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Risk guide: Becoming confident with PE valuations

Anthony Cecil of KPMG examines the critical valuation issues pertaining to private equity investing. An excerpt from PEI Media's new book: The Definitive Guide to Risk Management in Private Equity: A comprehensive intelligence source for investors, fund managers and professionals who need to manage risk.

Fund managers generally report to their investors the value of the portfolio managed on their behalf. What risks of material error are inherent in private equity valuations and how can those risks be minimised? It is important that investors understand these issues to successfully assess how far they can rely on the valuations given to them. This chapter serves as a guideline for best-practice in dealing with valuations provided by private equity funds.

Throughout the holding period of an investment the valuer is likely to report the value using different methodologies, depending on the circumstances of the investment. As a rule, methodologies should be changed only infrequently, but at certain moments when it is appropriate to do so.

A common transition would be that an asset is valued on the basis of:
• price of recent investment when the investment is made;
• multiples once the price of recent investment is no longer considered valid; and
• DCF once an agreement in principle has been reached with a purchaser.

Valuations under each of these methodologies carry different risks of error.

When an asset is acquired, on the day that the transaction price was agreed, that price was by definition the fair value. Using that price as definitive evidence of fair value, the question is then posed about how long after the date of the transaction this price will continue to be the best evidence of fair value.

The length of this period is a matter of judgement by the valuer.

The risk of error largely arises from holding the asset at its acquisition price once this is no longer appropriate.

This may arise when a standard fixed period is applied as a part of the valuation policy, rather than a consideration of the evidence. This consideration might be expected to include internal factors relating to the profitability and prospects of the business, but also external issues. Asset owners should ask themselves how and why any market developments affect the value of their investments, including a focus on the general economic environment as well a specific issues in the market in which the investment operates.

Once the original price is no longer deemed to be the best evidence, comparison to other entities gives strong evidence of value, but introduces additional areas where risks of error arise.

In its most basic form, a multiple basis of valuation is a multiple derived from the marketplace, multiplied by an internally generated profit number and then a deduction of any financial instruments which would rank higher than the instruments being valued on realisation.
The selection of the appropriate multiple requires significant judgement by the valuer.

Selecting a multiple from either the quoted markets or a transaction involving a company in the same industry then requires consideration as to what adjustments might be appropriate.

While by no means an exhaustive list, the valuer may consider adjusting for differences arising from:
• Scale of operations
• Business areas
• Geographic spread
• Efficiency of operations
• Growth prospects
• Perception of the quality of management
• The period of time since the transaction in the same industry took place
• Lack of marketability of the investment
• The control rights attaching to a significant equity position

As no two companies are identical, any assessment of an appropriate multiple carries a risk of error. These risks start with whether the companies selected are indeed appropriate comparables and conclude with whether all the differences which a prospective purchaser would consider appropriate have been suitably taken into account.

Once a multiple has been adopted, this is then applied to an earnings figure. Earnings (after interest and tax) is rarely used since private equity structures historically these have included a significantly higher level of borrowings than those seen in public companies.

Commonly, EBITDA is used since this reduces differences arising from the financing structure; this is likely to be, at least in part, forward-looking rather than entirely historic.

The valuer should consider whether the earnings are those that a prospective purchaser would use to value the business and that the risk that any forecast earnings might not be achieved, is appropriately reflected.

The final part of the calculation is to deduct financial instruments which will be repaid from realisation proceeds ahead of the instruments being valued. Many of these instruments are complex with redemption premiums, elements which are convertible, contain liquidation preferences or other clauses which mean that the accounts balance may not be the repayment amount on the measurement date. Cash in the business is often deducted from the debt outstanding.

Errors may arise from these complex clauses or from deducting cash, on the basis that it could be used to repay outstanding borrowings, when in fact it is a necessary part of the working capital of the business.

Apart from the obvious risk of mathematical error in the calculation, further risks of error may exist arising from inherent conservatism. There is a pressure from investor behavior which encourages valuers to apply a degree of conservatism to their valuations. Realising an investment at less than its carrying value is viewed as disappointing to the investors.

When discounted cash flow techniques are used to value a continuing investment the value is based on the assumed projected cash flows over future years discounted back at an appropriate rate. After a number of years, future cash flows are assumed to continue indefinitely in accordance with the ‘terminal assumptions’.

Any cash flow-based valuation is highly sensitive to these terminal assumptions. In the case of an investment that is expected to be loss-making in the short term before becoming profitable, the majority of any estimated value resides in the ‘terminal value’. So the most significant drivers of the value estimate are the assumptions of cash generation in year ten to infinity.

The risks of error arising from these assumptions and the discount rate being inaccurate are not necessarily higher than for other techniques, merely much harder to assess.

Any multiple valuation methodology used is essentially an abbreviated form of a discounted cash flow calculation. Importantly though, it is the market’s assessment of value based on future assumptions rather than the valuer’s assumptions.

When DCF is used to value an investment where the price of a future transaction has been agreed and so the future cash flows are reasonably predicted, the risk of error has been significantly reduced. There always remains the risk that the discount rate applied is inappropriate.

This partial chapter is one of 19 in The Definitive Guide to Risk Management in Private Equity: A comprehensive intelligence source for investors, fund managers and professionals who need to manage risk, a new book from PEI Media. Edited by risk management experts Capital Dynamics, this guide provides investors and fund managers with valuable tools and practical guides to risk management scenarios, as well as case studies and best practices. Sample contents and more information on the book are available at www.peimedia.com/risk.