A common mistake we see private equity managers make is to value recent investments at cost without giving due consideration to changes in fair value.
Over time the validity of cost as an indication of fair value diminishes, particularly in a dynamic environment, which leads to stale pricing. Industry practice is often still to hold investments at cost for the first twelve months following acquisition: this doesn’t necessarily match accounting standards and the International Private Equity and Venture Capital Valuation (IPEV) guidelines.
For example, under UK GAAP, investments would still need to be examined for signs of impairment in the first year of ownership per FRS 11.
The IPEV guidelines endorse using cost to value recent investments, but valuers still must consider whether there are any factors indicating fair value has changed – this is sometimes overlooked. Managers should also be performing alternative valuations of investments, which should help them ascertain whether cost is still appropriate.
One of the most common issues on private equity valuation we witness is excessive conservatism.
The tendency is always to undervalue assets. This is in part driven by the investors. If you realize an asset for marginally less than its previously reported value, they think that you are an idiot. If it sells for a premium, you are a hero.
The innate desire of managers to under-promise and over-deliver, reinforced by the investor reactions, acts as an effective control over optimistic valuers, but may hold valuations too low until a clear exit price is established.
Adjusted Earnings before Interest, Taxation, Depreciation and Amortization (EBITDA) presentations form a key part of the valuation of a business on acquisition, sale or when raising capital through a high yield bond or an IPO.
PwC is frequently asked what adjustments are acceptable in the presentation of adjusted EBITDA but there is no universal solution. These measures have evolved through market practice and general acceptance by stock exchanges and regulators, although they are not defined by specific accounting standards or regulations.
The adjustments should be evaluated individually and in aggregate, and should be consistent with the overall business strategy and plans of the portfolio company. It is also critical that management define what metrics will be adjusted early on so that information can be collaborated and analyzed on a consistent basis. The underlying premise is that the adjustments should be factually accurate, verifiable and supportable.