Article
Valuation of Level 3 portfolio companies: Why is it so important, and how can I help make the audit process easier?
Jan. 13, 2026 · Authored by Lauren Hayes and Sylvia Dyke
Private equity funds are required to conform to FASB ASC 820 Fair Value Measurements and Disclosures, which establishes a hierarchy used to measure fair value. Investments with limited market activity for which the investment and significant management judgments or estimations are classified as Level 3 investments. Level 3 investments must have a valuation completed to determine the fair value at each year-end.
A private equity fund’s balance sheet and income statement are typically minimal, and the majority of the financial statements revolves around the annual valuation. As a result, valuations are at the heart of most private equity audits. Whether the fund invests in privately held oil and gas, manufacturing, real estate healthcare, technology companies or anything else, determining the fair value at each year-end is paramount to both the private equity fund and the auditor. Consequently, this is often the most difficult part of the audit of Level 3 investments for everyone involved, as key inputs – such as discount rates and multiples – are subjective and can result in large variances in fair value conclusions.
From a fund manager perspective, there are several steps that can be taken to help make the process easier. A few things to consider when moving into year-end valuations and the annual audit, include:
Consulting the AICPA guide
Starting with its June 1, 2019, issuance, the American Institute of Certified Public Accountants (AICPA) releases an annual “Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies” (otherwise known as 'the Guide'). This details best practices for the valuation of investments in this space. Most firms, including Baker Tilly, have whitepapers summarizing some of the key components of this – many of which will be covered in this article. This is a resource and starting point when preparing valuations, as it will provide insight into auditor expectations..
Selecting valuation methodologies
One of the most specific points from the Guide is the types of valuation methodologies utilized. Valuation methodologies fall into one of three valuation approaches: market approach, income approach and asset (also commonly referred to as cost) approach. Common market approach methodologies include the comparable company analysis and the comparable transaction method. The discounted cash flow method is the most common of income approach methodology. The asset approach includes asset-based valuation (fair market value of assets less liabilities) and sum of the parts valuation method..
A well-performed valuation generally uses multiple approaches – ideally from at least two different approaches – and weights the values to come up with a final valuation. If you currently only prepare your valuation with one methodology, consider utilizing other approaches for a blended fair value.
Initial valuation
For newly acquired investments that will have been held for less than one year at the time of audit, the Guide presents the option of determining whether the transaction price (or cost) represents fair value at initial recognition. FASB ASC 820-10-30-3A lays out the following factors that may indicate that transaction price may not represent the fair value:
- The transaction is between related parties
- The transaction takes place under duress or the seller is forced to accept the price in the transaction
- The unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value
- The market in which the transaction takes place is different from the principal market (or most advantageous market).
In the absence of the above factors, standard industry practice for private equity allows for the transaction price to represent fair value when the transaction happened within one year. Barring significant industry, economic, regulatory or business environment changes, presenting fair value based on cost is often reasonably indicative of fair value. Management should determine if cost is appropriate for the period under audit.
Documenting assumptions in estimates
Valuations are very subjective, and management estimates are just that – estimates. These estimates are typically the hardest area for auditors and their valuation teams to gain comfort with. Assumptions and projections become key to determining the value of the underlying portfolio company. Thus, it is of the utmost importance that the reasonableness of the assumptions along with the methods used in arriving at the assumptions are considered. A few things to consider when developing your estimates:
- Try to minimize bias or being overly optimistic or pessimistic. Make sure estimates are reasonable and attainable. Aspirational goals are not always achievable and can artificially increase the fair value of an investment, all else equal. Auditors will review estimates year to year to assess the reasonableness of management’s assessments.
- When preparing projection estimates, provide support for how these were determined. If there are material purchase orders, invoices, back-fill reports or other such items after year-end, maintain this support to help corroborate growth forecasts. When developing a new product line, have support for pertinent milestones being achieved. Be prepared to show management’s ability to project revenues. Have financial statements (historical and current) available. An auditor can gain comfort on future projections if the company has historically met projections included in prior valuations, and industry and economic factors corroborate the outlook.
- Maintain support for comparable companies. Why were certain comparable companies included or excluded? Were certain multiple outliers excluded? Have the criteria for these decisions been consistent over time and, if so, why? Include that rationale and thought process within the valuation.
- Maintain any support used to develop growth rates, multiples, discount rates, market participant acquisition premiums (control premiums), working capital adjustments or any other inputs.
- If calibration is used to support fair value, provide rationale for calibration adjustments and ensure all calibrated inputs and assumptions have been updated to reflect all changes in the company and market since the transaction occurred. Include any other potential factors which could impact the calibration or valuation, such as new debt instruments, changes in the principal market, differences in rights and preferences of equity classes, etc.
- Should recent financing rounds, public share prices, broker quotes or appraisals be used in the valuation assumptions, include these documents with the valuation to support rationale. The Guide provides some factors to consider regarding the use of prior financing rounds.
Due to the highly subjective nature of valuations, it is possible that inputs and estimates used will be challenged by the auditors or their valuation teams. Unobservable inputs, by their nature, include subjectivity, but with sufficient documentation and consideration over all reasonably available inputs, the fund manager should be in a position to support their conclusions.
Allocating enterprise value
Once enterprise value is determined, an additional decision will need to be made regarding the equity allocation.
The current value method and option pricing model are two of the more common equity allocation techniques. The current value method allocates value based on the company’s current capital structure and rights and assumes an immediate liquidity event. The option pricing model simulates equity valuation between classes, most often when timing of a liquidity event is uncertain and there may be complex liquidation preferences depending on performance or other factors at the time of liquidation.
The current value method is most ideally used under the following circumstances:
- When the private equity fund owns a controlling interest and, therefore, can determine the timing of liquidation
- When a liquidity event is imminent and going concern is not an issue
The current value method is easy to understand, easy to apply, and provides a tangible, objective basis for valuation. However, it is not forward-looking and has high sensitivity to underlying assumptions. Additionally, the focus on immediate liquidation makes it less suitable for going concerns.
The option pricing model is most commonly under the following circumstances:
- When the private equity fund does not own controlling interest and has little or no influence on the timing of liquidation
- When the fund with controlling interest has convertible debt or another arrangement, for which liquidation preferences may be treated as a strike price that is consistent with the investors’ required rate of return for conversion
The option pricing model is forward looking, can handle complex capital structures, and can be used in conjunction with a hybrid or probability-weighted method to consider various possible outcomes. However, its flexibility adds an additional layer of subjectiveness. Additionally, this method is also highly sensitive to volatility and less useful for near liquidity events.
In-house valuation specialists versus outside consultants
A private equity fund manager may choose to have valuations prepared by an in-house specialist or engage an external accounting or consulting firm. Outsourcing to experienced firms can ease the process, reduce long-term issues and provide auditors with reliable third-party value reports. A conclusion of value report from an independent, reputable, third-party provider is one of the best ways to provide your auditor comfort over fair value. The auditor can typically place more reliance on these independent reports, and the value determined, leading to fewer questions given the nature of the report prepared. The trend towards using external experts has grown, driven by new guidelines, heightened auditor scrutiny and the need to minimize bias in valuing Level 3 investments.
Documenting activity and communication throughout the year
All this said, valuation should be assessed periodically during the year. While it may only be prepared quarterly, semi-annually or annually, , best practices can and should be implemented throughout the year to facilitate the process. As you meet with the portfolio companies to discuss projections, forecasts and the business in general, maintain documentation of these meetings to show that discussions are occurring and the investment team is involved with management’s forecasting process. Prepare documentation regarding the controls over the valuation process including management’s methodology, meeting records and related documents. This documentation will help the auditors gain comfort over the process surrounding the valuation. Having good controls may help reduce the auditor’s risk.
Communicate with your audit team throughout the year. Inform them you are considering changes to your valuation methodology or underlying assumptions. This allows the audit team to engage their valuation specialists as needed to evaluate and discuss proposed changes, as well as to perform a preliminary assessment of the valuation’s reasonableness prior to investor communications. Initiating these discussions early helps reduce potential questions and ensures a more efficient review process.
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