Dealing with a significant drop in market comps, private equity firms have had to turn to other qualitative data or to re-evaluate the comps they use when preparing valuations.
“One of the more significant challenges private equity managers are facing is the lack of strong comparables,” said Anthony Minnefor, partner-in-charge of National Private Equity Services Group at EisnerAmper. “It’s forcing firms to do a real refresh of the comparable companies they are looking at to make sure they really are the best benchmarks for an investment company.”
Private equity valuations are normally based on a combination of public peer multiples and recent private M&A deals in order to filter out the impact of public market sentiment. Alex Di Santo, group head of private equity at private equity and real estate investor Crestbridge, said valuations methodologies have been strained due the linked factors of rising global rates, sinking equity prices and a potential economic recession.
A valuations void
With those in mind, firms have greatly scaled back their transaction rates. M&A deals and IPOs are down precipitously from prior years, and private companies in many industries haven’t performed as expected, meaning sponsors lack comparables to rely on.
That’s caused private equity firms to take a more wholistic look at their portfolio companies when trying to determine value.
“We’ve put less weight on market comps in our recent valuations simply because there’s not enough information out there to rely on the data from similar companies,” the CFO of a tech-focused private equity firm told Private Funds CFO.
“You have to look at differences in growth size, risk and margins and make adjustments, whether it’s a quantitative or qualitative model or a combination of both in order to get a meaningful result.”
Valuation has never been a purely quantitative exercise. Managers make determinations based on various factors; a portfolio company’s management team, the growth rate of a particular sector and labor force issues, for example. Managers rely more heavily on qualitative factors for younger companies and those in niche industries where quantitative data is hard to come by.
Following the 2008 meltdown, comparable transactions dried up and public market equivalents crashed, forcing many PE firms to shift to the more speculative discounted cash flow valuation model, the tech-focused CFO explained. Firms seem to have largely avoided that route, so far, the CFO says as they’ve put less emphasis on comps amid the recent economic and market uncertainty.
In fact, John Beczak, CFO of Resource Capital Funds, advises firms not to over-rely on comparables, using them only to help form valuations decisions while including other factors and risks specific to a given portfolio company, alongside market-facing data points.
“You should be looking at risk, premium or discounts to NAV to account for company-specific risk,” he said.
Beczak said the firm had to get more creative – or at least less dependent on the obvious – for recent valuations.
“There have been limited M&A transactions or strategic acquisitions in the past 12 months, so it was a little bit of a challenge for us to find good transaction comps and to be able to rely on the transaction comps that we did find,” he said. “Because of this, we had to do some extra analysis to show, for investments where we were relying on more dated transaction comps, how current volatility was impacting these comps and if the comparables we were using were truly representative of current market conditions.”
Another CFO said his firm has spent more time assessing comparable private transactions to see if they still support the multiples they use, given the firm has been conservative relative to public comps for the past couple of years.
“Now that cushion has gone away,” that CFO said. “If we were 60 percent of public comps one or two years ago, and now, we’re 90-110 percent of those comps, do we [recalibrate] down to the 60 percent, or calibrate so that we’re still [within a reasonable range] to the comps, but with a diminished cushion? The private transactions help us work through that and make that call,” he explained.
Reliable, and desirable, alternative approaches to valuation are scarce.
EisnerAmper’s Minnefor said putting more emphasis on company performance in the valuations process can also be problematic, given companies are operating under difficult market conditions, presumably temporarily.
“Managers tend to consider things like expected performance and assumed growth rates, and these things are hard to forecast right now. So, trying to come up with those inputs in your valuations can be challenging for managers when the markets are strained, like we’re seeing now,” he explained.
And a discounted cashflow approach – or any that relies on assumptions about future performance – allows a significant amount of subjectivity into the process, as firms try to predict what a return to “normal” market conditions looks like for their investments.
The golden rules: consistency and communication
However a firm values its portfolio, consistency is critical, particularly in any period of uncertainty, those speaking with Private Funds CFO said. That holds especially true for forward-looking models at a time when there are so many high-impact variables.
“We try to be consistent with our methodology across periods. Even through covid, we did a deep assessment of inputs and outputs, but we didn’t change our fundamental valuation methodology,” said the CFO of the tech-focused firm.
“In a forecast, you’re trying to estimate what the next five years will be like for a particular company, and where multiples might be at the end of that period. That’s where the models can be challenging: you’re trying to figure out if there will be a recession, how long it will be, and how interest rates and multiples will change over the period. No one knows those answers, so reasonable, consistent modelling is important,” the CFO explained.
Beczak said his firm’s valuation process is unique because its holdings span a range of mining project and companies, from those that are pre-operational to those in full production.
“For anything that’s pre-operational, our primary valuation method is looking at projected cashflows and applying commodity price forecasts to those cashflows. In these cases, the projected cashflows tend to stay pretty stable, so really the main driver would be commodity price forecasts and those tended to be neutral to positive for the past six months,” he explained.
And clearly communicating your methodology to investors can help put their minds at ease.
“With so much going on in the markets and in the economy overall, investors really want to comfort that the private equity firm is looking at the whole picture when valuing portfolio companies,” said the CFO of the tech-focused PE firm. “They want valuations to be as accurate as possible so there are no surprises later because the PE manager was optimistic or unrealistic in their valuations.”
Crestbridge’s Di Santo agreed, adding, “The private equity market is adept at protecting investors and has done so across many market cycles. But it stands to reason that investors want a better grip on their investment data, too.”
That is driving innovation in products that allow investors access to their data, he said. “And we’re seeing more demand amongst mid-market private equity managers looking to outsource this activity.”