Private Equity: Valuation Metrics Overview
In general terms, valuation is the process of determining the present value of an asset or a business. In the context of Private Equity, valuation is essential for investors, fund managers and other stakeholders to analyse the overall and ongoing performance of a Fund.
In practice, fund managers are required to carry out periodic valuation of investments, usually on a quarterly basis. Such computation is among the core duties of the fund managers and forms part of the reporting process to limited partners / debt lenders. Fund managers report investments on a ‘fair value’ basis in order to portray real market conditions.
Standards and best practices for valuation
“Fair value is the hypothetical exchange price taking into account current market conditions for buying and selling assets.” Given the life cycle / stages of a Private Equity Fund, the fund managers tend to use more than one valuation technique to better anticipate various market scenarios as well as future opportunities. The two main metrics for measuring ongoing and ultimate performance of Private Equity Funds are Internal Rate of Return (IRR) and multiples.
The International Private Equity and Venture Capital Valuation (IPEV) has established, in October 2018, a set of valuation guidelines for providing high-quality, uniform, global and best practice standards to the various stakeholders operating in the Private Equity.
According to the IPEV, “the fair value of each investment should be assessed at each measurement date”. When performing a fair value assessment, a valuer should apply relevant valuation technique or techniques, which is / are more appropriate depending on current market conditions. It is key to recognise the subjective-nature of an investee’s valuation. Such process is mostly based on estimates, assumptions, and judgements of the active market conditions that are prevailing at the date of measurement, and depending on the nature of a particular investment.
Below are the valuation techniques that fund managers / independent valuers make use of when assessing fair value of an investment (as illustrated by the IPEV).
- Apply a multiple that is suitable and reasonable (given the size, risk profile and earnings growth prospects of the underlying company) to the applicable indicator of value (earnings or revenue) of the investee company;
- Adjust the Enterprise Value for surplus or non-operating assets or excess liabilities and other contingencies and applicable factors to derive an adjusted Enterprise Value for the investee company;
- From this amount, deduct any financial instruments ranking ahead of the highest ranking instrument of the Fund in a liquidation scenario (e.g. the amount payable) and taking into consideration the effect of any instrument that may dilute the Fund’s investment to derive the attributable Enterprise Value; and
- Adequately distribute the attributable Enterprise Value between the relevant financial instruments with the perspective of potential market participants. Judgement is required in assessing a market participant perspective.
b) Industry valuation benchmarks:
- In limited situations, the use of industry benchmarks is a reliable and appropriate method in estimating fair value. It is also useful as a sanity check of values produced using other techniques;
- These benchmarks vary among industries. They make use of industry-specific valuation benchmarks such as ‘price per bed’ (for nursing home operators) and ‘price per subscriber’ (for cable television companies). Other industry sectors, including financial services and information technology where long-term contracts are a key feature, use multiples of revenues as a valuation benchmark; and
- These industry norms often base themselves on the assumption that investors are willing to pay for turnover (revenue) or market share, and that the standard profitability of businesses in the industry does not vary much.
c) Available market prices:
- In the absence of an active market for financial instruments, but where observable prices are available, the valuer should consider observable prices when estimating fair value, utilising one or more of the other valuation methodologies; and
- It can be common for Funds investing in debt instruments and other infrequently traded instruments to use third-party sources, such as pricing services and quotes from brokers or dealers, to assist in their fair value estimation process. Funds investing in illiquid instruments may also obtain indicative offers from brokers, dealers, or other potential buyers.
Discounted Cash Flow:
- Derive the Enterprise Value of the company, using reasonable assumptions and estimations of future Cash Flows (or expected future earnings) and the Terminal Value, and discounting to the present by applying the appropriate risk-adjusted rate that captures the risk inherent in the projections;
- Adjust the Enterprise Value for surplus or non-operating assets or excess liabilities and other contingencies and relevant factors to derive an adjusted Enterprise Value for the underlying company;
- From this amount, deduct any financial instruments ranking ahead of the highest-ranking instrument of the Fund in a liquidation scenario (e.g. the amount that would be disbursed) and taking into account the effect of any instrument that may dilute the Fund’s investment to derive the attributable Enterprise Value; and
- Adequately distribute the attributable Enterprise Value between the relevant financial instruments using the perspective of market participants. Judgement is required in assessing a market participant perspective.
Replacement Cost Approach
Net asset value:
- Derive an Enterprise Value for the company using the perspective of a market participant to assess its assets and liabilities (adjusting, if appropriate, for non-operating assets, excess liabilities, and contingent assets and liabilities);
- From this amount, deduct any financial instruments ranking ahead of the highest-ranking instrument of the Fund in a liquidation scenario (e.g. the amount that would be paid) and taking into account the effect of any instrument that may dilute the Fund’s investment to derive the attributable Enterprise Value; and
- Adequately distribute the attributable Enterprise Value between the relevant financial instruments using the perspective of potential market participants. Judgement is required in assessing a market participant perspective.
The IPEV notes that “IFRS 10 (Consolidated Financial Statements) states that the fair value of controlled investments held by investment entities should be measured at fair value through profit or loss in accordance with IFRS 9 (Financial Instruments). IFRS 9 has been interpreted by some to require the unit of account of a financial instrument to be assessed as a single or individual share”.
The Invest Europe (formerly known as the European Private Equity & Venture Capital Association) is the world’s largest association of private capital providers. Its handbook of professional standards is a result of signficant expertise invested by private equity players for the establishment of clear guidance, principles of corporate governance, transparency and accountability of private equity stakeholders.
Importance of valuation
It is fundamental for a Private Equity Fund to value its investee companies by making us of the most appropriate valuation methodology. Such tool defintely helps fund managers to establish a proper SWOT analysis to fine-tune general operations and to address issues in the right direction.
The benefits of proper valuation metrics are as follows (among others):
- To improve the fund’s overall performance and healthiness
- To tackle inefficiencies and promote internal controls where applicable
- To give assurance to buyers during mergers, acquisitions and sale of business
- To help capital funding or any other finance raising
- To monitor the fund’s performance
- To adapt to changing market conditions
- To mitigate business risks
According to Aswath Damodaran, “the intrinsic value of an asset is determined by the cash flows you expect that asset to generate over its life and how uncertain you feel about these cash flows”. Therefore, the use of appropriate valuation techniques is key when fair valuing the investees of a Private Equity Fund. Prudential measures must be undertaken at all times to ensure effective decision-making as well as to reap maximum IRR.