To Buy or To Sell? Techniques in the Valuation of Private Companies

Valuation of private companies is a challenging task. Financial data on private companies is not usually available while the market for private transactions is less liquid than this of publicly traded companies. Yet, it is often imperative to assign a specific value on a private business. This could be part of due diligence before and during a transaction or a necessary internal process for allocation of shares among owners or employees.

Quantitative data must be used in combination with contextual and subjective information on the company. There is no absolute value to be derived with calculations and no mathematical formula that can be used with exact science. Additionally, even when one has been hired internally to conduct research and value the company, which consequently means that one has access to all in-house financial data, the market plays a major role in the final valuation. This has to do with market liquidity at that particular time but also with recent sales transactions of comparable companies. Price-earnings relationships defined in other sales can be applied to value the company.

When I am asked to value a company I prefer a combination of discounted cash flow techniques (DCF) and price-earnings multiples from comparables. Generally, I tend to mistrust appraisers’ approach that is based on industry-specific formulas, which account for financial and operational data and result in an approximate figure. Given that figure, I would still run a DCF valuation because it calculates the underlying economic value of the company based on the company’s ability to generate cash in the future. This method presents inherent difficulties such as forecasting expected cash flows and estimating the cost of capital to be used as the discount rate in the calculations.

Multiplies are based on revenue and earnings figures found on the income statement or on assets found on the balance sheet. For example, one may want to look at Price/Revenues (P/R), Price/EBIT (Earnings Before Interest and Taxes), Price/EBITDA (Earning Before Interest, Taxes, Depreciation and Amortization), Price/Earnings (Net Income, after all expenses and taxes). A valuation based on these numbers may result in a value that needs adjustment up or down by as much as 30%. This often has to do with the size of the company and the premium that is assigned to large companies (larger companies are worth more than small companies in general) or the discount rate applied to private companies to account for the lack of liquidity within the market. Furthermore, a premium may be assigned for substantial assets on the balance sheet, or excess cash, or a superior brand etc. The company is always worth more to a strategic investor who gets involved in managing the business and therefore contributes with value added.

The complexities of a multiples-based valuation are numerous but may be clarified when a DCF approach is applied simultaneously. A DCF valuation usually consists of four steps: 1. Forecasting of future cash flows for five years and for a best and worst case projection; 2. Estimating the firm’s value at the end of the forecasted period (residual value); 3. Estimating the cost of capital using the weighted average cost of capital (WACC) formula; 4. Calculating a net present value (NPV) of the firm by discounting the residual value and each year’s cash flow projection by the appropriate discount rate and then adding them together.

It is important to value the company based on both approaches because while its market value is a reflection of the underlying economic value, if the numbers reveal inconsistencies (unusually low or high market value) this may point to a buying or selling opportunity.

The Direction of Independent Research in 2010

A variety of interesting topics were discussed today at The Sixth Annual Investorside Research Conference: Indepedents’ Day 2010 (sponsored by Bloomberg Tradebook and co-sponsored by the New York Society of Security Analysts) at Bloomberg’s headquarters, at 731 Lexington Avenue.

The challenges that have shaped the financial landscape within the last two years are still present. Nevertheless, several of the analysts who participated in the panel discussions agreed that these challenges also present opportunities for investors (primarily hedge funds and private equity firms) who are looking to enter the market with new positions.

There has been an array of regulatory and legislative initiatives but the truth is that research remains fundamentally central in the process of due diligence as well as in later stages of investment. The role of research has functionally persevered for about the last fifty years, it was argued, and its strength remains in the fundamentals. This means that all financial statements are crucially important and that more emphasis needs to be given to the study of the balance sheet. In contrast, think of the Internet bubble of the early 2000s, when analysts were satisfied with information on revenues and cash flows even if these were not giving a complete picture of the company’s health.

While analysts are returning to the fundamentals with a newly found rigor, investors are more willing to invest in equity rather than public/private partnerships because liquidity has become a big concern. No one wants to lock capital for the next ten years and with no provision of certain exit strategies. Equities by contrast offer a more manageable investment in terms of liquidity and timely exit. Analysts are still basing their due diligence for equities on strong fundamentals and they also expect the Fed to provide market surveillance, especially in the areas of interest derivatives, SWAPS, and CDS.

The flux of the financial landscape is evident in its own consolidation, an idea we discussed here in January (See: “Is Uncertainty the New Paradigm?”). It seems that this remains a major concern on everyone’s mind: there are 9000 banks in the US and five in Canada. The proper number of banks in the US is somewhere between 9000 and five, but five is a scary number for the American taxpayer because too few banks would imply that they are also too big to fail. This, in combination with a persistent weakness in risk management, implies that the consolidation in banking will continue within the next two years.

As for risk management, everyone’s trepidation stems from the realization that statistical models do not work and that contextual research is equally and even more important. It is time to think about the norms rather than mathematics. It is also time to think about who is on the managing team of a company, who is on the board, and who is the major player. The presenters unanimously agreed that qualitative research proves far superior to quantitative because behavioral economics must be taken into account.

The case studies presented at this conference confirmed the classic example of unrealistic expectations and bad accounting that leads to elevated risk for the shareholders. (Just to name a few of the companies elaborately discussed: First Solar, Q-Cells, Conergy, Suntech Power, Renewable Energy Corporation among others.) They all responded to unsustainable demand (demand based on temporary incentives to install solar panels for production of alternative power in European countries, mainly Germany and Spain), increased production, and tripled their inventory. This is where research on fundamentals can save shareholders from losses. In the aforementioned cases, growing inventory was coupled with growing receivables. When businesses were questioned what was happening with their balance sheet, the usual answer was that they were in the process of altering their business model. This, they claimed, was normal to show on the balance sheet, which should be excluded from analysts’ reports. Theirs was not a very plausible story, as we all know by now (the time frame of these cases studies was from 2006 to late 2008).

The only remaining issue with analysis of fundamentals and accounting in general is that US GAAP regulations are being tested. It was argued today that US GAAP might be soon going away to be replaced with IFRS rules. This may solve the problems of comparability and transparency within the global economy but also presents a tremendous conundrum for educational institutions with accounting departments. Accountants should definitely know how to work with both the US GAAP and the IFRS system but shaping the curriculum in schools is not an easy task while retroactively adjusting company records may be impossible.

Independent research has been strengthened by technological platforms such as LinkedIn and other forms of social networking, all of which become very useful tools for service providers looking to acquire industry knowledge and specific expertise. This combined with a renewed commitment to fundamentals and an interest in behavioral studies is where Independent Research stands in 2010.

Is Angel Investing Irrational?

The Berkley Center For Entrepreneurial Studies at the Stern School of Business is famous for its courses and co-curricular activities in entrepreneurship and innovation. On February 24, 2010, the Berkley Center’s Himelberg Speaker Series featured David Rose, Chairman of the New York Angels (http://newyorkangels.com/), angel investor himself, founder of Angelsoft (back-end infrastructure software) and manager of a proprietary portfolio that consists of no less than 75 companies. Rose was invited to present his strategy in angel investing. He faced an auditorium tightly packed with about 300 entrepreneurs, entrepreneurs in the making, and investors in entrepreneurial ventures. Rose spoke for a good two hours to mainly communicate one idea: angel investing is irrational.

Who are the angels? They are individuals (they are not professional money managers who represent institutions, endowments, or wealthy individuals); they are rich (-ish) people who invest their own money for economic or other reasons; they invest on average amounts that range from $25K to $100K. Yet, compared to Venture Capital investments (that today represent later stage investments), angel investments cover about 49,000 deals (and about $20 billion).

Why are angel investors irrational? Because they know that half of the deals in which they invest will go under and the rest will greatly underperform expectations. While the economics of angel investing is predictably irrational, it is also highly lucrative as long as angels invest in that one deal that will return a 30 times multiple the original investment and will compensate the investor for the losses he incurred with the rest of the deals that flopped or underperformed.

How does one find deals to invest in? Rose insists that there is logic to the madness of angel investing. He usually looks for:

· Large and growing market

· Scalable business model

· Competitive advantage

· External validation

· Reasonable valuation

· GREAT PEOPLE

While every deal comes with a team, the most important person for Rose is the ENTREPRENEUR, someone who has already demonstrated:

· Integrity

· Passion and the desire to create something big

· Experience (but not necessarily in the field of the new enterprise)

· Knowledge

· Skills (how to make it happen)

· Leadership

· Commitment (to her idea)

· Vision (to change the world via her idea)

· Realism

· Coach-ability

Having completely disproven his original point, Rose defined angel investing as a highly complex thought process that focuses less on analytics and fancy presentations and more on the qualities of the people on the team.

Global IPO Market 2010 Outlook: Slow Activity and Strong Exits

If history is ever a good predictor of the future, 2010 is going to remain slow in IPO activity but may showcase a few very strong exits for fundamentally sound companies, Graham Powis, Managing Director and Head of U.S. Equity Capital Markets, Lazard Ltd., asserted on January 28^th during a panel discussion organized by FTSE and Renaissance Capital exclusively for New York Society of Security Analysts members.

Right now, private equity firms affected by credit dislocation and the recession have one primary goal: to ascertain the quality of IPO opportunities as an exit strategy for the global private sector. While other exit considerations include dividends financing in the debt markets and despite the fact that valuations are substantially lower than what the IPO market achieved from 2000 to 2005, General Partners are concerned with returning capital to their LP investors.

Christopher Turner (Warbug Pincus), Phil Drury (Citigroup), and Jonathan Art (Federated Kaufmann Fund) of the same panel, moderated by William Smith, CEO of Renaissance Capital, agreed that uncertain capital origination, market ambiguity, and indeterminate liquidity exemplify an opportunistic market. This type of market has a two-sided effect: on one side, researchers observe low willingness on investors’ part to join in public offerings within volatile markets paired with high preference for less risky deals; on the other side, capital markets participants recognize the IPO market as a highly inefficient category of public equities.

Inefficiency is good. In fact, for sophisticated investors inefficiency is great. Paul Bard, Head of Research for Renaissance Capital, demonstrated that the IPO market presents experts with the opportunity to create investing strategies with remarkable returns. As an indication, while the returns for the Russell 3000 and S&P were -5.8% and -8% respectively in 2009, the IPO index registered returns of 28.5% for the same year.

The inefficiency of the IPO market is based on the following facts: private companies are not well researched; they operate within new industries; their management teams are relatively unknown; private companies have not been traded yet and therefore the predictability of their success in trading is practically impossible. A bottom-up fundamental study of IPOs as well as expertise based on historical data lead researchers to believe that 2010 may be the year for some very strong companies to go public as it happened in the 1970s, another period of slow activity. With an approximate number of 100 to 120 deals in the pipeline, of which 39% in Technology and Healthcare, the sophisticated investor has the advantage of deep discounts in some fundamentally strong, top performing private companies that promise high quality operations, overall growth, and proven profitability.

Is uncertainty the new paradigm?

I would like to dedicate the first entry to my professor, Ed Altman, the Max L. Heine Professor of Finance at the Leonard N. Stern School of Business at NYU and Director of Research in Credit and Debt markets. Dr. Altman is an expert in the fields of corporate bankruptcy, high yield bonds, distressed debt and credit risk analysis.

To Dr. Altman I owe a solid understanding of corporate and municipal bonds and primarily an insight into what it means to be a leader and professional of the highest caliber and standards.

“The New Paradigm for Private Equity” was the inaugural annual conference in a series organized by Alvarez & Marsal, a leader among global professional services firms today and originally founded as a restructuring boutique in New York City. For this conference that took place on January 21st, Alvarez & Marsal collaborated with the Stern School of Business and placed Ed Altman at its helm as the co-chair and one of the two keynote speakers, the second one being Wilbur L. Ross, WL Ross & Co. and Invesco Private Capital.

Both Dr. Altman and Mr. Ross maintained that the New Paradigm is actually not so new or surprising but rather a resurgence of trends that mark a distinct phase of evolution within private equity. The point was proven eloquently and convincingly with two different methodological approaches:

Dr. Altman presented his rigorous analysis of the market and, specifically, the default rate of corporate bonds and how these can be studied to predict an impending credit bubble. His five discrete approaches (the Macroeconomic Model, the Mortality Rate Model, the Market Based Model, the Recovery Rate Model, and the Distressed Debt Market Size Estimate) confirmed events that today everyone recognizes in retrospect. For example, Dr. Altman proved that historically, default rates of corporate bonds rise for two years before a recession. While his predictions for corporate defaults are in agreement with those announced by the big rating agencies, the point worth noting here is that a thorough study of market conditions gives early warning signs. These can be used as techniques to assess the sustainability of market trends, avoid credit bubbles, and assist investors understand the true financial profile of companies as well as identify opportunities for investing.

The evolving nature of private equity was confirmed in the second keynote address, in which Mr. Ross presented a list of seven “new” paradigms for private equity drawn from his own long career in the field:

#1 Washington is the new Wall Street; #2 By necessity, there is a proliferation of private public partnerships; #3 The FDIC framework cannot protect failing banks, which is leading to an extreme reduction in the number of existing banks in the US—not such a bad thing, after all; #4 Private Equity firms are becoming the new tax revenue targets; #5 The terms of financial engineering in private equity are changing rapidly. The gap between the top 25% and low 25% of distressed firms is widening. #6 It will take years to repair the economy while the slow recovery will affect turnarounds, the success of which will be more the result of the micro aspects of the business rather than the macro conditions of the economy; #7 There will be more capital available for distressed investing in private equity.

The remainder of the conference was organized in three panels:

Panel 1, Distressed Investing for Control (Moderator: Mark Patterson, MatlinPatterson Global Advisors LLC; Panelists: Kipp DeVeer, Ares Management; Angus C. Littlejohn, Jr., Littlejohn & Co., LLC; Michael Psaros, KPS Capital Partners, LP; Jason New, The Blackstone Group)

The volume of defaults in the last two years has substantially increased the scale of supply of distressed companies and, therefore, has impacted the breadth of management expertise needed in distressed investing. Screening of distressed companies has become more complex as well. This has led investors to a greater degree of specialization and conservatism. The panelists represented investors who are in distressed investing for the long run, and not for the quick trading of distressed companies in which hedge funds are usually interested. Consequently, the relationship between the private equity sponsor and distressed company management is very important and becomes tighter in difficult times. Therefore, conservatism, management, and execution are the key characteristics of the panelists’ approach to investing. In addition, these three are their tools for success in creating value for the management and the sponsors, which is, they asserted, the definition of private equity: value creation for the stakeholders.

Panel 2, Private Equity Investment in the Banking Sector (Moderator: Steve D. Goldstein, Alvarez & Marsal; Panelists: P. Olivier Sarkozy, The Carlyle Group; Mark K. Gormely, Lee Equity Partners LLC; Max Holmes, Plainfield Asset Management LLC; Fred D. Price, Sandler O’Neill + Partners, L. P.)

Compared to the clearly operations-driven first panel, this panel on banking left the audience trying to decipher aphorisms on banks and “their notoriously weak management teams.” Having said that, Steve Goldstein did an excellent job setting up the discussion and introducing banking as a new area of distressed investing, a perfect follow up to Mr. Ross’s keynote speech in which he had admitted to favoring investing in regional banks of relatively small size ($5 to $8 billion market cap). This panel’s negative overview of American banking is based on: the government’s involvement in subsidizing the real estate market and, consequently, in creating an unsustainable economy; the weak management teams that still remain in place; the restrictive legal framework that does not allow private equity sponsors to hold a seat on the board in any of the banks they partially own. In fact, a private investor holding anywhere between 15% and 24.99% will be called to sign a passivity agreement; one holding anything above 25% and up to 49% will be called to sign a bank holding agreement. Both agreements are designed to strip private investors from power in any management issues (i.e. no voting power on the bank’s board) despite the capital they may have poured in.

Panel 3, Portfolio Company Management—Picking the Right Horse for the Course (Moderator: Jeff Feinberg, Alvarez & Marsal; Panelists: Joseph R. Edwards, First Reserve Corporation; Kevin Haines, Protostar Partners, LLC; Dean B. Nelson, KKR Capstone; Bill Sullivn, Apax Partners LLP)

The uniqueness of this last panel derived from its own composition: all four panelists are specialists within a particular industry, except for Mr. Haines, whose firm, Protostar Partners LLC has a unique approach to investing since it is one of the very few firms who buy entire portfolios of companies. This approach confirms a point made earlier, namely that private equity firms today have a need for breadth of expertise. In contrast, the other three firms have found their respective market niches in which they know all the players. This makes it easier for them to distinguish who is a good fit for their team, usually a professional who combines deep knowledge in the specific field combined with finance experience. Still, they all agreed that private equity creates an intrusive relationship that affects or even completely erases existing management. Regardless, the sponsor-management relationship can work successfully when it is based on: commitment from both parties; courage to make the necessary difficult decisions for the company; and conviction that this relationship can indeed bring results.

Regulatory uncertainty may very well be a sign of the times but the main takeaway from the January 21st conference was Tony Alvarez’s II (Co-CEO Alvarez & Marsal) three-prong assertion on private equity’s new paradigm: #1 One cannot take anything for granted when liquidity capacity is unpredictable; #2 One should ask a lot of questions, especially when the goal is to assess a partner and his/her suitability; #3 Teams need a leader and one needs to be ready to pick one and move on with the task at hand. Considering that Tony Alvarez II transformed the small boutique firm he co-founded to a global service organization that operates in 16 nations, I would certainly follow his lead.