Q3 2020 - EisnerAmper Q&A with Antonella Puca, Senior Director, Alvarez & Marsal Valuation Services
- Sep 1, 2020
Alvarez & Marsal’s valuation services practice provides a broad range of valuation services, including, among others, independent valuations of portfolio companies and investments to support quarterly, semi-annual and annual reporting requirements under ASC 820. EisnerAmper sat down with Antonella Puca, senior director in the firm’s Valuation Services practice, for an update on the valuation of private equity under COVID-19. Antonella has recently published Early Stage Valuation: A Fair Value Update (Wiley Finance: 2020).
As an expert in “early stage” companies, specifically those that have achieved “unicorn” (value over $1 billion) status, can you speak on the impact the COVID-19 pandemic has had on these firms?
“Early stage” companies is a broad definition that may include companies that don’t yet have an actual product all the way to multi-billion dollar “unicorns” such as Airbnb with substantial revenue and operations. One common characteristic to early stage companies as defined in my book on early stage valuation is that they have yet to achieve profitability. Early stage companies are typically still burning cash and rely on a sustained flow of funding from their investor base for their continued growth. They can often adapt more swiftly to changes in the economic and competitive environment, such as those brought about by COVID-19, than “mature” companies with stable growth. On the other hand, they are still burning cash and are dependent on the conditions of the capital markets to sustain their growth.
When we consider the effects of the COVID-19 pandemic on early stage valuation, we often think in terms of its effects on revenue and on the higher risk which is generally associated with revenue projections in the current environment. I would argue that the effects on the availability of capital are also critical for early stage companies. One of the immediate consequences of the pandemic has been a slowdown in the pace of capital market activities in the private fund environment, including new rounds of financing and exit deals. The level of IPO activity, especially, has slowed down significantly. Unicorns that have yet to achieve profitability feature prominent in 2020 IPOs, with Legend Biotech ($3.2 billion) and Vroom ($2.5 billion) among the largest.
The availability of capital is a key factor in the assessment of the risk profile of an early stage company, as reflected in the company’s cost of capital in a discounted cash flow model and/or in the assessment of the company’s probability of survival in a scenario analysis. From an investor’s perspective, the time to exit is a critical factor in calculating the internal rate of return (IRR) as a key indicator of the investment’s financial performance. Let’s take for instance an investment of $20 million with an exit that generates $40 million in proceeds (multiple of invested capital of 2x). This investment will have an annualized IRR of 41% if the exit takes place two years from origination. The annualized IRR, however, will drop to 15% if the exit takes place at the end of year five and to 10% at the end of year seven. As the expected term-to-exit increases, the return required to make the investment worthwhile for the investor (the company’s cost of capital or discount rate) is likely to increase, and the present value of a given stream of company’s cash flows will decrease as a result, leading to a lower current valuation.
As we move from the level of enterprise valuation to the valuation of individual security interests, it’s important to keep in mind that the capital structure of early stage enterprises is often the result of multiple layers of financing rounds, which are negotiated independently and may involve different investors. As the company builds its operations, additional rounds of financing take place which typically involve the issuance of multiple classes and series of preferred stock with different rights and preferences. As we envision an environment with greater risk of dissolution or lower exit scenarios, contractual features such as covenants for debt securities and preferred stock rights are likely to become all the more valuable for investors.
For year-end benchmarking purposes, how reliable do you think third-quarter data will be in determining valuations considering the volatility we have seen year-to-date?
For the third quarter, we will have greater transparency in the company’s performance under the COVID-19 pandemic, and on their revenue and EBITDA projections. Business valuations as of June 30 were still based for the most part on first-quarter reported results. At the time of the June 30 valuations, many companies had yet to update their forecasts. As of the close of the third quarter, on the other hand, companies will have gone through at least one full quarter of activity under the current pandemic. We will be able to see their reported information through at least June 30, as well as their updated projections. As of the end of September, we still expect significant uncertainty on projections, but we will also have more factual information on how companies are reacting to the pandemic which can be useful for year-end benchmarking purposes.
As a follow-up to the above, can you comment on the lack of comparable transactions as well as the impact on M&A in a depressed marketplace?
We have indeed witnessed a decline in the number and dollar volume of closed M&A transactions over the past quarter. The uncertainty associated with the pandemic has made both buyers and sellers reluctant to close their deals at prices driven by metrics of operating performance such as EBITDA or revenue that can change rapidly in the current environment. The multiples at which comparable transactions have closed even as early as the first quarter of 2020 may have lost some of their informational power as indicators of future performance. The valuation analyst may consider adjusting the weight assigned to the value indication resulting from the guideline transaction method under such circumstances.
In the specific case of M&A exits, a significant share of the purchase price is often in the form of an earn-out where future proceeds are contingent upon the performance of the company over a contractually-defined period of time. The valuation of earnouts is one of the most challenging areas in the valuation of early stage companies and it has been made all the more challenging due to the greater uncertainty surrounding a target’s revenue and EBITDA projections. The use of statistical techniques such as Monte Carlo simulation and option pricing models can help address the uncertainty embedded in earnout valuation.
How do valuation issues today compare to what we faced during the global financial crisis of 2008?
The 2008 global financial crisis was characterized by a lack of liquidity and market declines across a broad range of industry sectors and all major stock market indices. Private deal activity also dried up quickly and significantly: Over the period Q1 2008 to Q2 2009, early stage deals dropped 33% in volume and 45% in value and late-stage deals dropped 17% in volume and 28% in value. In the current environment, the distress has not impacted the banking sector and the stock markets as severely, at least so far. The Federal Reserve and other government institutions have taken prompt and decisive actions to allow for continued liquidity and active markets. As of July 28, the S&P500 index was down less than 1% from the close at December 31, 2019 and near its all-time high. The current crisis has impacted various industries in different ways, hitting much more heavily sectors such as travel and leisure and oil and gas, while sectors such as internet and direct marketing retail, wireless telecommunications, technology hardware and software are up significantly year to date. It could be argued that the COVID-19 pandemic has precipitated structural changes that were looming in the economy well before the pandemic started, which makes it all the more challenging for companies to develop updated projections. At the same time, with a federal rate now close to zero (it was 5.25% in September 2007 at the outset of the 2008 financial crisis), company valuations are highly sensitive to even small changes in the discount rate. Also, the timing of the valuation process has narrowed. It is common for private equity and venture capital funds to start the valuation process within 20 business days before the reporting date, and complete the process within 20 days after the reporting date.
Any additional thoughts or takeaways you would like to share?
So far, we have highlighted some of the characteristics and challenges of the valuation of portfolio company investments in the current environment. The 2008 financial crisis has fostered the development of a substantial volume of guidance on valuation under the fair value standard that can help us today address some of these challenges. Most recently, the AICPA has released Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies – Accounting and Valuation Guide. Other recent publications by leading professional organizations include the new edition of the International Valuation Standards released by the International Valuation Standards Council, the latest release of the International Private Equity and Venture Capital Valuation (IPEV) Guidelines and related special guidance, and the Valuation in Financial Reporting Advisory on the Valuation of Contingent Consideration of the Appraisal Foundation, to name just a few.
The valuation process has become more challenging due to a combination of a quicker turnaround of information and complexities related to COVID-19 and the new economy. In the current environment, following professional guidance on fair value is not only a best practice, but can also help fund managers protect themselves and defend their valuation approach vis a vis investors and regulators.
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