Making sure the paneling is clean first, and caulking the joints is also important.
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I have used heavy weight wallpaper liner paper for this purpose. Scuff the surface of the paneling to give it tooth, then primer with a good wallpaper prep like Sheildz, hang the liner paper, skim coat the seams with joint compound once the wallpaper is dry. This will take only a lite coat of mud at the seams, then sand. Prime the whole wall and it will look like brand new drywall has been hung. Using the liner paper will cut down on the mud needed to smooth the surface. You only need to mud the seams of the wallpaper, about every 20 inches rather than trying to fill the grooves in the paneling, deeper grooves and about 4 inches and more applications of the mud after is shrinks. I usually caulk around the top prior to priming and at the baseboards. I really prefer to pull the baseboards out first and reinstall them after the liner paper has been installed, no chance for gaps doing it that way. The liner paper comes in different grades, some seem to be made for just this purpose.
We've been doing this all over our house and have tried various techniques throughout each room. So far, the room that turned out the best (and cheapest) was the bathroom. We used the putty knife and drywall compound and went to work. Once it was all sanded we used a can of spray texture and gave it a nice orange peel. When it was painted, you couldn't even tell it was paneling underneath.
Actually... the BEST room we did was my office and we used Sheetrock and did the whole thing, but that was WAY more money. I'm working on another wall in my kitchen using the webbed drywall tape. I'll be curious to know how it turns out...If I ever get around to finishing it...
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