Making Valuations Audit-Proof: A Practical Guide for Private Equity Funds
Audit scrutiny of private equity valuations typically focuses less on the fair value conclusion and more on the reasoning behind it.
Audit-proof valuations are not about avoiding judgemental areas or suppressing quarter-on-quarter movements. They are about applying judgement in a disciplined and transparent way that can be followed, tested and justified by an auditor.
1. Start with the definition of fair value
Before selecting any valuation approach, be clear on what fair value represents.
Under IFRS 13, fair value reflects the price a market participant would pay in an orderly transaction
It is not the sponsor’s view of intrinsic value or long-term upside
Synergies, value creation plans and hold-to-maturity assumptions should only be reflected where market participants would price them in the same way
Fair value is assessed at the measurement date, based on information and market conditions that exist at that point in time
Audit issues can arise when the valuation contains some sort of fund-side bias, such as drifting towards a sponsor’s long-term value creation plan or by allowing post-valuation date developments to influence assumptions without clear justification.
2. Use multiple valuation approaches, with clear rationale
Best practice is to consider more than one valuation approach.
Common approaches include discounted cash flow analysis, trading or transaction multiples, and recovery analysis for more complex or stressed situations.
A coherent valuation should clearly explain:
Which approaches have been considered
Which carries greater emphasis, if any, and
Why that emphasis is appropriate given the nature of the holding, the stage of ownership and current market conditions.
3. Justify assumptions, not just outcomes
Audit challenges rarely arise because an assumption is too high or too low. They arise because the rationale is unclear.
Valuations should clearly explain:
Key forecast assumptions such as growth, margins and cash conversion
How peer groups and multiples have been selected
Why a particular earnings base has been used – e.g. trailing vs forward, normalised vs actual
How sensitive inputs (e.g. discount rates, probability weightings) were derived
The objective is not to prove the assumptions are correct, but to show they are reasonable and consistent when viewed against market evidence.
4. Separate inputs, judgement and conclusions
Strong valuations make the judgement areas explicit.
It should be clear what is:
An observable input, such as market data or contractual terms
A derived input, such as normalised earnings or discount rates
Valuation judgement, including method selection and scenario weighting
Judgemental areas that are clearly stated and explained are far easier to defend than assumptions embedded silently within a model.
5. Reconcile to prior valuations without defaulting to them
Auditors are often focused on the movement from the prior period, on top of the absolute number. In practice, they want to understand what factors have driven a valuation change from one quarter to the next, and whether that movement is consistent with changes in performance, risk and broader market conditions.
An audit-proof valuation explains the key drivers of quarter-on-quarter changes, and how those drivers benchmark against the market.
6. Address downside explicitly
Auditors expect downside risk to be considered. At a minimum, valuations should outline credible downside scenarios, their impact on cashflows, and how that risk is reflected in the fair value. This does not require excessive modelling, but it does require explicit consideration.
Conclusion
Audit-proof valuations do not necessarily have to be conservative. Instead, they should be coherent, well-reasoned and properly evidenced. Applying multiple valuation approaches, clearly justifying assumptions and making judgement explicit materially reduces audit friction and avoids unnecessary challenges.
