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Private Equity: is valuation fair?

By Régis Deymié, Principal Consultant

and  Kristian Lajkep, Regulatory Compliance Officer

Introduction

A substantial portion of equity takes the form of socalled private equity. Given its considerable size, private equity offers ample opportunity for good investments. Nevertheless, investing in private equity is inherently difficult. The value of the stock of private equity cannot be simply inferred from looking at publically available market figures, and the investors have little choice but to engage in some form of private equity valuation if they do not want to pass on a number of opportunities for flourishing investments. A sound and reliable equity valuation can make a difference between picking up the proverbial cash from the floor and sinking your fingers into something that – very much unlike money – does have an odour.

An additional motivation to engage in valuation for the investment funds, other than keeping track of their performance, is the information disclosure required by the new regulatory framework (AIFMD, MiFID).

This paper gives a brief description of the private equity regulatory framework, as well as what private equity funds are subject to, and common, possible, private equity valuation techniques. It will also introduce the notion of “fair value” and explain its assessment by asset managers.

Typical forms of private equity investments 
Leveraged buyouts (LBOs), in which the investors establish a buyout fund which takes on a considerable debt in order to fund the purchase of a company. The assets of the target company typically serve as the collateral for the debt, and the cash flows of the target company are used to service the debt. 
Venture capital, an investment in infant companies that have high potential for growth. 
Development capital refers to providing equity funding to a mature company that seeks to expand or restructure beyond its scope, in exchange for a minority share. 
Distress investing is a type of investment in a company that has an overall sound business plan and is in a manageable shape, but undergoing financial problems.1 
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1 - In practice, the vulnerability of these companies offers an opportunity to get on-board. Most of the companies prefer debt financing to equity financing whenever possible. A company in distress, however, has limited access to debt and more reasons to want to seek equity capital. 

What is private equity?

Investment in private equity can be described as an investment in shares of stock of a company that is not listed. This investment is often made via private equity funds. The general idea is to accompany the enterprises in their development during a predetermined lapse of time and sell back the investment (or exit from the deal) at the end of the period with, hopefully, a profit. Private firms (among which a majority consists of small and medium sized companies) are very important providers of employment in Europe. This makes the Private Equity sector strategically important for national and supranational authorities as well as a good market for institutional investors.

The private equity fund manager usually keeps hold of the company for five to ten years before entering into the exit process.

The regulatory framework of private equity valuation: “Fair value” as a master key

Previously, the private equity funds fell outside of the EU disclosure and transparency framework. They were only regulated by partnership agreements between general and limited partners. This has all changed with the Alternative Investment Fund Managers Directive (AIFMD), which AIFMs need to comply with in order to get a passport to operate in the European market.

The AIFMD was created to protect investors and consists of a broad range of standards that seek to improve financial stability reporting and disclosure as well as risk management processes.

One of the key issues that AIFMD addresses that is a concern for a private equity fund is the valuation of underlying investments. The valuation shall be performed according to procedures that “ensure a sound, transparent, comprehensive and appropriately documented process”. The fund should be able to calculate the Net Asset Value of its investment in order to provide limited partners and regulators with mandatory reporting information. In some cases, it is also used to evaluate intermediary remuneration for the portfolio managers.

With regards to the valuation function, AIFMD allows Management Companies to have it “in house” or to have recourse to an external valuation agent. It is important to differentiate between the valuation process and the valuation function. The function refers to the responsibility for the performance of the valuation whereas the process refers to the valuation itself (how it is performed).

Under certain conditions, the regulator gives the possibility to the Management Company to delegate the valuation function to an external Entity (being different from the depositary).

The most frequent exit strategies 
Trade sale – The sale of the investment to a strategic buyer (competitor) at a price determined by negotiations or auctions. May be substantially simpler and yield a good price due to the nature of the buyer but there is a risk of treading on thin ice with regards to competition law, ethics and employee approval. 
Initial Price Offering – A procedure by which a private company issues its shares in the stock exchange market. It is generally dreaded for its complexity; as such, it is viable only for the largest companies. If successful, it allows for higher profit, and change of ownership is least likely to fetter its future operations. 
Recapitalisation – It allows the investors to extract money from the firm whilst retaining the ownership. In practice, this is very popular as long as the leverage does not get too excessive as to negatively impact the firm. 
Secondary Sales – The sale to another private equity firm or other investors. 
  

 

In such case, the Management Company keeps the responsibility for the valuation towards investors and shall therefore perform a recurrent due diligence process on the delegated Entity. On the other hand, the external valuation agent endorses some responsibilities towards the Management Company: they are liable for any loss suffered by the AIFM as a result of negligence and/or intentional failure to perform their task. 

AIFMD also defines certain criteria for endorsing the valuation function. The external valuation agent shall:

  • be subject to mandatory professional registration and
  • be able to provide professional guarantees that prove its capacity to be in charge of the function.

It is therefore obvious that an AIFM choosing to delegate the valuation function to an external valuation agent, to some extent decides to opt out of the valuation process. Such a decision makes sense when the AIFM wants to disengage its responsibility in this field. By doing so, the AIFM accepts to lose part of its management capacity.

The AIFMD also authorizes to keep the valuation function inside the AIFM, provided it ensures that:

  • the task is performed independently from the portfolio management and
  • conflicts of interest are mitigated.

This means that the regulator considers that conflicts of interest can exist in a valuation process, but in that case, they request these conflicts to be mitigated and documented. Indeed, in many cases, it is difficult to completely avoid having recourse by any means to the portfolio management to evaluate the investments. This is due to the fact that in the absence of quoted prices, it is often the case that only portfolio managers can provide the necessary information.

A solution for AIFMs willing to keep the valuation function internally while setting up an AIFM compliant valuation process is to on-board an external valuation agent acting as advisory. In that case, the external entity guarantees the independence and transparency of the process but leaves the ultimate responsibility to the AIFM.

The key word in valuation for regulatory reporting disclosures is therefore fair value. In case of IFRS, the standardised definition of fair value at which funds are required to measure the assets and liabilities, is the price of a given asset or liability if the transaction is conducted in an orderly manner between market participants at a given date. This requirement is similar for accounting standards in the US (US GAAP) and NAV calculation under AIFMD (the AIFM shall ensure that a proper and independent valuation of the assets of the AIF can be performed).

Private Equity Valuation Techniques: where is the market?

In order to promote the use of calculations that make use of more objective observable inputs (leading to fair valuation), the main guiding regulatory pieces such as IFRS, US GAAP and IPEV create a hierarchy of valuation techniques based on how much observable information they are making use of. The guiding principle is that the more observable inputs, the better. This hierarchy consists of:

  • Level 1 – Quoted prices in active markets for identical assets/liabilities – applicable for most exchange-traded instruments, but a priori not possible with private equity.
  • Level 2 – Fair value derived from inputs that are either directly or indirectly observable for the asset/liability, used if and only if other types of prices are missing.
  • Level 3 – Fair value derived from unobservable inputs, involving significant investigation and subjective judgment - shouldn’t be used for regulatory reporting.

Price of recent investments

The best way to achieve a fair value pricing for a private equity investment is to infer the value of the firm from the price of a recent investment (if the required data are available). This valuation technique is better suited for venture capital investments as infant or developing companies take on more (relatively) large investments and are more likely to fund them through equity.

This type of valuation is representative of the fair value if and only if:

  • the parties involved in the investment are not associated,
  • the investor can be regarded as an informed, rational and self-interested market participant, and
  • the transaction is significant enough to be representative of the value of the entire firm.

Assuming that the investment is fairly priced, we can infer a per-share value.

 

A private company value would thus be:

Comparable approach

This approach is recommended if no recent equity funded investment is available or if its quality is not sufficient. It rests on deriving the value of the firm from a basket of similar publically traded firms and using an appropriate multiple (an accounting ratio such as EV/EBITDA ratio, P/E ratio or EV/EBIT ratio).

The natural difficulty is to find the appropriate basket of comparable companies. Such basket would typically include up to five firms that are comparable in their operational sector, business model, growth strategy, prospects and competitors. The figures of the companies may need to be further adjusted to account for the differences. This methodology contains a degree of subjectivity when choosing a limited number of peers. It is important here to make sure that the process is justified and documented in order to assess the independence of the valuation. Fairness comes from independence.

The IPEV guidelines recommend keeping a consistent approach over time. It means that after the group of peers has been defined, it is recommended to keep it as long as possible in order to obtain consistent prices over time.

IPEV Guidelines 
The International Private Equity and Venture Capital Valuation Guidelines – the IPEV guidelines, endorsed by more than 40 private equity and venture capital associations, offer a set of non-legally binding recommendations that set out the best market practices for the valuation of private equity and venture capital funds. 
Even if IPEV guidelines are not legally binding, they appear more and more as a standard in the fund industry and can even be included as a requirement in the management agreement. If IPEV rules are in conflict with IFRS (which normally should not be the case), then IFRS prevails. 
  

Cash flow/income approach

This is another possible valuation approach, one that ought not to be used for reporting and regulatory purposes for its lack of precision. However, it may further inform the investors, as it embraces that in theory, the value of a firm is the present value of its future cash flows. The first significant and to a large extent arbitrary decision is to determine what sort of accounting figures should be used for expected cash flows. Generally, Free Cash Flow to the Firm (FCFF) is preferred. The discount rate must also be chosen appropriately. If FCFF is used, then the most appropriate discount rate is the weighted average cost of capital (WACC) defined as:

 

A keen observer may recognize that the WACC cannot be really calculated without knowing the value of the equity in the first place – the very thing we are looking for. For this reason, a calculation is performed in a loop, starting with the book debt/equity ratio, each time getting more precise. The cost/return on debt is taken from the yields on the last issued debt (if substantial enough). The cost/return on an equity may be calculated for instance by CAPM:

 

The Return on Market and Risk free rate to be used are problematic terms. It is necessary to keep in mind that CAPM is an ancient model plagued with many other problems. As we can see, every term used rests on subjective assumptions and they are being fed to an inherently flawed model. There are more precise WACC and pricing models than those described (with simplicity in mind) above, but none of them is perfect. In case of a less mature firm, without a history of stable cash flows, this approach is unusable. In case of a more mature firm, it is still very subjective and, even with best efforts, dubious. This approach to valuation should thus be used to calculate fair value (under IFRS 13), if level 1 and 2 approaches are unfeasible. According to market best practices, this approach had better not be used in isolation.

Net assets approach

This method calculates the value of a firm by calculating the value of its net assets as they would be priced if the company was to be liquidated on the date of valuation. As such, the value of the firm is the total value of assets less the present value of the company’s debt. It has to be noted that the market value of assets often tends to be very different from its book value. As such, each item on the balance sheet needs to be re-evaluated, making this process cumbersome and less than precise. This approach can only be used on a company whose value is mainly in its physical assets in place. To the extent that the company’s value comprises growth opportunities or less tangible assets, this approach is unfeasible, but it may be good at giving the lower bound of a company’s value.

Conclusion

The evolution of the private equity business goes hand in hand with the evolution of regulation. As we have seen in this paper, the main regulations that can impact private equity funds are AIFMD and IFRS (US GAAP for US domiciliated funds). These regulations tend to provide more transparency to investors, especially in the fields of risks and performance disclosure. In this context, a fair valuation of assets is now an inescapable notion that aims to make everybody happy: Regulator, investors, portfolio managers, risk managers and accountants. That is why Asset managers (AIFMs) shall take great care in evaluating their investments. A way to mitigate conflicts of interest is to integrate an independent specialized entity in the valuation process to help guarantee the fairness of valuation. AIFMs are allowed to do so without losing their management control.