If you have been around ASM awhile, you know that valuation is a big topic of conversation here. What is a business really worth? In a sense, that is the question the world of private equity orbits around. Usually, we speak of it in terms of evaluating a business to acquire it, but what about the companies you or your fund already own?
Valuation doesn’t end after acquisition. Apart from the need to keep track of how your investment in a business is performing, the Securities and Exchange Commission (SEC) requires that PE funds provide quarterly information to their limited partners (LPs), which necessitates regular portco valuation.* This is not easily done, because a private company has no constantly updated, exchange-listed price like public companies have. Being illiquid investments, a private firm’s value at any one time is challenging to pin down and inherently subjective. Even many in the private equity industry do not think as much as they should about how periodic valuations are done and how much they can vary from fund to fund, method to method, and across different time periods.
Given the wide variance in ownership structures and underlying business models covered by the scope of private equity, there is no single model or prescribed method in which a portco must be periodically valued. In theory, this creates freedom for fund managers to employ basically any approach they think is best. This is potentially problematic, though, because managers are often incentivized to inflate portfolio performance, whether to help raise a follow-on fund or simply to avoid unpleasant LP conversations. Therefore, in order to maintain a semblance of unbiased assessment, whatever valuation method is chosen should be widely accepted and logically defensible, with the ones listed below being some of the most common.
- Comparable Company Analysis, or simply comparables analysis or “comps,” is based on the idea that broadly similar companies should be valued similarly by the market. It is a straightforward method that typically takes the current EBITDA of a business and applies a “multiple” to arrive at an estimated enterprise value (EV). The multiple used will come from comparable peer businesses currently trading publicly or in recent private transactions.
- A Basic LBO or Growth Model is based on the theory that knowing the growth prospects of a business and its financing structure will help you determine what it is worth. This method involves running a trimmed-down version of a leveraged buyout analysis like that a new buyer would employ. It takes into account company growth expectations and current financing markets to arrive at an enterprise value a reasonable buyer would likely pay, which is then taken as the value of the business.
- Discounted Cash Flow (DCF) is based on the theory that a business should be worth the present value of its future cash flows. By projecting these flows over a period of time—along with a terminal value at the end of the forecast period—and applying an appropriate discount rate, a present value for the business can be established at any point in time, though it is worth noting that a DCF typically returns a more conservative valuation than many of the other methods noted here.
- Majority Partner Valuation is a shortcut method. Rather than coming up with their own valuation, minority partners in a private equity investment may simply take the majority owner’s valuation of a portfolio company and apply it to their share. That being said, it is not uncommon for partners in a club deal to not share their internal valuations externally, so, in some cases, multiple partners in a deal may show different valuations for the same business in their reports.
In practice, funds often triangulate across multiple of the above methods to arrive at a final valuation for their holdings, on the theory that each one will capture a piece of the truth. It is also common to simply hold the value of an investment fixed at its original purchase price for the first several quarters post-acquisition, provided there are no material changes in the business, on the grounds that not enough time has passed for any theoretical valuation method to supersede the realized market price proven by the sale. Finally, when warrants or other option instruments are involved in a fund’s holdings, typical option valuation methods may be applied to assess their value independent of equity holdings in the business.
Another approach some funds take is to outsource valuation duties to an external adviser. In theory, this can mitigate potential conflicts of interest, though as with so much else in the PE world, it is important to remember that even an “impartial” adviser may not be 100% objective, especially when they are hired, paid by, and work at the will of the fund’s managers. Across the board, though, it is crucial to maintain checks against excessively rosy valuations. Regular audits are one important way to assess a fund’s valuation methodology, along with its financial statements and realized performance. LPs can and should study audit documents and question any red flags, such as managers selling an asset for significantly less than they have historically valued it internally.
It is also important not to get so bogged down in the techniques and mathematics of valuation that you lose sight of softer, qualitative information that is critical to assessing a business’s current worth. The Institutional Limited Partners Association (ILPA) produces guidelines on best practices for quarterly reporting, which at 36 pages I would advocate reading. Its recommended Quarterly Reporting Package opens with a Management Discussion and Analysis Letter, a place where funds often outline the latest key developments at companies they own. For many funds these can offer a valuable window into the thinking of managers, much like Warren Buffett’s letters to the shareholders of Berkshire Hathaway do in the public investing world.
Conclusion: Why Ongoing Valuation Matters
Some might question why any of this matters. After all, if a fund has already acquired a business, why worry about its value until an exit is in sight? The primary answer is that ongoing valuation matters to LPs, because it allows them to assess how the fund’s strategy is playing out, make internal decisions about resource allocation and staff compensation, and decide if they want to invest in other vehicles or follow-on funds from the same manager.
In addition, though, private equity professionals should themselves think long and hard about what they believe the objective, accurate value of their portcos to be, regardless of the formal approach their funds take to quarterly valuation (which in my experience and those of others I know in the industry, can range from incredibly in-depth to shockingly cursory). Embrace this as a “re-underwriting” process that will make you a better investor by forcing you to reason through how the value of your deals evolves over time, while potentially surfacing issues or growth opportunities in the business that you had not previously noticed. It may even help your long-range personal budgeting, since private equity is an industry where most compensation is deferred and tied up in the future value of your deals.
All of this is to say that both LPs and private equity professionals alike should always heavily scrutinize quarterly valuations, rather than simply taking them as gospel or viewing them as an annoying, meaningless exercise. Knowing the true worth of illiquid companies may be a dicey, partially subjective game, but it is the fundamental activity of private equity, and one we should always take seriously.
*If you want to learn more about the SEC’s ever-evolving reporting requirements for what it calls “private funds,” read this: (https://www.sec.gov/news/press-release/2023-86).
Learn more about private equity transactions with ASM’s Private Equity Training course. The Private Equity Training course at ASimpleModel.com was developed by industry professionals. The content below goes beyond the LBO model to explain how private equity professionals source, structure and close transactions.