THIS MONTH'S CHALLENGE: 'Fair value hotel'

THE CHALLENGE:
EAZY Rooms Limited was a division of a quoted hotel chain operating budget hotels in a number of European countries and was acquired on June 30, 2007 for £250 million by A1 Private Equity Fund II, a closed ended PE fund. The business operated 80 budget hotels and motels at acquisition and has subsequently added another five since the deal closed. The business is operating in line with the business plan at acquisition although there have been few similar transactions in the sector since the credit crunch took hold in September 2007. A transaction with a third party is currently at early stages which would result in a small partial exit for A1 at a slight premium to the £250 million acquisition price, although they would retain control of the business.

A1 are committed to reporting the fair value of their investment in their financial statements and commentary to investors – what approach(es) would they use to value the investment at a current date?

ANSWER:
Most valuers in the European private equity arena would swiftly turn to their copy of the International Private Equity and Venture Capital Valuation Guidelines (“IPEVCVG”) and rightly so, the ‘Bible’ sets out various appropriate methodologies for PE valuation. The unfortunate problem is it does not give you the answer, nor the precise methods you should follow – the guidelines are simply that – guidelines – and the valuer must exercise judgement as to what methods are appropriate, together with the underlying and source data.

The IPEVCVG suggest the most widely used methodologies are: Price of recent investment, earnings multiple, net assets, discounted cashflow (of underlying business), discounted cashflow (from the investment), and industry valuation benchmarks.

All of these could apply in our example above and are often used in pricing investments at acquisition. One key question over which there is a clear disparity in the PE industry is when is cost or price of recent investment not appropriate to use in a current valuation? When is ‘recent’ deemed to be too old?

The IPEVCVG are careful to suggest that due care should be taken in assessing the circumstances applying to each investment, for example external market factors (e.g. credit crunch, oil/commodity price movements, exchange and interest rate movements) or significant changes in the business (e.g. management changes, funding amendments, business plan targets not achieved) would imply historic cost may not be valid – although many PE firms rely on the one year suggested by the guidelines as being market practice. Hence for annual reporting, companies may only be revaluing each asset after two years of ownership.

This leads one to question how much market or internal factors need to change to be material enough to move away from cost. Circumstances change on a daily basis. The answer is that it depends – again the valuer needs to exercise judgement in the circumstances – a year is a long time in the financial world which is highly evident today with many stock markets sitting more than 20 percent below where they were 12 months ago. This would in most circumstances suggest material market movement and that cost may not be appropriate as an automatic default position.

In terms of methodologies, it is in most circumstances appropriate to utilise two or more approaches in order to support any valuation conclusions. The IPEVCVG suggest that discounted cashflow or industry benchmark methods should rarely be used on their own, (it is suggested they are a useful cross-check to market methods) although in practice it is common for all valuations to have two or more methods to confirm appropriateness.

In terms of EAZY Rooms Limited, there would appear a number of methods open to A1 to consider in terms of valuation. Given current market circumstances, historic cost is unlikely to be a reliable benchmark, despite being a typically comfortable approach for a closed fund. However earnings multiple, discounted cashflow, net assets based approach, industry benchmarks (e.g. £ per room) and prospective transaction analysis may all be applicable.

A key area of information available to the fund manager are the details of the impending transaction, although care needs to be taken especially considering the minority interest position acquired, the probability of its success at the date of valuation and the motives of the buyer. Whilst a premium to the £250 million may suggest a write up in value, other market factors may imply otherwise. The fact that the business is performing in line with the business plan would indicate that unless the risks to the business have changed materially (including current expectations vs. the original business plan), in the absence of distributions the DCF should reflect growth in the value of the investment.