Private Equity Valuation Considerations in the COVID-19 Environment

AM: Prior to COVID-19 we had seen a long period of very strong valuations across the spectrum of private equity. Multiples were through the roof and then in mid-March, things changed quickly. When you were talking to your clients, what did you initially see in terms of how they were approaching their valuations for the first quarter and the valuation methodologies they selected?
CTB: Well, first the big reporting period right before COVID-19 was obviously December 31st, 2019. That period and before that, most of our clients were using a combination of values that they derive from the guideline company method, which is a methodology under the market approach where they're utilizing market multiples. And then they're also using projections and the discounted cash flow, which is an income approach. And you have to have the projected performance of the investee company.

Once those two values have been determined, then typically a client would apply a weighting to those and drive their ultimate fair value that's reported to their investors. In mid-April, we had discussions with several clients regarding how they were going to approach those valuations for the first quarter ended March 31st, 2020. So at that point, the market caps, which affects the market multiples for most of the capital companies had decreased about 30% to 40% due to concerns related to COVID-19.

But the reported earnings of those comparable companies at the time of the period were results through December 31st, 2019, and maybe at most February 2020. Those earnings results had not been affected by COVID-19. Therefore, you had market multiples typically 30% to 40% below than what they were at December 31st, 2019.

In addition, the effects of COVID-19 on their earnings were only for a very short period, maybe a couple of weeks at most. So that's very similar to the public companies. So the value utilizing the market approach would, as I said before, be 30% to 40% lower at March 31st, 2020, a sense these multiples were down 30%, 40% and the earnings of both the public comps and the investee companies were flat.

So most of the clients that we discussed felt that the waiting on the market approach would probably be minimal even sometimes zero because they felt that the market was disjointed and did not represent fair value, which does assume an orderly market.

Also at that time, clients were focusing on their subject companies and trying to determine those companies' exposure to COVID-19 and its effects on the projected performance over both the near-term and the long-term.
AM:That's interesting. The guideline company approach was essentially put on the back burner it seems then, due to COVID-19. Under normal market conditions, comparable companies and their multiples, normally I think inform private company valuations in a significant way. Which sectors have you seen stock prices and their multiple suffer the most and which ones have shown resilience?
CTB:Well, some of the sectors hit the hardest were consumer discretionary, which includes cruise lines, retail companies, apparel companies. Another sector that was hit very hard was energy. You had oil and gas companies, and when I say oil and gas, I'm not just talking exploration, but also companies that service those exploration companies.

And you also had industrials, which includes airlines and manufacturing's. Some sectors that had shown some resilience are information technology and healthcare. At the end of June, the bottom performers in the S&P 500 and how we measured that was the percentage change year-to-date consisted of four consumer discretionary companies, which was all three major cruise lines and also a national department store, three energy companies, again, oil and gas exploration and production, oil and gas equipment, and service and storage and transportation companies. And it also included an airline which falls under the industrial sector.

The top performers consisted of four healthcare companies. And again, biotech healthcare companies that provide supplies and equipment, as well as some of the names that you kind of would expect during COVID-19. Netflix, Amazon and eBay.
AM:The sectors you mentioned are comprised of numerous individual companies. When investors value their investments, what's best practice for selecting comparable companies? Is it appropriate to use a broad market index, or is there a better approach?
CTB:I guess we could talk pre-COVID and a little bit post-COVID, but the best practice for selecting comparable public companies is first to identify the sector that the investee company competes in. Then within that sector look more specifically at the industries that the investee company has lines of business in.

So once that has been determined, you typically line up those public companies and you start to exclude companies that are significantly larger than the investee companies, or for some other reasons, like for example, the public company has operations that are significantly diverse than the one line of operations that your investee company has. A lot of times these comparable companies have been selected during the original investment thesis. When the fund bought into that company.

A sector index is probably more appropriate than a broad index, so for example the S&P at the end of June of 2020 was only slightly off from the December 2019 mark, yet what happened is you had quite a few companies that had market caps, 30%, 40% in certain sectors of the S&P 500.

And then the opposite side, you had other companies, like I mentioned, healthcare that had recovered and were significantly higher in some cases than they were December. So you have to be careful whether you use a sector index, or obviously even a broad index is not really appropriate, in my opinion.
AM:Craig, I know you've done some analysis on this topic. Could you share some specific examples of companies where their enterprise value to EBITDA multiples have deteriorated in the current environment?
CTB:Sure. I analyzed three companies in the consumer discretionary sector and different industries within that sector. So I looked at Ralph Lauren, which is an apparel company, Marriott hotel chain and Darden restaurants, which is casual dining. And I looked at their performance from the end of 2019, December through June 30th, 2020.

So keep in mind that when you're looking at an enterprise value to EBITDA multiples at December 31st, 2019, you are using the stock price at that time, December 31st, but the latest financial information such as cash, debt, and earnings, whether it's EBITDA or net income at December 31st are only for the 12 months ended typically September 30, 2019.

So for the three companies that we analyze the financial information was as of September 2019 for Ralph Lauren and Marriott, but it was for November 2019 for Darden and most periods, this offset and timing between the stock price and the reported earnings is not an issue.

So for the first quarter ended March 31st, 2020, the market caps for these companies were down 44%, 50% and 51% respectively, but their EBITDA's for the 12 months ended December 2019 and February 20. We're only down say around 1% to 8%. So therefore the enterprise value to EBITDA multiples were down 42%, 39% and 29% respectively.

So at June 30, 2020, you only have financial information through March 31st for Ralph Lauren and Marriott. But for Darden, now you have information through May 31st, 2020. So for Ralph Lauren and Marriott, you have market caps down an average of 42% at June 30th compared to December 31st EBITDA, which average around being down only down around 10%. So their average multiples were down approximately 30.

However, at the same time Darden's market cap is down 26% over that same period, but the last 12 months ended May 31st, 2020, Darden's EBITDA is now reported to be down 25% from what it was at December 31st, 2019. So after considering the other changes in net debt Darden's enterprise value to EBITDA multiple was actually higher at June 30th, 2020 at approximately 12.2 times versus 11 and a half at December 31st, 2019. At the same time, Ralph Lauren and Marriott's were down 29% over the same period.
AM: That's interesting that the multiples of the companies you spoke about reflect both the current stock prices and then the trailing 12 months of earnings that are a mix of both pre and post COVID results. So does that mean we have to wait until March of 2021 for the full year of the COVID effect before we can reliably look to public company multiples, or how do you see this evolving?
CTB:Well, as you can see for the three companies that we just discussed in the consumer discretionary sector, two of those companies had not announced the results for the quarter ended June 30th, 2020. One of them, Darden had results had announce and their enterprise value EBITDA multiples follow the same pattern. So hopefully that once the other two, Ralph Lauren and Marriott, once they announce it, it'll follow that pattern as Darden and increase the multiples to the level that we saw at the end of 2019.

With the significant increase in the COVID-19 cases right now in many parts of the U.S. if those individual states keep opening and then closing, or if you look at what's happening in Florida and Texas, and now California, I think that the post-COVID results may play out over a few more quarters than what was originally expected. I also believe that industry is directly affected negatively by COVID-19, cruise lines, dining airlines will be viewed differently than other industries that are not.
AM:Let's shift gears a bit. When I think of valuation, it's a highly quantitative exercise. So now we're in a period where the past is hard to rely on and predicting the future results of a company is murky at best. How do non-quantitative factors play into valuing private equity investments?
CTB:Non-quantitative considerations actually play a prominent role in valuations regardless of the market conditions. When making an investment it's essential to evaluate those matters such as the strength of the investee company's management team, the risks that a company's products or services are subject to technical obsolescence or competitive threats, or other matters such as these.

As I mentioned, the original investment thesis often identifies these issues. In many respects, periodic valuation analysis are a roll forward of all the original key considerations contained in the analysis prepared when a deal was originally priced.
AM:So as the private equity and venture capital firms think about these issues, they're in the middle of preparing their June 30th valuations, as we speak. Do you see differences in how they should approach it, or should an early stage venture capital firm approach its valuation exercise differently than a classic buyout firm?
CTB:Well, I believe that a lot of their concerns, whether it's a VC or a classic buyout firm are similar, such as the strength of their management team, the exposure to COVID, general cash needs. A lot of the VC firms that I work with are technology focused. So I believe that they could repurpose their products easier in a post-COVID world.

We have a client that initially developed their software for booking reservations at a restaurant, but now they had to shift and they're using that same software. So now you're using it for delivery orders instead of booking tables. I think that it's easier for an investee company for a VC to pivot their business than a classic buyout fund, which might be invested in manufacturing companies or what we call the old school industries.
AM:Interesting. So the people responsible for measuring and estimating the fair value of their investments, they're really dealing with some difficult and challenging issues in the current environment. Is there a silver bullet answer to how to approach it?
CTB:Well, unfortunately there is no silver bullet or easy answer when vowing private equity investments, even in times when the environment's stable. PE firms should have robust, but yet flexible processes in place. In times of market dislocation, certain techniques such as the guideline company approach will be de-emphasized with others gaining heavier weighting, such as the DCF.

In those discussions with several clients that we had in mid-April, at that time, they responded that for Q1 20, they were reaching out to their LPs to discuss their exposure of each investee company to COVID-19 the company's management teams, as well as qualitative factors, which will always be essential in concluding to an appropriate reasonable fair value estimate.
AM:Craig, thank you for your unique insights. I'm sure. We'll talk again soon.
CTB: Yeah, thank you, Tony.
AM:Thank you for listening to the EisnerAmper podcast series. Visit eisneramper.com for more information on this and a host of other topics.