complying. 

  • Rule 2a-5 requires the performance of certain functions in order to determine in good faith the fair value of a fund’s investments. These functions include a periodic assessment of material risks associated with valuation methodologies and oversight.
  • Rule 31a-4 requires funds or their advisers to maintain appropriate documentation to support the valuation process and fair value conclusions.

As SEC-registered ‘40 Act funds with quarterly reporting requirements and portfolios that can include a majority of illiquid private securities, performing valuations can be challenging due to the fundamental fact that there is no market that exists for these assets. Still, the audit process does not offer any relief for this extra layer of difficulty and includes an exhaustive review of the data, valuation inputs, controls, and judgments that have been used to arrive at the final valuation outcome. In short, there’s a lot at stake when conducting a portfolio valuation, but even more so when it comes to valuing Level 3 investments in house. In fact, many of the issues that BDCs and other non-bank lenders face when doing in-house valuations extend to privately held equity investment managers.

Risks of Doing In-House Valuations

All asset managers need to take steps to ensure that they have established written policies and procedures to determine the fair value of its holdings, including:

  • Creating and following independent valuation policies and procedures.
  • Consistently applying the appropriate approach as documented and disclosed to investors.
  • Following industry best practices and practice guides.
  • Using the most relevant and reliable inputs.
  • Documenting each approach and the inputs used, especially if a change of approach or inputs was determined to be warranted.
  • Establishing a process of quality control to reduce the risk of error.
  • Regularly testing internal valuation models and model inputs and comparing them to recent market transactions and sales to determine reasonableness.
  • Regularly testing third-party valuations and comparing them to recent market transactions and sales to determine reasonableness.
  • Establishing Valuation Committee/Board of Directors oversight and review of the valuation methodologies and calculations used.

Even if asset managers are able to establish such a comprehensive process for conducting their portfolio valuations internally, they still need to address several significant considerations that are inherent with this course of action. These include the following:

  • Lack of Transparency Creates a Negative Public Perception
    Managers that keep their valuations in house leave themselves open for skepticism from wary stakeholders and to questions about potential conflicts of interest.
  • Diminished Investor Confidence
    Potential investors who are unknowing or dubious about internal methodologies/objectives are less likely to become actual investors.
  • Strain on Internal Resources
    Taking investment teams away from their money-management duties in order to focus on portfolio valuations is an impractical and unproductive use of resources.
  • Multiple Rounds of the Audit Process
    The portfolio valuation audit process can be lengthy, which diverts employee focus/productivity over a sustained period.
  • Inability to Meet Timelines/Turnarounds
    For public companies, valuations are often performed quarterly. Many privately held companies are ill equipped to adequately meet these deadlines.

As a result of these issues, in-house portfolio valuations face increased scrutiny from all parties, including:

Auditors who check:

  • The consistency of methodologies throughout the entire valuation process
  • The accuracy of calculations
  • The credibility of judgments and assumptions

Investors who are looking for as much transparency as possible.

The SEC, who could perform an audit of the valuation as part of a routine exam, an industry-specific sweep, or as the result of an investor complaint.

The Public Company Accounting Oversight Board (PCAOB)

Adding to this dynamic is the existence of The Public Company Accounting Oversight Board (PCAOB), which oversees the audits of public companies in the name of investors and the public interest. The PCAOB essentially audits the performance of the auditors, which in turn only intensifies the level of scrutiny applied by these same auditors during the portfolio valuation process.

The fact is, there are a lot of interested parties and a lot at stake when a portfolio valuation is conducted. When companies weigh the pros and cons of conducting these valuations internally, it becomes clear that the potential pitfalls are significant. In order to avoid this downside, portfolio companies have started outsourcing their valuations to third-party providers.

The Upside of Outsourcing

Utilizing a third-party valuation advisor eliminates virtually all of the issues that arise when conducting portfolio valuations internally, as noted in the chart below.

In-House Portfolio Valuation Risk

How Outsourcing Solves for the Risk

Lack of Transparency

Partnering with an independent valuation firm increases the legitimacy of the process and removes any potential conflict-of-interest questions and builds trust for investors.

Diminished investor confidence

Strain on internal resources

A third-party provider allows investment teams to focus on investment management and frees them from the rigors of the audit process.

Multiple rounds of the audit

Inability to meet timelines/turnarounds

A capable third-party provider will be able to meet any timeline necessary on a recurring basis (quarterly, monthly, semi-annually, etc.).

In addition, one of the primary advantages of outsourcing portfolio valuations to a capable third-party provider — one who stays abreast of the latest regulations and industry methodologies — is the knowledge that they will utilize best practices throughout the valuation process. This helps financial managers in several critical areas:

  • Relieves managers and internal teams from the burden of keeping up with regulatory and industry changes.
  • Increases the chance for an efficient and successful outcome.
  • Auditors are receptive to third-party providers in that they expect industry-standard best practices to be utilized.

The Elephant in the Room: Cost

Some asset managers may consider conducting portfolio valuations in house because it can be viewed as more cost efficient. From a straight accounting perspective, that may be true. However, when management considers the considerable time, effort, and strain that conducting portfolio valuations places on internal resources, plus the goodwill that bringing in an independent valuator creates amongst shareholders and regulators, the decision to bring in an outside provider, even from a cost perspective, can be well justified.

Outsourcing is the Right Choice. Now Choose The Right Provider.

As has been clearly established, outsourcing portfolio valuations provides savvy financial managers with a number of advantages over conducting them in house. Once the decision to outsource has been made, selecting the right provider is paramount. Careful attention should be paid to a number of different factors during this vetting process, including the provider’s experience, scalability, and history of success under scrutiny.

Considerations in Hiring a Valuation Advisor

Capability

How much experience does your potential provider have? Do they have a comprehensive understanding of the specific issues and challenges in your area of need? Can they provide you a list of references?

Our professionals hold advanced degrees in financial engineering and other advanced analytics fields; bring deep experience from various areas of the financial industry; and possess practical, technical, and quantitative skills. They also hold professional designations and leadership positions in various organizations that are instrumental to developing financial reporting standards. Our experience and expertise enables us to apply a wide range of valuation methodologies for any specific type of security from debt securities, such as term loans and corporate bonds, to the most exotic derivates and everything in between.

Scalability/Ability to Meet Deadlines

Does your provider have the capacity to meet your valuation needs, large or small?

Under quarterly, semi-annual, or annual deadlines?

For more than 30 years, Stout has provided valuations that help our clients meet their financial reporting requirements, and today we are one of the largest independent valuation practices in the country. We:

  • Are a full-service valuation firm with specialized expertise in portfolio valuations, complex securities, and structured finance.
  • Complete more than 5,000 engagements per year and have worked in more than 80 countries.
  • Are trusted by some of the largest publicly traded corporations, including 64% of the Fortune 500.
  • Have extensive experience with some of the largest and most complex engagements around the world.

Analytical Rigor

Does your provider have a sustained history of success delivering comprehensive valuations that withstand investor, auditor, and government scrutiny?

For more than 30 years, Stout has developed defensible valuations that have withstood scrutiny. Our professionals take the time to understand the businesses realities related to each valuation in a thoughtful and practical manner. To this end, we use a sophisticated multidisciplinary approach to every assignment incorporating various perspectives such as:

  • Traditional and contemporary financial and valuation theory
  • Real-world market information and transaction data from our Investment Banking professionals
  • Advice from our Dispute Consulting professionals whenever legal or other related controversies arise
    Our technical expertise and robust valuation processes ensure accuracy. In addition, our knowledge of accounting standards, extensive documentation, and significant testimony experience has made it possible to support and defend our opinions from auditors, regulators, and tax authorities. Specifically, our valuations are prepared to meet accounting standards, our analyses are developed with clear and comprehensive documentation that includes our approach and assumptions, and we have significant experience working with various regulatory bodies to support our opinions, whether it’s managing the IPO process, IRS audit, or SEC comment letters.

Involvement of Senior Staff

Our project team will be staffed with the appropriate mix of experienced individuals to meet your needs. Our senior project leaders maintain a high level of involvement on the engagement to ensure that we consistently deliver value, quality service, and unparalleled responsiveness.

Are You a Priority?

Where does your company fall in the hierarchy of your provider’s client roster?

When you work with Stout, you can expect the capabilities and experience that come from working with some of the world’s largest financial advisory firms, as well as the efficiencies and client attention that you can only get from your most trusted advisors.

We deliver on time and within budget so that our clients can focus on more strategic initiatives and the daily responsibilities of their jobs. As a part of the engagement, we will:

  • Communicate effectively within our teams and with you and your advisors
  • Understand your businesses, challenges, and needs
  • Respond proactively to build a lasting relationship with you and your colleagues
  • Provide value inside and outside of each engagement
  • Set, manage, and convey expectations at every opportunity

At Stout, we take great pride in putting clients first. Our disciplined approach to premium client service is based on our principled approach to understanding clients’ needs, always adding value for our clients, and setting and managing client expectations, all while providing unparalleled responsiveness with great communication. Stout’s professionals are committed to their work and bring a positive, team-oriented approach to any engagement, big or small, no matter the location, industry, or task at hand.

In today’s financial environment, where transparency and accountability are top priorities for investors and regulators, it’s clear that outsourcing portfolio valuations to an experienced third-party provider offers a far greater return than conducting them internally. Outsourcing gives firms the opportunity to implement best practices, puts less strain on internal resources, provides documentation support that they have met their fiduciary responsibility, and enhances public perception and investor trust. These advantages not only justify switching to a third-party provider, they also offer companies a more clearly defined path to getting more value from their valuation process.


  1. Marsh LLC, “Business Development Companies Face Increasing Regulatory Risks,” Insights, December 2017.

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