Experts respond to our 'valuation challenges'

First things first, our valuation challenges below are by design succinct and therefore focused on highlighting potential questions. As fair value determinations require judgment, the answers provided may of course be different after a thorough vetting of all actual facts and circumstances.

That said, it’s incredibly useful to see how different valuation experts approach the same “valuation challenge” that CFOs often encounter during the valuation process. With no clear cut answers on how things like “the value of control” can (or should) be measured, it’s not always easy to determine fair value in private equity. But by asking different auditors (and at least one CFO who for obvious reasons wished to remain anonymous) about these gray valuation spots, one can gain a greater sense of comfort in their own thinking about the below three valuation challenges: 

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VALUATION CHALLENGE 1: CONSIDERING CONTROL

Two private equity managers purchase 100 percent of the equity of a private company. Fund A owns 75 percent of the portfolio company and Fund B owns 25 percent. The purchase price is 1,000, with Fund A paying 750 and Fund B paying 250. At future valuation dates, how would the control and non-control positions be valued?

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Anthony Rockley, partner at KPMG, says: 

This goes directly to the issue of whether a ‘control premium’ exists. There is some evidence from acquisitions of public companies and tax valuation case law, where a premium is observed or applied. The argument runs that shares are typically traded in small quantities and that a higher multiple would be paid for a control position and conversely that a discount should be applied to a minority position. 

As an alternate view, there is no such thing as a ‘control premium’. Only 3 percent of companies are taken over each year, is it reasonable to apply evidence from 3 percent to the whole? If a ‘control premium’ exists, why aren’t all public companies subject to takeover bids as they would be more valuable under a single owner? If the company is already well run, what is the benefit of control? Can the acquirer explain why having control increases their cash return or reduces risk? A 40 percent stake in a public company would be a position from which control can be achieved. So if a control premium exists in practice, this 40 percent would be worth more that the quoted price. Typically large positions in public companies are placed at a discount.

So, accepting that there is no inherent premium for control, in the example what other differences may exist between the two positions which result in differential cash flows or risks. The minority holder may be unable to force a realization and may have to follow the majority holder, but frequently these matters are contractually agreed between the parties. 

So in the absence of different rights which impact the expected cash returns or risk, I would expect the control and non-control position to be valued at the same value per share.

CFO of a US buyout firm says:

I would value both positions the same. I believe GAAP literature suggests that the value should be based on the price at which the asset would change hands between a willing buyer and seller. Therefore, I would value A and B’s interests the same. I do believe you could argue that you could ascribe a control premium to A’s interest along with a lack of marketability discount for both A and B, but I don’t subscribe to that approach.

David Larsen, managing director at valuation specialists Duff & Phelps, says:

The question leads immediately to consideration of valuation theory with respect to control premiums or minority discounts. For private equity investments, using the concepts of a control premium or minority discount, in most cases, could lead to an answer which deviates from the required market participant perspective in determining value. While space does not allow all permutations and combinations of facts and circumstances to be considered, generally it is better not to focus on control vs non-control but to focus on proportionality of cash flows (at entry, exit and during the life of the investment), and calibration.

In the fact situation presented, Fund B pays the same proportional price as Fund A. Implicitly, upon exit, Fund B will receive proportionally the same proceeds, 25 percent, as its ownership percentage. As there is no information to indicate that the Fund A and Fund B would receive disproportionate proceeds and calibrating the entry price which is assumed to be fair value, at future valuation dates Fund B would estimate fair value as 25 percent of the enterprise value and Fund A would estimate Fair Value as 75 percent of the enterprise value. Complicating the analysis by using theoretical premiums or discounts would deviate from assumptions used by market participants, and could result in arbitrary indications of value which do not reflect the cash flows associated with the investment.

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VALUATION CHALLENGE 2: THE DEBT DIFFERENCE

Private equity manager ABC owns 80 percent of the equity of portfolio company XYZ. ABC paid $800 for its 80 percent stake (enterprise value was 2,000 minus debt of 1,000 equaled total equity value of 1,000). XYZ has been adversely impacted by economic conditions. Its enterprise value has fallen from 2,000 as of acquisition to 1,500. Outstanding debt remains at 1,000. ABC purchases 50 percent of the outstanding debt for 250. What is the fair value of the debt and what is the fair value of the equity? Does the answer differ if the debt and equity are held by the same fund managed by ABC or by different funds managed by ABC?
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Anthony Rockley, partner at KPMG, says:

Taking this multilayered example in stages but starting at the end with the equity value. The equity value can be estimated as the enterprise value less the debt. What is the amount that should be deducted for the debt when it may be acquired at 50 percent of face value but is repayable at par.

This relates to the Unit of Account debate which continues amongst the standard setters. If we are valuing our 80 percent stake in the enterprise by reference to the whole, if we were to realize our stake, the debt is likely to become repayable at par. So logically we should value our equity on the basis of expected future cash flows, i.e. enterprise value less the full (par) amount of the debt ((1,500 – 1,000)*80 percent = 400). 

The converse argument in the unit of account debate is that we are valuing a single share, whose realization would not trigger a debt repayment, so it should be valued at its share of the enterprise value less debt at fair value. The best indicator of fair value being the last price at which it was traded, so the equity would be valued higher ((1,500 – 500)*80 percent=800). 

So in valuing the equity the critical question should be what will happen to the debt and how might a third party acquirer view that debt when assessing the value of the equity. If the debt structure can remain in place through an acquisition, then the latter answer may be appropriate. However if the debt is immediately repayable on acquisition, then the acquirer might be more likely to consider the former calculation.

We know the fair value of the debt at the point of acquisition, and that is the amount that it was acquired for (50 percent of face value). Judgment is needed to estimate the value thereafter. What are the expected future cash flows? Presumably the debt was acquired with the intention of holding the debt until redemption at par. Is that reasonably certain or might the debt be sold back into the market? Are the debt and equity so intrinsically linked that they should be valued together as a package?

Typically the debt is deducted from the equity at par value and the uplift on the debt instrument is recognized over a period and in full once a decision has been taken by the portfolio company to repay the debt, or a sale process is progressing well. 

As a manager of several funds, it is better to avoid the situation where different funds hold instruments that rank at different places in a cash waterfall as this creates multiple conflicts of interest which require careful management. Logically the value should be same regardless of which fund holds the debt, although those charged with governance of the fund are not constrained in exercising their judgment as to value by the views of another fund, so may report a different value.

CFO of a US buyout firm says:

I would say the fair value of the debt would be 50 percent of its face value, since that is what ABC paid for it. However, given the facts, if the enterprise value remained the same for a period of time, I would mark the debt up to 100 percent of the face value within a reasonable period of time. Interestingly, despite paying only 50 percent for the debt, when valuing the equity, I believe you need to assume that 100 percent of the debt, or $1,000, needs to be paid out of the enterprise value before any value is left for the equity. That then leaves $500 for the equity. At an 80 percent ownership, ABC has a value of $400. I don’t think my answer would differ if ABC held both the debt and the equity in the same fund or in different funds, but, like I said above, I would likely mark the debt up to 100 percent of face value within a few quarters as long as enterprise value didn’t decrease in value.

David Larsen, managing director at valuation specialists Duff & Phelps, says:

Accounting standards generally recognize “unit of account” or the item being fair valued, to be the individual equity security or debt security. The question posed, has several different permutations. If only the equity is being valued, one could come to the conclusion that, the equity should be valued at 500 (1,500 enterprise value minus 1,000, representing the amount of debt that would need to be repaid upon the sale of the company). If the debt would not need to be repaid upon a change of control, or if it were clear that the debt could be settled for less than 1,000, the value of equity would be increased.

The value of the debt instrument on a stand-alone basis is arguably more complex. Calibration requires determination of whether or not the 250 paid for the debt was deemed Fair Value, i.e. was it an orderly transaction price, or was the seller compelled to sell. If deemed fair value, even though there is sufficient enterprise value to cover the face value of debt, 1,000, the fair value would be 250, because of the risks associated with the instrument. If the purchase was deemed a bargain purchase, then fair value would be estimated somewhere between 250 and 1,000 depending on facts and circumstances.

If the same Fund invested in both the equity and the debt, then the total Fair Value would be 1,500 (based on the facts presented), and the fund manager would need to establish a basis for allocating value between the debt and equity instruments. If separate Fund’s invest in the debt and equity, the value would be established as described above.

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VALUATION CHALLENGE 3: THE WORTH OF GOOD NEWS

A drug discovery company with only one drug in testing is seeking a cure for cancer and will be worth billions if successful. The drug has passed initial clinical trials and just completed stage two trials which should demonstrate that drug does not kill people and may be beneficial. Is the company really worth more on the day that the letter confirming the passing of stage two has been received than it was the day before when all that has happened is that the post arrived? 

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CFO of a US buyout firm says:

I think it is worth more. Presumably, the company had some type of appraisal or valuation performed before they received the good news letter. However, until they received the letter, at best, they would have had to apply a discount to that valuation to probability weight the valuation for the odds of the drug passing all clinical trials. Once the letter is received, the discount can be reduced. I would suggest that the overall valuation/appraisal shouldn’t be impacted by the one day change from pre- and post-receipt of the letter, if the appraisal was done properly.

David Larsen, managing director at valuation specialists Duff & Phelps, says:

While individual facts and circumstances would govern and more information would generally be available, the fact situation presented is conceptually common and straightforward, but quantitatively difficult. The starting point for all fair value estimates is how do market participants assess value. Market participants, while acknowledging the potential value in the billions, generally limit the value of these types of company because of the risk involved. Said differently, notwithstanding the potential billions in value, market participants would cap the potential future value of such companies, at say 200 million. This market participant imposed valuation cap may fluctuate over time depending on market conditions and company specific factors.

Therefore, for arguments sake, if the last round of financing implied a company value of 20 million, implicitly, the probability of success was deemed 10 percent (20 million divided by 200 million). Upon the successful completion of the stage two trials, if market participants would deem the potential success of the company to remain at 10 percent, then the fair value may not have changed. If the successful trials raised market participant’s estimate of success to say 20 percent, then the value of the company would have increased to 40 million. So yes, if market participants would attribute value to successfully passing state two, then value does accrete upon hitting such a milestone. The harder question to answer is by how much?

Richard Bibby, director in Deloitte’s corporate finance department, says:

A good day to get the post as the answer is almost certainly yes. The fundamental concept of any valuation is the appropriate matching of risk and reward in order to properly assess the value associated with an asset or liability. Key factors that impact the risks (either increasing or decreasing) are therefore likely to change the value. In pharmaceutical businesses the key decision points are major tests for the success or otherwise of a drug. Even with the most optimistic investors, the official success of a clinical trial is likely to de-risk the investment opportunity and therefore increase the value, notwithstanding there may be many more additional hurdles to complete successfully before a full commercial launch of the drug.