Private equity’s ‘fair value’ judgment

Heightened economic uncertainty, the euro crisis and its impact on banks have sparked greater volatility in financial markets in recent months. At times like this, emotion and short-term momentum impact share performance. In the UK, the FTSE 100 fell 7% in the first 11 months of 2011 and the FTSE 250 fell 11%. These falls have been reflected in the values of investments which have led to lower net asset values of the few stock market-listed private equity funds.

Analysts and investors alike expect that sharp declines in quoted equity prices will lead to similar declines in private equity investment valuations, and the market signals cannot be ignored. The IPEVC Guidelines, IFRS and US GAAP accountancy standards all require market value to be the basis of fair value – what an asset might fetch in an orderly transaction at the valuation date. For the private equity industry seeking to prepare defendable valuations of fund investments at the 2011 year end, sound judgement will be required and careful articulation of the process adopted.

General Partners (GPs) can also expect both Limited Partners (investors) and regulators to give valuations extra scrutiny. While investors have tended to examine valuations more closely in recent years, they are likely to be even more attentive this year given the downward trend.

Fine-tuning market value in practice
During times of economic turmoil, obtaining appropriate valuation multiples can be challenging. As transaction volume disappears, valuers increasingly rely on market multiples of comparable companies as the primary benchmark for fair value. While comparable companies can be identified, their multiples are highly susceptible to the prevailing moods of the markets.

In a turbulent market, we believe that it is important to base the market approach, more than ever, on a limited number of meaningful comparable multiples. Instead of simply taking the average multiple from 20 companies in the same sector, each multiple should be scrutinised. When selecting multiples, we recommend looking into all factors that might affect the value, including: the sustainability of earnings, the likelihood of meeting growth targets in today’s weak economy and the ability to remain competitive. Within the retail sector, for example, some companies’ sales have fallen sharply, while others have been more resilient. Judgement is required to identify a small number of comparable companies with similar activities, geographic operations, business models and growth profiles. You can then factor in adjustments to valuation multiples accordingly.

We would also advise looking into whether to use a historical or forward-looking earnings measure, such as EBITDA. Each method has advantages and disadvantages. A historical calculation has the benefit of being based on actual performance while, in practice, most public companies are valued by analysts based on projected earnings and cash flows. A multiple is only meaningful if the earnings on which it is based are indicative of sustainable earnings potential. So the quality of forward-looking multiples depends on the ability to accurately forecast future earnings, which is undoubtedly difficult in a volatile economic environment. Based on our observation of FTSE 250 multiples over the financial crisis of 2008/2009 and subsequent recovery, multiples based on historical earnings exhibited significantly more volatility than forward-looking multiples – perhaps indicating that investors did not view current earnings as representing long-term earning potential.

Cross-checking with fundamental value
Calculating fundamental value is a useful cross-check for values derived using a market approach. Theoretically, the market value methodology should bring you to the same valuation as fundamental value. But, in practice, market value tends to be higher than fundamental value when markets are rising – and lower when they are falling. Emotion and momentum are among the factors leading markets to tend to overshoot on both the upside and the downside in the short term.

Fundamental approaches like discounted cash flow analyses are not perfect either. Discounted cash flow approaches rely on projected cash flows and discount rates, which can be equally difficult to assess in times of economic uncertainty. To address some of the uncertainty, it is important to review the underlying projections objectively within the context of long-term trends.

When valuing specific investments, it is important to understand why market value derives a different answer to fundamental value. Ultimately, the reason lies in the difference between the fundamental assumptions implied by market valuation multiples, and those explicitly factored into a discounted cash flow analysis. Having a clear picture of the different assumptions and value drivers will make a fair value analysis more robust and able to withstand scrutiny.

A transparent guide
Fair value is intended to provide investors with a transparent guide to portfolio companies’ performance. Whatever choices are made when calculating fair value, it is important to explain the reasoning behind them thoroughly. In today’s volatile economic environment, exercising and exhibiting sound judgement when making these choices is more important than ever.

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If you have any questions, please contact
the author or your local PwC representative:

Nick Rea

Partner, financial services valuations
+44(0) 20 7212 3711