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Valuation Challenge: Debt is down; is the equity up?

David Larsen, managing director of Duff & Phelps, examines how a middle-market buyout firm's investments should be valued

THE CHALLENGE:
A middle market buyout firm, Fairdeal Partners, strives to robustly determine fair value for its investments. Current credit market conditions have raised questions on the appropriate application of SFAS 157, especially on the impact of equity values when debt values change.

Fairdeal entered into a buyout transaction for XYZ Products with the following characteristics:

  • Fairdeal purchased 100 percent of XYZ's equity for $40 million, in August of 2007.
  • LTM EBITDA at August 2007 was $10 million.
  • Biggie investment bank provided staple debt financing of $60 million, which was subsequently syndicated.
  • Implied enterprise value: $100 million ($40 + $60) Implied acquisition multiple: 10 ($100/$10) Comparable public companies LTM EBITDA multiples median: 11

    Fairdeal is now completing its valuation assessment for June 30, 2008. The market has changed and the following facts now exist:

  • XYZ is performing well. LTM EBITDA has increased to $11 million.
  • Comparable public companies are trading down due to market conditions. Average LTM EBIT DA multiple for comparable companies has dropped 10 percent to 9.9. Surprisingly, the comparable companies all have increased EBITDA. The multiple decrease is purely due to the overall economic environment.
  • The debt markets have become very illiquid. XYZ's syndicated debt is trading at 80.
  • Fairdeal is considering purchasing XYZ's outstanding debt at 80.

    How should this investment be valued?

  • How should the equity be valued, if only equity is owned?
  • How should the debt be valued, if only debt is owned?
  • How should the debt and equity be valued if both are owned?

    DAVID LARSEN'S ANSWER:
    The starting point for the valuation assessment would be to determine enterprise value, e.g. what value would be received in the “exit” market (for simplicity's sake, assume the principal exit market is a sale to another financial sponsor). Comparable company EBITDA multiples have dropped 10 percent (11 to 9.9). Unless there are facts to the contrary (assume none for this transaction) we can assume that the multiple used by potential buyers of XYZ would also have decrease by 10 percent from 10 to 9. Given EBITDA of $11 million, enterprise value would now be calculated as $99 million (9 X $11 million).

    valuing standalone equity: Once enterprise value has been determined, another key factor for determining the fair value of Fairdeal's equity is to determine the value of debt. Historically, the face value of debt would be used to calculate the value of the equity. In this case, assuming debt with a face value of $60 million, the fair value of the equity would be $39 million (slightly below the entry price given that comparable companies are trading down, mitigated by the uptick in EBITDA).

    However, the fact that the debt is trading at 80 ($48 million) should also be considered. Mathematically, the value of equity appears to be $51 million ($99 – $48). Equity value increases as debt value decreases. To reach our final fair value conclusion we must come back to the exit market concept. Fairdeal must conclude on what would be received in the exit market at June 30. Would they receive dollar;39 million, or would they receive $51 million after debt repayment. $51 million would make sense if Fairdeal could conclude that the owners of the debt would only require $48 million to be repaid, which is highly unlikely. Therefore, $39 million appears to be the best assessment of the fair value of standalone equity.

    valuing standalone debt: If there is an active market for the debt (enough volume and frequency to determine price) then the market price would be used to determine fair value. In this case 0.8 x par value x quantity owned.

    If the debt is not publicly traded in active market, then a bond yield analysis taking into account credit quality, market interest rates, expected term, etc. would be used to determine the fair value of the debt (detailed calculations are beyond the scope of this discussion).

    valuing when both debt and equity are owned: Had Fairdeal purchased all the outstanding debt at 80 ($48 million), then there is a strong argument that the combined value of Fairdeal's investment (cost basis $88 million; $48 million + $40 million) would be $99 million, e.g. the total enterprise value given that Fairdeal would own 100 percent of both the debt and equity. There would be an open question as to whether the debt should be valued at $48 or $60 and whether the equity should be valued at $51 or $39. Mathematically a change in the value of debt indicates an equal and opposite change in the value of equity at the same enterprise value. If a bond yield analysis was used to value debt, the value of debt may change, but the combined value of debt and equity would remain the same.

    The discussion above has been simplified for presentation purposes. All facts and circumstances must be taken into account in assessing fair value. Depending on which securities are owned individually, or in combination, the fair value answer logically may differ because the exit price differs.