Private Equity Valuation Considerations
November 28, 2022
By Eugene Katsman
Overview: Recent Trends in Markets
Following a sustained period of market growth, the economic environment as of September 30, 2022 was offset by market declines in the Dow Jones (YTD -21.5% through 9/30/22) and S&P 500 (YTD -25.2% through 9/30/22), strong inflationary headwinds and aggressive monetary policy tightening by the Federal Reserve. While there was some recovery from these declines over October, this market turbulence gives rise to complexities when considering private equity valuations. These considerations were discussed in a recent webinar titled “Alternative Investments Year-End Planning Webinar Series – Private Equity Valuation Considerations” by the following panelists:
- Craig Ter Boss, Partner, EisnerAmper;
- William Johnston, CEO, Empire Valuation Consultants; and
- Anthony Minnefor, Partner, EisnerAmper
The following topics were discussed:
Market Participant Pricing
For financial reporting purposes, there is a framework for approaching valuations (ASC 820-10-20), defining fair value as “the price that would be received to sell an asset…in an orderly transaction between market participants at the measurement date.” It was emphasized that fair value is based on an “exit price” concept and not a transaction or entry price. The assumptions involved when an investment is purchased, which is an entity-specific measurement, may not be the determination of a willing market participant. The framework specifically addresses “orderly markets;” despite the uncertainty in the current environment, markets are considered relatively active and orderly.
Market Approach Considerations
The most common approaches in valuing private equity investments include the market and income approaches. The market approach includes the guideline company or comparable company method, utilizing earnings multiples of EBITDA (earnings before interest, taxes, depreciation, and amortization) and non-earnings multiples of revenue of market comparables (“comps”) to derive the enterprise value of the subject company.
EBITDA can take on many forms, one of which may be more meaningful based on the specifics of the subject company, including the stage in its life cycle, whether its business is subject to seasonality, whether the subject company is a platform company involved in a number of acquisitions or whether EBITDA is defined pursuant to a debt agreement. In the context of the current year’s uncertain market environment, a forward-looking, next-12-months EBITDA could be a more meaningful valuation metric. Revenue multiples, unlike EBITDA, ignore differences in profitability and are less frequently used in evaluating deals. It is difficult to compare revenue multiples across different industries and stages of the subject company’s life cycle. Where EBITDA is adjusted or revenue is further dissected (e.g., between recurring and non-recurring, subscription and non-subscription based), it is important the public comps reflect the same assumptions for a meaningful analysis.
The discussion of the comparable company methodology was summed up using the term, “sharpening the pencil.” Private equity investors should make effort to hone in on comparable companies that were affected similarly to the subject company, as a result of the market declines over the past several months. Multiples for companies in certain industries and sectors have been affected differently and it is important to consider the specifics of the subject company when determining the criteria for selecting or eliminating comps that were used in prior analyses.
The panel discussed another market approach, the precedent transaction approach or M&A (mergers and acquisitions) approach, which is reliant on historical data to derive the multiples used to value the subject company. However, where current trends are more volatile, investment activity will likely be based on an expectation of future performance. The panel discussed identifying the market participants in these deals, as a strategic or financial buyer, both of which have very different viewpoints considering synergies and potential cost savings. There could also be platform or add-on acquisitions and earn-out considerations involved, all of which must be factored when comparing relevant multiples. Lastly, with recent declines in market capitalization, it’s important to factor this distinction when comparing recent deals to prior year activity.
With all the aforementioned considerations, the panelists discussed some takeaways including: (1) the idea of weighting the methodologies of the market approach less than in prior periods, given the current market place turbulence, (2) the importance in consideration of the relevant comps’ stage of development, size, growth and profitability, and clearly defining how these are weighted and (3) being able to link the original investment thesis to the current valuation and prior analysis through the process of calibration, all of which could provide for a more accurate valuation.
Income Approach Considerations
The panel continued to discuss the income approach, the most common methodology being the discounted cash flow (“DCF”) analysis. The DCF analysis could provide useful in this environment, where any variables currently impacting the subject company and any future expectation of recovery can be reflected in the analysis. It is another method that can help corroborate the values derived from the market approach or any other method utilized. The panelists stressed the importance in the consistency of assumptions used across all methods, stressing the use of comps under the market approach as a sanity check for the growth projections and terminal (or horizon) value of the subject company under the DCF method.
The discussion concluded with some key takeaways, including: (1) re-emphasizing the concept of calibration, (2) using qualitative factors, not just quantitative analysis, to further support investment value in the current market place, (3) being able to reconcile the levels of values from multiple approaches, including addressing any outliers that would result in a vast range of values and (4) stressing the need for transparency of valuation policies and procedures, consistency in the their application, and documentation of any divergence from them. There is no “one-size-fits-all” approach in the current environment for a company or industry and each valuation has its own unique circumstances to consider.
The webinar can be viewed here.