Grant Thornton private equity (PE) valuation professionals recently held a conference call with CFOs, controllers and compliance officers from numerous investment companies, generating several key insights that may inform upcoming valuation exercises.
COVID-19 has caused PE firms to evaluate and adjust their valuation practices – postponing valuations to avoid reset triggers, exploring new approaches to valuations or diversifying existing ones (for example, considering overall changes in total enterprise values for comparably traded guideline companies, not just absolute multiples). Firms are relying less on once-stable assumptions and relying more on a robust and nuanced examination of all relevant variables. Bottom line, in this new world order, the same old, same old may not be enough. Today’s valuations will be more rigorous, well-thought-out and supportable. The market and investors simply expect that.
A profound impact prompts immediate structural responses.
The COVID-19 crisis is so profound that current valuation concepts and principles themselves, which were designed for a normal steady state, are being re-evaluated. The crisis is affecting variables ranging from liquidity to supply chain health to the presence of willing buyers and non-distressed sellers and the access to capital; its effect on industries may be substantial.
To avoid duplicative efforts and ensure the most accurate valuations in these times, select investment companies, including PE firms, have been deferring their valuation cycle to early/mid-April in part to avoid resetting their valuations of March 31. These firms reset at a defined trigger – e.g., a market being down a certain percentage, which would mandate that the deal teams develop new valuations that dig deeper into their models.
The situation highlights the importance of robust evaluations.
Robust evaluations have become imperative, meaning valuations should employ more than one methodology, reference as much data as possible, scrupulously articulate and aggressively identify assumptions, and — because new information becomes available daily — build in checkpoints. Moreover, a reconciliation of results between each method is critical.
The crisis promises to affect all valuation methodologies and tools.
Discounted cash flow analysis
While blended or supplemental approaches are a good way to go and considered best practices, spending more time in developing a well-thought-out discounted cash flow analysis is also needed to make sure your market-based inputs mirror the risks identified in a meaningful cash flow analysis. While this is a difficult task, identifying and quantifying risk areas related to your future cash flow are extremely important. In this market environment, given the overall uncertainties in the general economy, that may require you to consider probability-weighted cash flows. However, keep in mind, FASB ASC 820 requires the use of observable market inputs over unobservable inputs, so you cannot simply ignore the market approach.
In normal times, you could simply look at expected cash flow. In the current state, you will want to supplement expected cash flows with probability-weighted cash flow scenarios. This allows you to account for risk in the cash flow analysis itself – as opposed to applying a discount after you’ve completed the analysis.
At the time of the government shutdown, defense contractors used prospective cash flows that assumed the shutdown would end at various dates. In a similar way, probability weighting allows you to make assumptions about when the market will normalize and what normalization means for the company you’re valuing. Some companies may not come back fully; some may not come back at all.
The uncertainty around the extent and timing of the market return also has implications for terminal value. Conservative expectations seem appropriate here, although you can use weighting to account for more optimistic expected outcomes.
Because they include a one-quarter lag, market multiples may be distorted. Warns John Ferro, corporate valuation partner, Grant Thornton: “I think you’re going to have less meaningful market multiples as of March 31.”
Because multiples may be distorted, comparables may serve as an important supplemental (or alternative) way to look at value.
While standard practice is to look at the median of a cluster of comparables, best practices in the current situation suggest you look at — and interrogate — the particular comparable that best matches your profile while still referencing multiple comparables.
According to Ferro, “You need to do a fairly robust assessment of those business lines, how those comparables might be positively or negatively impacted, what’s driving their change, and then correlate that to your business.”
For example, have the companies diversified to mitigate risk? Are they vulnerable because they do more business with stressed sectors such as hospitality or travel? Have their suppliers or distributors been particularly hard hit? Are they regional? How liquid are they? How well are they capitalized?
When you complete your analysis, it might help to develop some “sanity checks.” Said Ferro, “You might ask, ‘where do I think my normalized level of EBITDA [earnings before interest, tax, depreciation and amortization] might be in 12 months?’”
If you’re employing a transactional methodology, it’s especially important to deeply understand the nature of the transaction, the participants and the market itself.
In normal times, active markets are assumed. But do such markets exist now? Is there sufficient activity? Are deals arms-length? Are the buyers and sellers transacting in the same market with the same assumptions and purposes? Do they have access to the same information? All are difficult questions to answer, but beware, you cannot simply ignore the market.
Carrying at cost and calibration
The assumption that recently purchased assets can be carried at cost for any length of time doesn’t appear to hold in the new environment. Asset values can change dramatically in weeks, even days. Similarly, calibration approaches, which rely on a cluster of assumptions, need to be re-examined.
The current situation demands dynamic, fact-specific decision-making informed by expert perspectives. It’s also an opportunity to evaluate your valuation process and overall conclusions. “This is a great opportunity to update your policies and protocols,” said Carlos Ferreira, Transaction Advisory Services partner, Grant Thornton. Anyone wanting a quick evaluation or a more in-depth analysis should call on valuation professionals.
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