This reading is not intended to be a comprehensive review of valuation techniques applicable to private equity transactions. Instead, we highlight some essential consid- erations specific to private equity. As you might expect, private equity firms are a rich laboratory for applying the principles of asset and equity valuation. The case study on venture capital valuation that follows this reading demonstrates how a specific valuation technique can be applied.
First and foremost, we must distinguish between the price paid for a private equity stake and the valuation of such private equity stake. The price paid for a private equity stake is the outcome of a negotiation process between two or more parties with each possibly assigning a different value to that same private equity stake. Unlike shares of public companies that are traded regularly on a regulated market, buyers and sellers of private equity interests generally employ more efforts to uncover their value. Private equity valuation is thus time bound and dependent on the respective motives and interests of buyers and sellers.
The selection of the appropriate valuation methodologies depends largely on the stage of development of a private equity portfolio company. Exhibit 2 provides an overview of some of the main methodologies employed in private equity valuation and an indication of the stage of company development for which they may apply.
Exhibit 2 Overview of Selected Valuation Methodologies and Their Possible Application in Private Equity Valuation Technique Brief Description Application
Income approach:
Discounted cash flows (DCF)
Value is obtained by discounting expected future cash flows at an appropriate cost of capital.
Generally applies across the broad spectrum of com- pany stages.
Given the emphasis on expected cash flows, this methodology provides the most relevant results when applied to companies with a sufficient operating his- tory. Therefore, most applicable to companies operat- ing from the expansion up to the maturity phase.
Relative value:
Earnings multiples
Application of an earnings multiple to the earnings of a portfolio company. The earnings multiple is frequently obtained from the average of a group of public companies operating in a similar business and of comparable size.
Commonly used multiples include: Price/
Earnings (P/E), Enterprise Value/EBITDA, Enterprise Value/Sales.
Generally applies to companies with a significant operating history and predictable stream of cash flows.
May also apply with caution to companies operating at the expansion stage.
Rarely applies to early stage or start- up companies.
2
Valuation Technique Brief Description Application Real option The right to undertake a business decision
(call or put option). Requires judgmental assumptions about key option parameters.
Generally applies to situations in which the man- agement or shareholders have significant flexibility in making radically different strategic decisions (i.e., option to undertake or abandon a high risk, high return project). Therefore, generally applies to some companies operating at the seed or start- up phase.
Replacement cost Estimated cost to recreate the business as it stands as of the valuation date.
Generally applies to early (seed and start- up) stage companies or companies operating at the develop- ment stage and generating negative cash flows.
Rarely applies to mature companies as it is difficult to estimate the cost to recreate a company with a long operating history. For example, it would be difficult to estimate the cost to recreate a long established brand like Coca- Cola, whereas the replacement cost methodology may be used to estimate the brand value for a recently launched beverage (R&D expenses, marketing costs, etc.).
One other methodology, the venture capital method, is discussed more fully as part of the case study that follows this reading.
Note that in a vibrant and booming private equity market, there is a natural ten- dency among participants to focus primarily on the earnings approach to determine value. This approach is perceived as providing a benchmark value corresponding best to the state of the current private equity market. Because of the lack of liquidity of private equity investments, the concurrent use of other valuation metrics is strongly recommended.
Thus, valuation does not involve simply performing a net present value calculation on a static set of future profit projections. The forecasts of the existing management or vendors are, of course, a natural place to start, but one of the key ways private equity firms add value is by challenging the way businesses are run. The business would have additional value if the private equity firm improves the business’s financing, operations, management, and marketing.
In most transactions, private equity investors are faced with a set of investment decisions that are based on an assessment of prospective returns and associated probabilities. Private equity firms are confronted generally with a large flow of infor- mation arising from detailed due diligence investigations and from complex financial models. It is essential to understand the extent of the upside and downside potential of internal and external factors affecting the business and their resulting effect on net income and free cash flows. Any possible scenario must pass the judgmental test of how realistic it is. The defined scenarios should be based not only on the analysis of past events, but on what future events may realistically happen, given knowledge of the present. The interplay between exogenous factors (such as favorable and unfavorable macroeconomic conditions, interest rates, and exchange rates) and value drivers for the business (such as sales margins and required investments) should also be consid- ered carefully. For example, what will be the sales growth if competition increases or if competing new technologies are introduced?
When building the financial forecasts, all variables in the financial projections should be linked to key fundamental factors influencing the business with assigned subjective probabilities. The use of Monte Carlo simulation, often using a spreadsheet add- in such as Crystal Ball™ or @RISK, further enhances the quality of the analysis and
Exhibit 2 (Continued)
may be instrumental in identifying significant financial upsides and downsides to the business. In a Monte Carlo simulation, the analyst must model the fundamental value drivers of the portfolio company, which are in turn linked to a valuation model. Base case, worst case, and best case scenarios (sometimes called a triangular approach) and associated probabilities should be discussed with line managers for each value driver with the objective being to ensure that the simulation is as close as possible to the realities of the business and encompasses the range of possible outcomes.
Other key considerations when evaluating a private equity transaction include the value of control, the impact of illiquidity, and the extent of any country risk. Estimating the discount for illiquidity and marketability and a premium for control are among the most subjective decisions in private equity valuation. The control premium is an incremental value associated with a bloc of shares that will be instrumental in gaining control of a company. In most buyouts, the entire equity capital is acquired by the private equity purchasers. But in venture capital deals, investors often acquire minority positions. In this case the control premium (if any) largely depends on the relative strength and alignment of interest of shareholders willing to gain control. For example, in a situation with only a limited number of investors able to acquire con- trol, the control premium is likely to be much more significant relative to a situation with a dominant controlling shareholder invested along with a large number of much smaller shareholders.
The distinction between marketability and liquidity is more subtle. The cost of illiquidity may be defined as the cost of finding prospective buyers and represents the speed of conversion of the assets to cash, whereas the cost of marketability is closely related to the right to sell the assets. In practice, the marketability and liquidity dis- counts are frequently lumped together.
The cost for illiquidity and premium for control may be closely related because illiquidity may be more acute when there is a fierce battle for control. But there are many dimensions to illiquidity. The size of the illiquidity discount may be influenced by such factors as the shareholding structure, the level of profitability and its expected sustainability, the possibility of an initial public offering (IPO) in the near future, and the size of the private company. Because determining the relative importance of each factor may be difficult, the illiquidity discount is frequently assessed overall on a judgmental basis. In practice, the discount for illiquidity and premium for control are both adjustments to the preliminary value estimate instead of being factored into the cost of capital.
When valuing private equity portfolio companies in emerging markets, country risk may also represent a significant additional source of risk frequently added to a modified version of the standard CAPM. Estimating the appropriate country risk premium represents another significant challenge in emerging markets private equity valuation. These technical hurdles relate not only to private equity investments in emerging markets but also increasingly to global private equity transactions conducted
“en- bloc” in multiple countries. More than 15 approaches exist for the estimation of the country risk premium.1
Valuation in private equity transactions is, therefore, very challenging. Whereas traditional valuation methodologies, such as discounted cash flow analysis, adjusted present value, and techniques based on comparisons from the public market of prec- edent transactions, are used frequently by investment and valuation professionals, they are applied to private equity situations with care, taking into consideration stress
1 The modified country spread model, also called the modified Goldman model, is frequently used in prac- tice. The Erb, Harvey, and Viskanta model, also called the country risk rating model, is gaining increasing popularity among valuation practitioners, partly because of its ease of use and theoretical appeal. For a comprehensive analysis of this topic, see Estimating Cost of Capital in Emerging Markets, Yves Courtois, CFA Institute webcasts, www.cfainstitute.org.
tests and a range of possible future scenarios for the business. Given the challenges of private equity valuation, value estimates based on a combination of several valuation methodologies will provide the strongest support for the estimated value. Private equity valuation is a process that starts as a support for decision making at the transaction phase but should also serve as a monitoring tool to capture new opportunities, or protect from losses, with the objective to continuously create value until the invest- ment is exited. It also serves as a performance reporting tool to investors while the company remains in the fund portfolio. These ongoing valuation and reporting issues are discussed in Section 3.
2.1 How Is Value Created in Private Equity?
The question of how private equity funds actually create value has been much debated inside and outside the private equity industry. The survival of the private equity gov- ernance model depends on some economic advantages it may have over the public equity governance model. These potential advantages, described more fully below, include 1) the ability to re- engineer the private firm to generate superior returns, 2) the ability to access credit markets on favorable terms, and 3) a better alignment of interests between private equity firm owners and the managers of the firms they control.
Do private equity houses have superior ability to re- engineer companies and, there- fore, generate superior returns? Some of the largest private equity organizations, such as Kohlberg Kravis Roberts (KKR), The Carlyle Group, Texas Pacific Group (TPG), or Blackstone Group, have developed in- house high- end consulting capabilities supported frequently by seasoned industry veterans (former CEOs, CFOs, senior advisers), and have a proven ability to execute deals on a global basis. Irrespective of their size, some of the very best private equity firms have developed effective re- engineering capabilities to add value to their investments. But it is hard to believe that this factor, all else being equal, is the main driver of value added in private equity. Assuming that private equity houses have a superior ability to re- engineer companies, this would mean that public companies have inherently less ability to conduct re- engineering or organizational changes relative to corporations held by private equity organizations.
Many public companies, like General Electric or Toyota, have established a long track record of creating value. Thus, only a part of value added created by private equity houses may be explained by superior reorganization and re- engineering capabilities.
The answer must also come from other factors.
Is financial leverage the main driver of private equity returns in buyouts? Ample availability of credit at favorable terms (such as low credit spreads and few covenants) led in 2006 and the first half of 2007 to a significant increase in leverage available to buyout transactions. Borrowing 6 to 8 times EBITDA (earnings before interest, taxes, depreciation, and amortization) has been frequent for large transactions conducted during this period. Note that in private equity, leverage is typically measured as a mul- tiple of EBITDA instead of equity. Relative to comparable publicly quoted companies, there is a much greater use of debt in a typical buyout transaction.
When considering the impact of leverage on value, we should naturally turn to one of the foundations of modern finance: the Modigliani–Miller theorem.2 This the- orem, in its basic form, states that, in the absence of taxes, asymmetric information, bankruptcy costs, and assuming efficient markets, the value of a firm is not affected by how the firm is financed. In other words, it should not matter if the firm is financed by equity or debt. The relaxing of the “no taxes assumption” raises interesting ques- tions in leveraged buyouts as the tax shield on the acquisition debt creates value as a
2 F. Modigliani and M. Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment.”
American Economic Review (June 1958).
result of tax deductibility of interest. One would also expect that the financial leverage of a firm would be set at a level where bankruptcy costs do not outweigh these tax benefits. Unlike public companies, private equity firms may have a better ability to raise higher levels of debt as a result of a better control over management but also as a result of their reputation for having raised, and repaid, such high levels of debt in previous transactions.
Such debt financing is raised initially from the syndicated loan market, but then is frequently repackaged via sophisticated structured products, such as collateralized loan obligations (CLOs), which consist of a portfolio of leveraged loans. In some cases the private equity funds issue high- yield bonds as a way of financing the portfolio company, and these often are sold to funds that create collateralized debt obligations (CDOs). This raises the question of whether a massive transfer of risks to the credit markets is taking place in private equity. If the answer to this last question is positive, then one would expect that it will self- correct during the next economic downturn.
Note that at the time of this writing (early 2008), the CDO and CLO markets were undergoing a significant slowdown as a result of the credit market turmoil that started in the summer of 2007, triggered by the subprime mortgage crisis. The CDO and CLO markets are (at this time) inactive. As a result, the LBO market for very large transactions (“mega buyouts”) was affected by a lack of financing. Additional leverage is also gained by means of equity- like instruments at the acquisition vehicle level, which are frequently located in a favorable jurisdiction such as Luxembourg, the Channel Islands, Cayman Islands, or the British Virgin Islands. Note that acquisitions by large buyout private equity firms are generally held by a top holding company in a favorable tax jurisdiction. The top holding company’s share capital and equity- like instruments are held in turn by investment funds run by a general partner who is controlled by the private equity buyout firm. These instruments are treated as debt for tax purposes within the limits of thin capitalization rules in certain jurisdictions.
In Luxembourg, such equity- like instruments are called convertible preferred equity certificates, or CPECs.
The effect of leverage may also be analyzed through Jensen’s free cash flow hypoth- esis.3 According to Jensen, low growth companies generating high free cash flows tend to invest in projects destroying value (i.e., with a negative net present value) instead of distributing excess cash to shareholders. This argument is a possible explanation4 as to why a LBO transaction may generate value as excess cash is used to repay the senior debt tranche, effectively removing the management’s discretionary use of cash. Part of the value added in private equity may thus be explained by the level of financial leverage.
What other factors may then significantly explain the returns earned by private equity funds? One important factor is the alignment of economic interests between private equity owners and the managers of the companies they control, which can crystallize management efforts to achieve ambitious milestones set by the private equity owners. Results- driven management pay packages, along with various contractual clauses, ensure that managers receive proper incentives to reach their targets, and that they will not be left behind after the private equity house exits their investment.
Examples of such contract terms include tag- along, drag- along rights, which are contractual provisions in share purchase agreements that ensure any potential future acquirer of the company may not acquire control without extending an acquisition offer to all shareholders, including the management of the company.
3 Jensen, M., “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review, vol. 76 no. 2 (1986).
4 Jensen, M., “Eclipse of the Public Corporation,” Harvard Business Review, 67 (1989).
Empirical evidence also shows that managers from public companies subsequently acquired by private equity groups tend to acknowledge an increased level of directness and intensity of input enabling them to conduct higher value- added projects over a longer time frame after the buyout, as opposed to the “short- termism” prevailing during their public market period. This short- termism is mostly driven by shareholders’
expectations, the analyst community, and the broad market participants who place a significant emphasis on management to meet quarterly earnings targets. As private equity firms have a longer time horizon in managing their equity investments, they are able to attract talented managers having the ability to implement sometimes profound restructuring plans in isolation of short- term market consequences. Note however, that private equity firms are not the sole catalysts of change at large compa- nies. Some large organizations, for example General Electric, have a proven ability to stir entrepreneurship at all levels within the company and generate substantial value over a long time horizon.
Effective structuring of investments terms (called the “term sheet”) results in a balance of rights and obligations between the private equity firm and the management team. In addition to the clauses discussed above, the following contractual clauses are important illustrations of how private equity firms ensure that the management team is focused on achieving the business plan and that if the objectives are not met, the control and equity allocation held by the private equity firm will increase:
■ Corporate board seats: ensures private equity control in case of major corpo- rate events such as company sale, takeover, restructuring, IPO, bankruptcy, or liquidation.
■ Noncompete clause: generally imposed on founders and prevents them from restarting the same activity during a predefined period of time.
■ Preferred dividends and liquidation preference: private equity firms generally come first when distributions take place, and may be guaranteed a minimum multiple of their original investment before other shareholders receive their returns.
■ Reserved matters: some domains of strategic importance (such as changes in the business plan, acquisitions, or divestitures) are subject to approval or veto by the private equity firm.
■ Earn- outs (mostly in venture capital): mechanism linking the acquisition price paid by the private equity firm to the company’s future financial performance over a predetermined time horizon, generally not exceeding 2 to 3 years.
Effective contractual structuring of the investment can thus be a significant source of return to private equity firms. In particular, it may allow venture capital firms, which invest in companies with considerable uncertainties over their future, to significantly increase their level of control over time and even seize control in case the company fails to achieve the agreed goals.
2.2 Using Market Data in Valuation
In most private equity transactions—with the exception of public- to- privates—there is no direct market evidence on the valuation of the company being acquired. But virtually all valuation techniques employ evidence from the market at differing stages in the calculation, rather than relying entirely on accounting data and management forecasts.
The two most important ways in which market data are used to infer the value of the entity being acquired are by analyzing comparison companies that are quoted on public markets and valuations implied by recent transactions involving similar entities.
Typically, these techniques focus on the trading or acquisition multiples that exist in