While private equity investment has increased apace, methods for fund managers to value their holdings have had to evolve. A downturn in the market may reveal which of the competing methods are the best, finds Iain Morse
Business is good at the commercial valuations department of KPMG Corporate Finance, where companies, mainly private ones, are valued for buyers, sellers, and investors, including pension funds.
“Trustees and pension boards have a fiduciary obligation to obtain robust valuations on a private equity holding,” says Doug McPhee, a partner at the firm. This applies as much to the growing number of private equity funds and partnerships as it does to directly held investments.
“The emphasis now is on marking assets to market values. The very rapid growth of the private equity sector over recent years has made this a pressing issue for all investors.”
The need is also for a source of genuinely independent valuations. “A fund manager or private equity partnership may have great expertise in their corner of the market, but this is no longer sufficient to reassure many investors, particularly trustees,” adds McPhee.
The expertise required for ongoing valuation is not the same as that required for the purchase and resale of companies over periods of time. Not so long ago little attention was given to the issues arising from the ongoing valuation of private equity holdings. After all, these comprised a small, sometimes negligible component of portfolios. Companies would be booked at their purchase cost. These might or might not be revised depending on which assumptions were selected as relevant in their determination. “In practice these were often very conservative assumptions,” says David Currie, a partner at Standard Life Private Equity.
This has one of two consequences depending on whether disposal values are rising or falling against acquisition values. “If values are not revised then in a rising market they leap up at disposal, and in a falling market they can fall below expectations,” warns Herman Daems, chairman of the International Private Equity and Venture Capital Valuation Board (IPEV) and chairman of SIMV, a listed Dutch private equity fund. Over the past few years, this volatility sparked a major debate within the industry on valuation methodologies. Meanwhile accounting standards were also having an impact on this debate. “IFRS is very explicit that it is not acceptable to simply discount private companies against listed ones,” adds Daems. “We have worked to find a better set of pricing solutions.”
Last year the IPEV published valuation guidelines now adopted by the private equity industry in the UK, Europe and most emerging economies, though not the
USA. This codifies valuation methodologies under five headings: price of recent acquisition; earnings multiples; net assets; discounted cash flows or earnings from businesses; discounted cash flows from investments and industry valuation benchmarks. The type of private equity enterprise to which one or more of these methodologies can be most appropriately applied depends on looking at each case separately. “We need flexibility in this regard,” says Daems. “Private equity is inherently harder to value than listed equity and that point needs to be understood by investors.”
Using the price of recent investment looks the most certain of these with one crucial caveat: the interpretation of the word ‘recent’ is a vital one. The strength of a valuation reached this way erodes over time. In some business sectors, say pubs or nursing homes, this time may extend over a longer period than another type of enterprise, for example a company developing a new drug subject to regulatory approval. IPEV is particularly concerned about the consequences of subsequent or later stage investments with regard to establishing fair value. These include further investment by existing investors with little participation from new investors. Another is that different rights attach to different groups of shareholders, or that a new investor may be motivated by strategic considerations. Forced sales and rescue packages are also commonplace in some areas of private equity, but hardly seen in others. Relevant market conditions can also radically effect valuation as shown by recent events. Regulatory change is an obvious example, because the range of potential factors is far wider.
Earnings multiples are a tried and tested valuation methodology, but only with businesses that generate earnings. According to IPEV the key requirement in using earnings multiples is the application of a multiple judged appropriate and reasonable to the maintainable earnings of the company. Of course, this leaves open the question of which earnings multiple is judged appropriate. A number of multiples are widely used.
These include price-to-earnings ratios (p/e ratios), enterprise value/earnings before interest and tax (EV/EBIT) and depreciation and amortisation (EV/EBITDA). Matching multiple to business type remains a matter of judgement.
But IPEV is clear that wherever possible those making a valuation should refer to market valuations, reflected in the market valuation of listed companies or the price at which companies have recently changed hands.
Even then there is nothing straightforward about the use of multiples. For instance, the use of P/E ratios requires adjustment so that comparison is on a like for like basis after taking account of each company’s financial gearing and the rate at which they pay tax. EV/EBITDA multiples remove the impact on value of depreciation and the amortisation of goodwill and other intangibles. When making a comparison IPEV also recommends that the value of a company may be reduced if it is smaller and less diverse than a comparator, and if it is reliant on a small number of key employees or is dependent on one product or customer, and has high gearing. Much of this sounds like common sense. IPEV’s emphasis on these points is clearly intended to make it harder to justify the over-optimistic valuations of recent years.
Net asset values are more important in some types of business than others. IPEV accepts this point, while not being over prescriptive about which types of business this might be. Typical examples are likely to be those that own heritable property, such as nursing homes or pubs, as an integral part of their business. This methodology requires the valuer to derive an enterprise value for the company using appropriate measures of its assets and liabilities. Next all debt ranking senior to debt or shares owned by the investors needs to be deducted from the enterprise value to derive a gross attributable enterprise value. This amount then needs to be discounted by any further discount arising for the marketing of these relevant assets. The residual amount is then distributed among the remaining investors, including those holding equity.
Discounted cash flows are also widely used as a valuation methodology. This derives the current value of a business by calculating the present value of expected future cash flows. It is flexible in that it can be applied to any stream of cash flows, but IPEV says there are clear limits to its use. These are most obvious when considering businesses going through periods of change such as rescue refinancing, turnaround, strategic repositioning, loss making or during a start-up phase. The problem with discounted cash flows is that so much depends on the judgements used in reaching the estimates of these future cash flows. Wild predictions of the cash flows of high-tech companies were widespread in the late 1990s. Their uncritical use was an important factor in the tech boom and bust.
Discounted cash flows can be used to value private equity funds as well as individual investments. The essential methodology remains the same. But IPEV concedes that because of its use of “substantial subjective judgements” this methodology needs to be treated with great care. IPEV goes further, hinting that discounted cash flows should be used in addition to at least one other methodology. There remain two less widely used methodologies. Industry valuation benchmarks tend to be industry-specific, such as ‘price per bed’ or ‘price per subscriber’. IPEV warns that these are best seen as ‘sense-checks’ on other valuations. IPEV’s final methodology is the use of available market prices. Private equity investors may hold listed equities, particularly as a result of an IPO in which they own equity. IPEV’s recommendation is to use the most recent market values.
The IPEV guidelines have had a good reception from all sides of the industry. They sound very sensible but leave plenty of room for valuers to insert their own assumptions while staying within IPEV guidelines. “That is the nature of private equity,” says Daems. These are relatively illiquid assets, and despite the reassurance of the IPEV valuation guidelines, most investors will concentrate on the track record of a partnership or fund when making an investment decision. Currie adds: “We have had several years of very good returns. If the market has reached an inflexion point then we will soon be able to judge who is best at interpreting the IPEV guidelines.”
© fe October 2007