Q&A: The value of sensitivity

PE Manager revisits some of its best on the record interviews of 2013: In February, PwC valuations partner Nick Rea told us why not all CFOs are convinced certain sensitivity tests on their valuations is time well spent.

What is the difference between the US and international standards in regards to sensitivity testing?

Broadly speaking International Financial Reporting Standards (IFRS) requires you to put out more numerical analysis in terms of sensitivities than US Generally Accepted Accounting Principles (GAAP). The methodology used in the market to value private assets is typically EBITDA multiples and it is relatively easy to show the impact on value from different multiples or assumptions. When the more detailed discounted cash flow (DCF) analysis is used (which is rare), then you can flex some of the underlying assumptions which would be typically growth rates, margins, exchange rates and discount rates.

Whether EBITDA multiples or DCF are being used for valuation purposes under IFRS, you can flex some of the underlying assumptions to show ranges of value. By contrast, in the US you do not have to produce numerical analysis. Instead, you can discuss which assumptions would significantly impact value without assigning a number to that impact.

How important is sensitivity testing in the private equity sector?

Valuation is asset specific and should always be considered in a range. Very rarely can you point to a single number and argue that it is the only possible outcome. Therefore it tends to be much more useful to show a range and point out the key factors that drive the ends of the range. This tends to provide greater insight into value for investors or those interested in the values of the investments. So this has got to be a good thing as sensitivity analysis does give investors more information typically as long as sufficient detail (and not too much information) is provided.
Increasingly investors want to have detailed discussions on valuations and make sure that they fully understand the key drivers behind the analysis. This is evidenced by the increase in the transparency from private equity houses to their investors in the past few years and the International Private Equity and Venture Capital Board’s updated guidance on valuations and investor reporting supports this.

Some CFOs argue rigorous sensitivity testing doesn't work for private equity assets because the valuation process is too subjective, resulting in an information overload. Are they right?

I think that something that shows you asset by asset, as the funds already do in the UK, the range of values for each asset on a different multiple basis should be achievable. The point about being able to do something meaningful is evident by the number of private equity houses that already do this. Where it gets more problematic is the amount of detail – i.e. to what level of assumption do you go – and this is where some high-level analysis using different EBITDA numbers or different EBITDA multiples can provide some useful insight without being overly-onerous.

Do you think that sensitivity testing will be adopted by the US as greater alignment is sought between accounting standards?

I wouldn't be at all surprised if the US looked at this and decided it is what investors want and is achievable for private equity houses. I think the issue about convergence is a much bigger one than this difference and this is a very minor issue. While the fact that differences still remain between IFRS and US GAAP is not ideal, we are seeing greater transparency generally as investors ask more questions about valuation. So investors are by and large getting what they need anyway.