The update was released as part of the 2022 International Private Equity and Venture Capital Valuation Guidelines. It offers new advice on determining target company assumptions and retains existing advice for when transactions don’t meet criteria for fair value.
The IPEV document last underwent a broad update in 2018. It now incorporates special guidance released in 2020 due to the covid pandemic, as well as earlier this year as the war in Ukraine disrupted markets globally.
Paying ‘heightened attention’
IPEV says that valuation processes should still be “consistent” during market dislocation but that there should be “heightened attention” paid to a GP’s target company, the company’s industry and the broader market. The report notes that fair value doesn’t automatically fall by the wayside due to disruption.
“Even in such times, the premise of fair value remains the same, that being the amount that would be received in an orderly transaction given then current market conditions,” it says.
GPs should determine the performance and operational impacts to their targets, IPEV says. This includes figuring out market impacts – current and looking ahead – to companies’ customers, supply chains, revenue, geographical operations and product operations.
Sponsors should figure out whether metrics for earnings and revenue represent amounts for each that are “maintainable” from the views of market participants. Additionally, IPEV cautions GPs to determine how extended depressions of target company cashflows could play out, such as in working capital and potential covenant breaches.
The report includes guidelines for using comparables. It advises sponsors to pick and use “appropriate multiples which reflect the current market environment including risk and uncertainty in projections and historical results.”
IPEV recommends that GPs figure out if target company performance metrics have been updated to reflect market changes and expectations when the same types of figures haven’t been adjusted by public company comps.
The report advises sponsors to be flexible with valuation techniques. It includes deciding on whether scenario analyses need to be done for figuring out the probabilities of market dislocations happening for different durations.
IPEV’s other technique recommendations include avoiding multiples linked to public company comps that haven’t updated their performance metrics; how to determine discount rates that are “congruent with the risk inherent in the cashflows being used,” when using income valuation approaches; and picking back-up techniques and exchanges if trading in listed securities in a given exchange is paused.
When fair value is out of reach
Fair value represents the value of an asset when sold in orderly markets, but IPEV adds that there are transactions that are not orderly, and thus are “not indicative of fair value.” These deals are known as “forced” or “distressed” ones, the report says.
The body is responding to the challenge with a standalone sub-section that GPs can use to determine whether their transactions are at fair value. It lists criteria to consider that include whether a seller is in bankruptcy; whether an asset divestiture must be made immediately and without enough time for marketing; and whether there is a legal obligation to conduct a transaction.
Additional criteria include whether there was sufficient market exposure for “usual and customary marketing activities” to occur; whether market participants view the transaction as an “outlier” for comparison purposes; and whether a single potential buyer was available due to time and legal constraints.