Q&A: Pricing your firm

When, and for what purposes, would a private equity firm need to be valued? 

Vataha: Owners of private equity firms require independent valuations of their ownership interests for a number of reasons. In general, valuations may be required for transactions, tax filings, disputes and estate planning. 

Using tax as an example, an incoming partner may be subject to income taxes when granted interests that are “in the money”. That can happen when the interest includes a right to the firm’s management fees, or if it includes carried interest that has “intrinsic value”. 

What are some of the most difficult challenges in valuing a private equity firm?

There really are myriad challenges involved, the first being to understand in detail a particular firm’s entity structure, including the specific cash flows and ownership at each of the many partnerships and LLCs. Every firm is organised differently, and knowledge of exactly how and why the entities are arranged as they are often is spread between owners, CFOs, and legal and tax advisors. It’s never a straightforward valuation process.

Kyle Vataha

And when valuing privately held firms, experts rely on three basic approaches: market, income and cost. For firms with little tangible asset value relative to their historical or projected cash flows, the market and income approaches are preferable. The usefulness of the market approach is however limited to the availability of transaction data in similar firms and interests. Moreover it’s never an apples to apples comparison, and even less so when considering the various unique interests in these firms. So in most cases, valuation experts are left to rely on the income approach, and specifically the discounted cash flow method.

I’d imagine the discounted cash flow method has its own inherent challenges when valuing illiquid ownership interests?

Certainly, and the process begins with a reasonable forecast of a private equity firm’s future cash flows. Because developing long-term cash flow projections is generally not a normal business practice for private equity firms, valuation experts often must prepare these forecasts themselves. Private equity firms do not generate smooth cash flows that can be projected by using long-term growth rates or average expense margins. Their cash flows can be extremely lumpy, depending on the stage of their investment funds under management. 

Then take for instance valuing carried interest. Careful consideration must be given to the exact terms of a fund’s distribution waterfall. Is it paid on  the back end or deal-by-deal? What are the clawback obligations? Finally, changing macroeconomic trends may also cause a wide divide between a firm’s historical performance and its expected future results.  

How often does a firm typically have itself valued?

Private equity firm owners often elect to transfer interests for estate planning purposes upon the formation of each successive investment fund, with the goal of transferring a portion of the fund’s carried interest as early as possible in order to minimise the present value of the transferred interest.  

Sometimes, at a later stage of a fund, a firm owner may desire to transfer interests when there is the possibility that a given investment will pay off big in the foreseeable future, but that can be a risky bet. 

Kyle Vataha, Vice President at Pluris Valuation Advisors, focuses his work on the valuation of alternative asset management firms.