Given the specialist nature of private equity valuation, Boards often use an investment manager or external specialist to value the portfolio entities to include in the annual financial statements. Even though the Board utilises another party, they are still required to assess and conclude whether the resulting valuation is both reasonable and suitable for accounting purposes.
A strong valuation process is more vital now than ever. Prior to a 31 December 2019 valuation date it is generally accepted that, unless the portfolio company was operating in China, COVID-19 was not known at the valuation date and therefore should not be factored into the year-end valuation.
Now the landscape is different and COVID-19 is certainly a knowable consideration for any reporting. The key issue now therefore becomes how to factor COVID-19 into any valuations for financial or investor reporting purposes for year-ends post a 31 December 2019 valuation date.
What valuation approach should now be applied?
Previous models may no longer provide a reliable valuation conclusion and care should be taken to ensure that any approach taken now appropriately accounts for current market data, or lack thereof. It is important to consider both market and income valuation approaches to provide a cross check to support the fair value assessment. All valuations should be derived from the perspective of a market participant.
What are the key considerations when a multiple model is being adopted?
Maintainable earnings
- A market participant relies on maintainable earnings, therefore deemed one-time impacts on performance would be excluded.
- In addition, a view may need to be taken at the measurement date as to the potential for, and impact of, possible government subsidies that may impact individual companies and the overall economic environment. The impact of government subsidies or initiatives generally would not be reflected in the results of a portfolio company until it can be reasonably assured.
- Any adverse expected performance, even if one-off, would need to be factored into the debt-like item line as there will be a requirement to either expend cash or take on debt to get through the crisis.
- A scenario analysis may be required to incorporate the probability of the crisis extending over six, twelve and eighteen months, with a weighting then applied for maintainable earnings.
Multiple
- Where a comparable basket of listed multiples has previously been applied, a good indicator of market movements from the impact of the crisis is to calibrate how multiples have moved from a valuation date of 31 December 2019 to 31 March 2020.
- It is appropriate to consider the Alpha of implied multiple discounts between market multiples and the subject company multiple. If the company being valued is more sensitive to the market conditions, then it may be appropriate to increase these implied discounts. Conversely, if these were to increase it may be appropriate to narrow these discounts.
- Where a multiple applied is a recent transaction multiple, this will need collaboration to market multiple movements since entry and may need adjustment.
- Comparability needs to be considered to avoid any “double dip.” For example, if maintainable earnings have been adjusted to take account of expected lower performance, care should be taken in using a discounted multiple against comparable public companies whose results have not yet been lowered.
Net debt
- Any cash burn requirement to enable the subject company to weather the storm should be included in the net debt amount. Cash burn is required to sustain the business to enable a valuation to be realised.
Other considerations in use of a market approach
- A key consideration in any valuation is the liquidity of the business to sustain itself. At a minimum, qualitative and quantitative judgements will be required on expected cashflows, any likelihood on breach of loan covenants, the likelihood of delayed customer payment and overall cash requirements.
- Market multiples have moved significantly over the quarter to March 2020 and significant uncertainty exists with respect to company performance and achieving projections. Therefore, a combination of modifying projections and historical results, combined with adjusting factors such as multiples and discount rates, is required.
INCOME APPROACH
The income approach can be very sensitive to changes in the discount rate. The current market conditions, as a result of COVID-19, have affected various elements of the discount rate which may result in a significantly different conclusion when arriving at a valuation output.
What are the key considerations when an income model is being adopted?
Cashflow projections
- A buyer would expect to have available up-to-date projections at any point in time. To the extent where projections are out of date or have not been updated for current developments, a market participant would consider the cash flows riskier and would likely decrease the multiple or increase the discount rate used in estimating the amount they would pay in an orderly transaction.
Discount rates
- If future cash flows have been adjusted, care is required not to overly adjust the discount rate to again prevent any “double dipping” on the valuation.
Cost of capital
- While the risk-free rate may have decreased, company-specific risk and equity risk have likely increased. On a combined basis, in general, it can be expected that discount rates will increase.
Capital structure weightings will shift based on decreases in equity market capitalisation for comparable companies, along with the potential need for increased debt to weather the storm.
In summary, there are many considerations to be made in respect of valuations in these uncertain times. At BDO we are here to assist in valuations or second opinions and our team has vast experience in the private equity space. If you need advice then get in touch with me or your usual asset management team contact.