FV Challenges in the PE Industry-PwX-2009 Update

8/3/2019 FV Challenges in the PE Industry-PwX-2009 Update

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Asset Management

Fair value challenges in theprivate equity industry2009 update

December 2009


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2 PricewaterhouseCoopers LLP

Valuation remains at the top o the agenda or privateequity rms and refects increasing demands or moreinormation and transparency rom investors. This isat a time when valuation o private equity investmentcontinues to be extremely challenging given marketvolatility and ew transactions.

It was in this environment that the Updated PrivateEquity Valuation Guidelines (Updated Guidelines) werereleased by the International Private Equity and VentureCapital Valuation Board (the Board) on 9 September2009 with immediate eect, replacing the previous 2006version o the Valuation Guidelines (the Guidelines).

We also note that the current drat EU directiveon Alternative Investment Fund Managers (theDirective) raises the prospect o increased valuationrequirements or the industry by establishing the needor independent review over the valuation processor unds. While it is not clear at this stage exactlywhat this will mean in practice, it would appear thatadditional external reviews o managements valuationprocess are likely when the Directive is nally issued.Our own perspective on this emerging issue is that itis consistent with the general trend towards increasedscrutiny o valuation and the processes that surround it

and that this remains an area where improvements canand should be made.

In this paper, which ollows our publication last yeartitled Fair value challenges in the current environment,we provide our detailed thoughts on the UpdatedGuidelines and general observations relevant orupcoming 2009 year-ends including views on thetreatment o debt which is attracting particular interestat the moment.

In summary, the strong rebound in public equitymarkets may not necessarily translate into privateequity valuations given the continued challengingtrading conditions. In this context, we believe thatcurrent earnings perormance, potential covenantbreaches and uture earnings prospects will come

under much scrutiny or 2009 year-ends. Private equityrms will need to continue enhancing internal valuationprocesses and evidencing especially in the short termas they embed the changes suggested by the UpdatedGuidelines.

Summary

Summary o top 10 considerations or 2009 year-ends UpdatedGuidelines- pagereerence

1. Fair value is a hypothetical exchange price at the Reporting Date. The Updated Guidelines do not changeFair value even though they suggest dierent procedures

11

2. Valuation needs to be considered rom a market participant viewpoint and is not entity-specic 11

3. Valuation is judgemental and should not be perormed with excessive caution 13

4. The explicit 12 month window or holding investments at cost has been removed 16

5. The risks associated with the lack o marketability o an unquoted investment and any impact rom controlshould be incorporated into Fair value through an appropriate adjustment to the multiple

19

6. Maintainable earnings need to be assessed careully with a preerence or historic rather than orecastgures

20

7. Discounted cash fow (DCF) analysis remains a useul cross check in some circumstances but should notbe used in isolation

21

8. Compliance with IFRS and US GAAP has been considered (but is not, in our view, automatically achieved) 7

9. Guidance is now provided on the use o net asset value or und interests and the requirement to air valuemezzanine debt based on current yields

24, 28

10. Debt is assumed to be repaid at par in the Updated Guidelines without consideration o any need to airvalue debt which in the case o investments without change o control clauses may ignore the option valueo equity

28


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While there has clearly been a strong rebound in equity markets during2009, it is dicult to predict the extent o any increases or decreases invalues or investments as any recovery in public markets may well be o-set by challenging trading conditions.

The value o investments thereore needs to be considered careullyespecially as we note that the value o private companies tends to lagbehind their public counterparts and is generally less volatile, as evidencedby transaction multiples which tend to be less volatile or private comparedto public companies. The impact o this is that signicant collapses andrallies in public markets may not lead to equivalent changes in the value oprivate companies i.e. we may not observe signicant uplits in the valueo investments at the end o 2009.

In terms o the equity market rebound, the FTSE 250 as at 31 October 2009had increased by 40% since 1 January 2009 against a 40% decrease in2008, leaving it 14% below the index at the start o 2008:

Figure1: Change in the FTSE 250 index since January 2008

Introduction

FTSE2

50

index

Change in index

January 08 - December 08

Change in index

January 09 - October 09

+40%

C

Note:

A B = -40%

B C = +40%

A C is still -14%

0

2000

4000

6000

8000

10000

12000

B

A

-40%

31 Dec 07 31 Mar 08 31 Jun 08 30 Sep 08 31 Dec 08 31 Mar 09 30 Jun 09 30 Sep 09

Source: Capital IQ


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At the same time, the number o transactions in the UK has remaineddepressed during 2009 (1,912 deals in the 10 months to October 2009),representing a 31% decline compared with the same period in 2008 (2,777deals) with a signicant decline in transaction value. Transactional data isextremely useul or arriving at Fair value and the lack o deals contributesto the current challenges.

Figure 2: Transaction volumes or UK deals since January 2008

UK Deals from January 2008 to October 2009

0

5,000

10,000

15,000

20,000

25,000

30,000

Jan-

08

Feb-

08

Mar-

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Apr-

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May-

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09

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09

Apr-

09

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09

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Sep-

09

Oct-

09

m

0

50

100

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350

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Numberofdeals

Deal Value Deal Quantity

Source: Dealogic



The Updated Guidelines were released by the Board on 9 September2009 with immediate eect in a particularly challenging environment. In astatement accompanying the release, the Board stated that the UpdatedGuidelines take account o the evolution o global Fair value accountingrequirements and practices. Further, the Board explained that the changeswere made to ensure consistency with converging international accountingstandards i.e. International Financial Reporting Standards (IFRS) andUS Generally Accepted Accounting Principles (US GAAP) (together theReporting Standards).

We note that the Guidelines have not been widely adopted in the US asentities oten use other published guidance including the American Instituteo Certied Public Accountants (AICPA) Audit and Accounting Guide orInvestment Companies. However we do observe a number o European

private equity rms reporting in accordance with the Reporting Standardsusing the Guidelines as the basis or assessing the Fair value o theirinvestments.

In its release letter, the Board highlighted the principal updates asrelating to:

Clariying how the marketability discount should be applied;

Eliminating any reerence to the 12 month period which had been used inpractice or retaining investments at cost (reerred to as Price o RecentInvestment);

Additional guidance on how to include additional milestone analysis into

the Price o Recent Investment concept; and

Guidance on the valuation o und interests.

As part o the consultation process, PwC provided a number o views to theBoard ocusing on these principal updates and other areas. We summarisebelow our observations given the recent release o the Updated Guidelines.

Background

The Updated

Guidelines werereleased on 9September 09 in thecontext o converginginternational accountingstandards


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1. Concept of Fair value

The concept o Fair value is a hypothetical exchange price as at theReporting Date regardless o whether there is actually any intention todispose o the investment. In our view, the assessed Fair value shouldnot change as a result o the Updated Guidelines and the need or properprocess (including robust, independent internal challenge) and evidencingremains essential. The valuation process is under increasing scrutinyrom investors in terms o valuation approach, earnings, multiples andconsistency o approach with any general changes rom previous periodslikely to attract particular attention. These also remain key areas ordiscussion with auditors.

Although the updates to the Guidelines were made with a view to ensuring

consistency with the Reporting Standards, we note that the denition oFair value in the Updated Guidelines does not ully comply with the exitprice denition o Fair value within US GAAP (SFAS 157) or with the IASBsFair value measurement exposure drat.

2. Market participant basis

According to the Updated Guidelines and consistent with the ReportingStandards, the concept o Fair value is considered rom a marketparticipant view point as opposed to the way a specic owner or acquirermight value the investment.

3. Need for judgementThe Updated Guidelines continue to emphasise a key valuation concepti.e. the assessment o Fair value is a subjective exercise requiring orward-looking estimates and judgements about the underlying business, marketand other conditions at the Reporting Date.

While the Updated Guidelines express a preerence or historical earningsgures given their greater reliability, we support the use o multiplevaluation approaches to arrive at a conclusion which may include the use ohistorical, current and orecast earnings gures to the appropriately derivedhistorical, current and orecast earnings multiple. Where these multipleapproaches suggest widely dierent values, the underlying reasons or

these dierences need to be considered, rather than or example, adoptinga value based on the average o the various approaches.

4. Price of recent investment

The reerence to the 12 month window or holding investments at costhas been removed in the Updated Guidelines and more guidance isprovided on the need to assess any Fair value impact ater a limited period(albeit this period is now undened). That said, we would not necessarilyexpect signicant changes in value in the rst three to six months butthis ultimately depends on the acts and circumstances specic to eachinvestment.

Further, the Updated Guidelines now include milestone analysis to acilitatethis review or an investment in early or development stages. We notethat this milestone analysis may be particularly applicable to biotech,pharmaceutical, real estate and venture capital investments.

Fair value should notchange as a result othe Updated Guidelines

PwC observations

Valuation is inherently

a subjective exercisewhich needs to beconsidered rom amarket participantviewpoint

We support theconsideration omulitiple valuationapproaches but takinga straight average othe approaches shouldbe avoided

Holding investments atcost or 12 months isno longer supported



5. Marketability discount and control premium

The Updated Guidelines now suggest that consideration o the riskassociated with a lack o marketability should be incorporated withinmarket multiples under the market approach alongside other considerationssuch as size, growth and risk. This has the eect o applying the discount atthe Enterprise Value level i.e. against both equity and debt even though theeect o adjustments such as marketability discount and control premia aretypically observed at the Equity rather than Enterprise Value level.

We note that applying an adjustment to the multiple to refect a lack omarketability at the Enterprise Value level rather than the Gross AttributableEnterprise Value level under the previous Guidelines, will generally reducethe marketability discount percentage compared with previous practice

depending on the level o gearing in the portolio company.

We illustrate this in Figure 3 below where a 20% marketability discount,which under the previous Guidelines was applied at the Gross AttributableEnterprise Value, would result in a signicantly lower value or a 10% equitystake o 0.6m as opposed to 2m i the same 20% adjustment was madeto the EBITDA multiple. To arrive at the same Fair value or the 10% equitystake as in the previous Guidelines would mean a discount o only 5%being applied to the EBITDA multiple:

Figure 3: Potential impact o the marketability discount adjustment

PreviousGuidelines

UpdatedGuidelines -Incorrect

UpdatedGuidelines -Correct

m m m

EBITDA 10.2 10.2 10.2

EBITDA multiple 9.5x 7.6x 9.0x

Enterprise Value 97.4 77.9 92.3

Net Debt (72.1) (72.1) (72.1)

Gross AttributableEnterprise Value

25.2 5.8 20.2

Marketability discount o20%

(5.0)

Equity Value 20.2 5.8 20.2

Fair Value o 10% equitystake

2.0 0.6 2.0

Cost 5.0 5.0 5.0

Write down implied m (3.0) (4.4) (3.0)

Write down implied % -60% -88% -60%

Note: Moving the marketability discount to the EBITDA multiple, ceteris paribus, will require the discount

to be lower i the portolio company is geared. For instance, in the example above, signicant gearing

requires a considerable reduction in the marketability discount rom 20% to 5%.

Eect o a 20% marketabilitydiscount applied directly tomultiple

(9.5x * 0.8 = 7.6x)

Marketability discount shouldnow be 5% not 20% applied

directly to multiple

(9.5x * 0.95 = 9.0x) to achievethe same Equity Value


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At the same time, any impact rom having actual or implied control is nowspecically mentioned in the Updated Guidelines as a actor to consideralthough no more specic guidance is provided. In our experience, this hasnot been explicitly adjusted or by private equity rms but has sometimesbeen considered by increasing the marketability discount where nocontrol exists.

In our view, the exit options or the investment need to be consideredat the Reporting Date to assess whether a control premium or lowermarketability discount is applicable. For instance, or a minority equitystake, the most likely exit route may be a sale in the secondary market orthat stake whereas or a controlling equity stake, the exit route is likely toinvolve an initial public oering or a sale o the entire portolio company. Inthis context, care needs to be taken in using transaction multiples given

the specic acts and circumstances around recent transactions as wellas the need to consider whether those transactions involved the sale o acontrolling or minority stake.

Overall, the multiple is a critical component in assessing Fair value and itis thereore important to review the multiple against other data points suchas the original acquisition multiple as well as current and, where possible,orecast multiples to assess whether it is reasonable.

6. Maintainable earnings

We believe that earnings will be a key area o scrutiny or 2009. Given the

challenging trading conditions, we expect a number o portolio companiesto be experiencing decreases in sales and prots which may take timeto reverse. This must be careully considered in assessing the level omaintainable earnings against which multiples are applied and it will also beimportant to consider how a market participant would assess earnings interms o a potential deal price. As always, it is critical that the appropriatemultiples (current or orward) are applied against the equivalent earnings.

7. DCF analysis

The Updated Guidelines appear biased against DCF analysis even thoughthis is a technique recognised by the Reporting Standards and representsstandard market practice or certain assets (such as inrastructure). Whilewe understand that DCF analysis is not typically the primary valuationmethodology or a private equity groups investments it can be useul as across check especially or material investments, early-stage investments orin those rare circumstances where no comparable companies exist. WhereDCF is used, we believe that it is still important to calibrate the underlyingassumptions to market data such as analysts reports or other industryanalysis. With respect to discount rates, in order to arrive at Fair value it isimportant to base the inputs on those o a market participant rather thanthe holder o the investment.

Maybeimage inhere

Earnings will be a

key area o scrutinyor 2009

DCF analysis can beuseul as a cross check



8. Compliance with IFRS / US GAAP

The Updated Guidelines suggest that their application can achievecompliance with the Reporting Standards. We believe that ollowingthe Updated Guidelines in their current orm may not automatically leadto compliance with the Reporting Standards particularly in the areas odiscounts and debt:

Discounts

We note that IFRS can be interpreted to prohibit the application odiscounts (such as or marketability) at all levels o the Fair value hierarchyand not just Level 1 (as is the case under US GAAP), a point which iscurrently being discussed and claried with the IASB. US GAAP is more

specic about discounts being allowed where listed prices are not available i.e. or Level 2 and 3 investments under the Fair value hierarchy in USGAAP (SFAS 157). Private equity investments are generally classied asLevel 3 in our experience.

Impact o debt on Fair value

The Updated Guidelines appear to ollow a settlement rather thantranser notion or nancial liabilities such as debt by assuming repaymento the debt is at ace value at the Reporting Date. This is consistent withIFRS which also has a settlement notion as opposed to US GAAP wherea nancial liability is measured based on the price that would be paid totranser that liability to a third party.

In our view, the guidance in the Updated Guidelines is appropriate orcontrolling equity investments where it is assumed that the sale o the stakeis likely to lead to repayment o the debt at par (i.e. a change o controlclause will likely be triggered).

However, we believe that there may be a dierent treatment required wherea change o control clause would not be triggered i.e or some minorityinvestments where the investment could be sold in the secondary marketwithout triggering a change o control clause. In these cases and especiallywhere the Fair value o debt may be signicantly less than ace value (i.e.as might be the case or distressed investments), it may be appropriate to

deduct debt rom Enterprise Value at Fair value i.e. at lower thanace value.

There is a concern that deducting the portolio companys debt at Fair valuewill overstate the value o the portolio companys equity which would notmake sense where a portolio company is distressed. However, we notethat there would be no uplit in Equity Value i the Enterprise Value o theportolio company is lower as a result o its distressed state. This wouldprincipally arise where lower maintainable earnings are expected but mightalso be the result o an industry as a whole or publicly traded comparablecompanies being in distress. Such distress might maniest itsel in the

Following the UpdatedGuidelines may notautomatically lead tocompliance with thereporting standards

For minorityinvestments, thetreatment o debt in thewaterall may require

separate considerationthan that outlined in theUpdated Guidelines


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Fair value o comparable company debt being signicantly below its acevalue, thereby resulting in a lower multiple being applied to arrive at theportolio companys Enterprise Value. As a result, we do not anticipate anyimmediate uplit in the Fair value o equity i the Enterprise Value o theportolio company has been adjusted downwards to refect distress.

9. Fund interests and mezzanine debt

The Updated Guidelines now provide additional guidance on valuing undinterests and, in particular, suggest that NAV is appropriate as a starting-point assuming that the underlying process is reliable and sets out anumber o circumstances (e.g. timing dierences, carried interest accrual)where adjustments to NAV may be necessary. Additionally, there is moreguidance on how to consider secondary transactions and the need or

considerable judgement given inormation limitations.

In addition, guidance on mezzanine loans is provided which suggeststhat current yields or comparable instruments need to be actored intovaluations and that a DCF analysis should typically be used or private debtwhere market prices are unavailable or unreliable.

10. Option value of equity

For investments in companies in distress where potential covenantbreaches have been identied or where the amount o debt appears to behigher than the investments Enterprise Value, we believe that the potential

or option value o equity needs to be considered.

As discussed above in Section 8, in scenarios where the sale o the equityinvestment will trigger a change o control provision on the debt, the Fairvalue o debt is not expected to be an issue because Fair value is basedon a hypothetical sale price at the Reporting Date and i the sale o theequity investment triggers a change o control provision, debt will likely besettled at ace value. We have provided an illustrative example below (seetraditional waterall approach) to highlight why the deduction o debt atace value may result in zero option value being attributed to equity in somecircumstances.

However where no change o control provision exists, or instance in thecase o a minority equity interest, the equity holder may be able to sell itsinterest without triggering a settlement o the portolio companys debt atace value. In such instances, the Fair value o that debt will refect anyavourable nancing. By avoiding settlement o the debt at ace value whenthe equity interest is sold, the minority equity holder is able to transer thebenet o avourable nancing to the secondary buyer o the equity interest.

The benet o having time or a portolio company to turn around itsnancial perormance means that the ability to exploit avourable nancingover the term o a debt agreement may translate into incremental value

The traditionalwaterall approach

may not alwaysbe appropriateor investments indistressed companiesas it can ignore theoption value o equity

Discount rates orvaluing mezzanineloans should be basedon current yields



or equity holders. This incremental value may not be evident i debtis deducted at ace value under the traditional waterall approach.Favourable nancing typically translates into debt with a Fair value that isbelow its ace value and deduction o debt at the lower Fair value enablesthe recognition o the option component to Equity Value.

In such situations or where portolio companies are generally experiencingdiculties, the Updated Guidelines do not provide guidance on how toassess whether the equity has been ully impaired and what techniquescan be used to measure any option value. We have observed moreconsideration o probability weighted models in valuation techniques in theUS and believe that this may be useul in considering option value to equitywhich, on the ace o it, appears to be underwater.

An example o the probability-weighted model is the multiple outcomeapproach which, in contrast to the traditional waterall approach, involvesa orward-looking analysis o the possible uture outcomes available to theenterprise. This comprises the estimation o ranges o current and uturevalue under each outcome and the application o a probability actor toeach outcome as o the Reporting Date to arrive at an expected value.By considering only one scenario or a distressed company which wouldtypically be settlement o the debt at ace value (or lower depending onavailable proceeds rom a sale o the enterprise), the traditional waterallapproach may overvalue debt and undervalue equity by ignoring the optionvalue o equity, as shown in gure 4 below:

Figure 4: Estimating the option value o equity

Enterprise valuation allocation summary (m)

Traditional waterallapproach

Multiple outcome approach

Estimated value Probability weighted

expected value

Low scenario (1) High scenario (1)

Business

Enterprise Value

260 100 420 260

Debt 260 (2) 100 400 250

Equity - - 20 10

(1) 50% probability(2) Face value o debt is 400

In the example above, the high and low scenarios are o equal probabilityand some value to equity is provided in the high scenario with an EnterpriseValue o 420m, (we note that there would need to be proper justicationo underlying assumptions i this technique was to be applied) as opposedto 100m in the low scenario, providing a probability weighted expectedvalue o 260m. This may mean that there is some value to equity which an

Fair valueo debt

Optionvalue oequity


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acquirer might also identiy in this case 10m or the equity compared tozero under the traditional waterall approach.

The low scenario might represent a situation where the companysperormance is deteriorating such that the debt holders may, at some point,be able to take over the business thereby extinguishing all Equity Value. Thehigh scenario might represent a situation where the absence o a change ocontrol provision means that the equity holders are able to sell their stake atthe Reporting Date without being orced to repay debt at ace value.

It is crucial to consider the position o the debt holders and it may be thatcovenant breaches mean that the debt holders already have eectiveownership o the entity and any Equity Value is thereore extinguished atthat point. We thereore note that the option value o equity may be a more

relevant consideration where debt covenants have not yet been breached.We also note that the option value o equity can be impacted not only bythe Fair value o debt but also other securities which rank above it in termso liquidation preerence so that it may be necessary to consider the Fairvalue o preerence shares in more complex capital structures.

Given the recent downturn in the economy, the discussion above ocuseson scenarios where companies are distressed or experiencing diculties.We have set out below other scenarios where the Fair value o debt and / orpreerence shares should be considered, both rom a comparable companyand portolio company perspective:

Expected term - given the changes in the credit and equity markets,

leveraged buyouts that were expected to be exited in two to three yearsmay now have considerably longer terms than were contemplated in theoriginal analysis or pricing o the debt;

O market covenants - prior to dislocation in the credit markets, debtsecurities were sometimes issued with limited protections aordedto the lender. Such covenant-lite debt may have limited or reducedmarketability in the current environment, which in turn impacts its Fairvalue; and

Widening spreads - general market conditions have resulted insignicant tightening o credit markets refecting the increased perceivedrisk o bankruptcy and o other nancial diculties (as observed by

widening yields on debt securities).

These actors require careul consideration in arriving at the Fair value oequity stakes when a sale o the equity interest does not trigger a change ocontrol provision on debt.

Option value o equitymay be a more relevant

consideration wheredebt covenants havenot yet been breached

A number o actorscan result in the Fairvalue o debt beinglower than its acevalue. Most o theseactors are relatedto recent marketconditions



In our view, there is likely to be vigorous debate within private equity rmsand with external parties around both the multiple and the maintainableearnings or the valuation o investments or 2009 year-ends.

However, the need to arrive at a best estimate o Fair value remains thecore principle and, in many ways, the Updated Guidelines acilitate this bytheir increased ocus on multiples which is consistent with how the industrygenerally considers values when making original investments.

Finally, it will be important or private equity rms (and their auditors) toensure that any changes in values rom 2008 have been assessed in thecontext o earnings perormance, uture prospects and recovery in marketprices to arrive at robust valuations. Firms will continue to rely heavily onproper process and evidencing given the increasing level o scrutiny in

this industry.

Conclusion


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Tel: +44(0) 20 7212 3711Email: [email protected]

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Peter Clokey

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FV Challenges in the PE Industry-PwX-2009 Update

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