Control premium means different things to different people. The concept of a control premium may presuppose the existence of a minority discount. Market participants in the private equity and venture capital industry do not typically think of value in the context of control premiums or minority discounts. Therefore, it is critical that concepts be clearly defined and articulated so that the use of the term control premium does not force the use of a minority discount and that resultant valuation measurements do not differ from the perspective of market participants.
Below, we look at two specific scenarios related to valuation and control (non-controlling equity and non-control equity with debt) as well as two case studies (see below case studies) for guidance purposes. However, it should be stressed that the valuation descriptions below are by design succinct and therefore focused on highlighting potential questions. As fair value determinations require judgment, the analyses provided may of course differ after a thorough vetting of all actual facts and circumstances.
Let’s begin with non-controlling equity. Remember that lack of control refers to the inability of the investor to control the company’s management, strategy and, in particular, the timing and form of the exit. This is usually because the investors’ equity position is a minority stake. There are two potential issues to consider here then: 1) application of adjustments; and 2) contemplated but not closed exit.
Application of adjustments
In many cases, the application of an adjustment for a non-control position will not be appropriate. Generally, a “minority” investor participates “in concert” with other investors. They pay the same proportionate price and receive the same proportionate return. Further, while they do not directly control the timing of an exit, when they are investing with other like-minded investors who would maximize value through the sale of the enterprise, the assumed orderly sale of the business at the measurement date provides the best indication of fair value. In such circumstances, there would not be an adjustment for lack of control. Only when facts and circumstances dictate that a minority owner would receive disproportionate cash flows or would maximize value through the sale of the minority position independent of the sale of the entire business, would an adjustment be warranted.
Many alternative asset investments include pari passu investment features. Buyers of minority positions pay the same pro rata amount as control investors and receive the same proceeds as control investors. Therefore, individual facts and circumstances must be considered to determine if a market participant would actually pay less for a minority position given the dynamics of investing in alternative assets as noted above.
In such limited cases, a valuer would determine if the value for a minority position is best achieved based on estimating the overall business enterprise value and then applying an adjustment, or if determining the value of the minority position using other methodologies would be appropriate. The application of an adjustment or an alternative valuation method would be supported by individual facts and circumstances and by market participant assumptions.
The determination of the appropriate adjustment, if any, for lack of control depends on the situation at hand as well as the specific valuation methodology chosen. A high-level guide would include:
– If the minority investor pays a different price than the control investor, the price paid by the minority, if deemed fair value, would be calibrated with inputs used to value the business or interest on an ongoing basis.
– The level of adjustment should not be predetermined (or always a certain number) but rather should be calculated based on the specifics of the transaction. This is intricate and difficult and requires a fair amount of experience by the valuer determining the adjustment.
In summary, the application of an adjustment for lack of control in a minority privately held security may be warranted in certain limited circumstances. The level of the adjustment, if any, needs to be calculated in supportable fashion based on what market participants would do.
Contemplated but not closed exit
A non-controlling co-investor in an equity-type investment is inherently at the whim of the party controlling the investment as to the ultimate form and timing of the exit. This occurs even if the investor was able to insert drag-along rights into the purchase agreement. Hence the investor will likely have limited informational rights as to the details of exit negotiations. As a result, to the extent an investor confidentially does know about suggested price levels being negotiated by the controlling stakeholder in regards to a potential exit, such price levels, while certainly to be taken into consideration as a fair value indicator, will need to be evaluated carefully to determine their relative merit as compared to more fundamental value indicators. Again, considerable (and ultimately documented) judgement will need to be exercised in this process.
Non-control equity with debt
Lack of control refers to the inability of the investor to control the company’s management, strategy and, in particular, the timing and form of the exit. The principal market for a sale of a minority interest may or may not be the M&A or IPO markets, but given that a market participant with a minority position cannot affect the timing of an exit through the sale of the entire company, the investor cannot trigger a change of control provision on the debt. Hence, the fair value of non-control equity interest is determined by subtracting from the business enterprise value the par or face value of debt because a market participant would determine the price of the equity position based on the assumption that the debt would have to be repaid at face amount. (Note: The minority interest may also be valued by reference to a controlling interest, as described above.) However, the fair value of debt, because the timing of an exit cannot be affected by a minority equity holder, would be determined using a valuation technique that considers current market yields, term and credit quality, and leveraging Level 1, 2 or 3 inputs as appropriate.
(Partially) impaired debt position
In a situation where the investors hold a minority stake in a company, as well as debt which now appears impaired, a relatively complicated valuation exercise will ensue.
This is because the investor is likely to have access to very limited information on which to base the valuation decisions. Questions that will need to be answered include:
Does the apparent (partial) impairment of the debt indicate that the fair value of the equity is also impaired? This is not necessarily the case, especially in dislocated markets as experienced during the 2008–09 financial crisis when debt markets were indicating very impaired price levels for performing loans of healthy companies.
What publicly available data can be used that reflects fairly the value of the instrument in question (as a comparable)?
Are there adjacent markets that trade in lock-step?
What base-data is available – for example, projections and last 12-month financial statements? If these are limited and no further data will be supplied, how can they be augmented and/or interpreted?
Differing values for debt
As a direct result of the valuation methodology described above where the par value of the debt is subtracted from the business enterprise value in determining the fair value of the non-controlling equity investment versus a yield analysis for determining the fair value of the debt position being held, the same debt position will likely carry a different value in each determination. This is a direct result of unit of account considerations. While seemingly illogical, the unit of account concept potentially drives a different valuation premise for individual securities being valued.
When looking at the debt on its own, its fair value is best described by what the debt could be sold on its own (that is, without the equity position). Hence, a yield approach to valuation is likely the most appropriate approach. When looking at the equity on its own, however, the application of the business enterprise value would not correctly reflect the equity value unless the par value of the debt is subtracted from the enterprise value to determine the fair value of the (non-controlling) equity position.
For a discussion on other valuation nuances, including ones pertaining to actively traded debt, non-traded debt and structured products, please see PEI’s newly-released Private Equity Valuation handbook.
Both based in New York, Stephan Forstmann is a managing director in Duff & Phelps’ Alternative Asset Advisory practice, whereas Robert Malagon is a director in the group’s portfolio valuation service line. This was an edited excerpt from a chapter in PEI’s newly released title “Private Equity Valuation – the definitive guide to valuing investments fairly,” available at: peimedia.com/books
Case study 1: Non-controlling equity
Situation: Private Company A is owned by three private equity funds in equal proportions (33 percent of equity each). The company has EBITDA of $100, debt of $400 and similar companies trade at 7x TEV/EBITDA. The implied TEV and equity values are $700 and $300, respectively. A strategic competitor agrees to acquire 100 percent of Private Company A’s equity for $500. The acquirer believes the value of cost synergies to be $150.
Key question: What is the fair value of the equity?
a) $500 given the strategic buyer’s acquisition price?
b) $300 given the TEV of $700 and debt of $400?
c) $450 given the value of the equity plus the cost synergies combined?
Answer: Judgement is necessary, including an assessment of the risk associated with the transaction closing. Until the transaction closes, the fair value of the equity could reasonably range from $300 to $500, given that the implied TEV is $700 and Private Company A has $400 in debt, assuming no risk to closing. If the time to closing is long and risk of closing is great, some valuers would likely gravitate towards $300 because they could conclude that not all market participants would offer the additional $150 paid for synergies.
Case study 2: Non-controlling equity with debt
Situation: In December 2013, Mid-tier Fund A acquires 10 percent of the equity of Company Z and 20 percent of the outstanding senior debt at par. At the time of the transaction, Company Z generated EBITDA of $50 and had $100 in debt paying a 10 percent interest rate for an implied interest coverage ratio of 5x. Similar companies are traded on the market at 10x TEV/EBITDA. One year later, the company’s EBITDA decreased to $25, reducing the interest coverage to 2.5x and similar companies traded on the market to 4x TEV/EBITDA. Outstanding debt remains at $100 and implied yield is 20 percent.
Key question: How should each security be valued on December 2008?
a) $0 for the equity given an implied TEV of $100 and par value of debt of $100?
b) $50 for the equity given an implied TEV of $100 and market value of debt of $50?
Answer: The solution is (a) since market multiples have traded down to 4x resulting in a TEV of $100. This would just cover the outstanding debt, leaving no value for the equity. If supportable, the equity could have some nominal option value, at best, in this scenario.