EVCA Handbook Professional Standards for the Private Equity and ...

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72 EVCA Handbook Professional Standards for the Private Equity and Venture Capital Industry3. VALUATION M ETHODOLOGIESHowever, their appropriateness in this respect is oftenundermined by the following:• the lack of forward looking financial data and otherinformation to allow points of difference to beidentified and adjusted for;• the generally lower reliability and transparency ofreported earnings figures of private companies; and• the lack of reliable pricing information forthe transaction itself.It is a matter of judgement for the Valuer as to whether,in deriving a reasonable multiple, they refer to a singlecomparator company or a number of companies orthe earnings multiple of a quoted stock market sector orsub-sector. It may be acceptable, in particular circumstances,for the Valuer to conclude that the use of quoted sectoror sub-sector multiples or an average of multiples froma ‘basket’ of comparator companies may be appropriate.Maintainable earningsIn applying a multiple to maintainable earnings, it isimportant that the Valuer is satisfied that the earningsfigure can be relied upon. Whilst this might tend to favourthe use of audited historical figures rather than unauditedor forecast figures, it should be recognised that value is bydefinition a forward-looking concept, and quoted marketsmore often think of value in terms of ‘current’ and ‘forecast’multiples, rather than ‘historical’ ones. In addition, there isthe argument that the valuation should, in a dynamicenvironment, reflect the most recent available information.There is therefore a trade-off between the reliability andrelevance of the earnings figures available to the Valuer.On balance, whilst it remains a matter of judgementfor the Valuer, he should be predisposed towards usinghistorical (though not necessarily audited) earnings figuresor, if he believes them to be reliable, forecast earningsfigures for the current year.Whichever period’s earnings are used, the Valuer shouldsatisfy himself that they represent a reasonable estimate ofmaintainable earnings, which implies the need to adjustfor exceptional or non-recurring items, the impact ofdiscontinued activities and acquisitions and forecastmaterial changes in earnings.3.5. Net AssetsThis methodology involves deriving the value of a businessby reference to the value of its net assets.This methodology is likely to be appropriate for a businesswhose value derives mainly from the underlying Fair Valueof its assets rather than its earnings, such as propertyholding companies and investment businesses (such asFunds-of-funds as more fully discussed in 4. ValuingFund Interests).This methodology may also be appropriate for a business thatis not making an adequate return on assets and for whicha greater value can be realised by liquidating the businessand selling its assets. In the context of private equity,it may therefore be appropriate, in certain circumstances,for valuing Investments in loss-making companies andcompanies making only marginal levels of profits.In using the Net Assets methodology to estimatethe Fair Value of an Investment, the Valuer should:(i) Derive an Enterprise Value for the companyusing appropriate measures to value its assetsand liabilities (including, if appropriate,contingent assets and liabilities);(ii) Deduct from this amount any financialinstruments ranking ahead of the highestranking instrument of the Fund in aliquidation scenario (e.g. the amount thatwould be paid) and taking into account theeffect of any instrument that may dilute theFund’s Investment to derive the AttributableEnterprise Value; and(iii) Apportion the Attributable Enterprise Valueappropriately between the relevant financialinstruments.3.6. Discounted Cash Flows or Earnings(of Underlying Business)This methodology involves deriving the value of a businessby calculating the present value of expected future cashflows (or the present value of expected future earnings,as a surrogate for expected future cash flows). The cashflows and ‘terminal value’ are those of the UnderlyingBusiness, not those from the Investment itself.The Discounted Cash Flows (DCF) technique is flexiblein the sense that it can be applied to any stream of cashflows (or earnings). In the context of private equityvaluation, this flexibility enables the methodology to beapplied in situations that other methodologies may beincapable of addressing. While this methodology maybe applied to businesses going through a period of greatchange, such as a rescue refinancing, turnaround, strategicrepositioning, loss making or is in its start-up phase,there is a significant risk in utilising this methodology.The disadvantages of the DCF methodology centre aroundits requirement for detailed cash flow forecasts and theneed to estimate the ‘terminal value’ and an appropriaterisk-adjusted discount rate. All of these inputs requiresubstantial subjective judgements to be made, and thederived present value amount is often sensitive to smallchanges in these inputs.Due to the high level of subjectivity in selecting inputsfor this technique, DCF based valuations are useful asa cross-check of values estimated under market-basedmethodologies and should only be used in isolation ofother methodologies under extreme caution.In assessing the appropriateness of this methodology,the Valuer should consider whether its disadvantagesand sensitivities are such, in the particular circumstances,as to render the resulting Fair Value insufficiently reliable.In using the Discounted Cash Flows or Earnings(of Underlying Business) methodology to estimatethe Fair Value of an Investment, the Valuer should:(i) Derive the Enterprise Value of the company,using reasonable assumptions and estimationsof expected future cash flows (or expectedfuture earnings) and the terminal value, anddiscounting to the present by applying theappropriate risk-adjusted rate that quantifiesthe risk inherent in the company;(ii) Deduct from this amount any financialinstruments ranking ahead of the highestranking instrument of the Fund in aliquidation scenario (e.g. the amount thatwould be paid) and taking into accountthe effect of any instrument that may dilutethe Fund’s Investment to derive theAttributable Enterprise Value;(iii) Apportion the Attributable Enterprise Valueappropriately between the relevant financialinstruments.3.7. Discounted Cash Flows (from theInvestment)This methodology applies the DCF concept and techniqueto the expected cash flows from the Investment itself.Where Realisation of an Investment or a flotation ofthe Underlying Business is imminent and the pricingof the relevant transaction has been substantially agreed,the Discounted Cash Flows (from the Investment)methodology (or, as a surrogate, the use of a simplediscount to the expected Realisation proceeds or flotationvalue) is likely to be the most appropriate methodology.20 I NTERNATIONAL P RIVATE E QUITY A ND V ENTURE C APITAL VALUATION G UIDELINESI NTERNATIONAL P RIVATE E QUITY A ND V ENTURE C APITAL VALUATION G UIDELINES 21
73 EVCA Handbook Professional Standards for the Private Equity and Venture Capital Industry3. VALUATION M ETHODOLOGIESThis methodology, because of its flexibility, is capable ofbeing applied to all private equity Investment situations.It is particularly suitable for valuing non-equity Investmentsin instruments such as debt or mezzanine debt, since thevalue of such instruments derives mainly from instrumentspecificcash flows and risks rather than from the value ofthe Underlying Business as a whole.Because of its inherent reliance on substantial subjectivejudgements, the Valuer should be extremely cautious ofusing this methodology as the main basis of estimatingFair Value for Investments which include an equity element.The methodology will often be useful as a sense-checkof values produced using other methodologies.Risk and the rates of return necessary to compensate fordifferent risk levels are central commercial variables in themaking of all private equity Investments. Accordingly thereexists a frame of reference against which to make discountrate assumptions.However the need to make detailed cash flow forecastsover the Investment life may reduce the reliability andcrucially for equity Investments, there remains a needto estimate the ‘terminal value’.Where the Investment comprises equity or a combinationof equity and other financial instruments, the terminalvalue would usually be derived from the anticipated valueof the Underlying Business at Realisation. This will usuallynecessitate making assumptions about future businessperformance and developments and stock market andother valuation ratios at the assumed Realisation date.In the case of equity Investments, small changes in theseassumptions can materially impact the valuation. In thecase of non-equity instruments, the terminal value willusually be a pre-defined amount, which greatly enhancesthe reliability of the valuation.In circumstances where a Realisation is not foreseeable,the terminal value may be based upon assumptions ofthe perpetuity cash flows accruing to the holder of theInvestment. These circumstances (which are expected to berare in private equity) may arise where the Fund has littleability to influence the timing of a Realisation and/or thoseshareholders that can influence the timing do not seeka Realisation.In using the Discounted Cash Flows (from theInvestment) methodology to estimate the FairValue of an Investment, the Valuer should derivethe present value of the Investment, usingreasonable assumptions and estimations ofexpected future cash flows and the terminal valueand date, and the appropriate risk-adjusted ratethat quantifies the risk inherent to the Investment.3.8. Industry Valuation BenchmarksA number of industries have industry-specific valuationbenchmarks, such as ‘price per bed’ (for nursing-homeoperators) and ‘price per subscriber’ (for cable televisioncompanies). Other industries, including certain financialservices and information technology sectors and someservices sectors where long-term contracts are a key feature,use multiples of revenues as a valuation benchmark.These industry norms are often based on the assumptionthat investors are willing to pay for turnover or marketshare, and that the normal profitability of businesses inthe industry does not vary much.The use of such industry benchmarks is only likelyto be reliable and therefore appropriate as themain basis of estimating Fair Value in limitedsituations, and is more likely to be useful as asense-check of values produced using othermethodologies.3.9. Available Market PricesPrivate Equity Funds may be holding Quoted Instruments,for which there is an available market price.Instruments quoted on an active stock marketshould be valued at their bid prices on theReporting Date. If bid price is not requiredby accounting regulation and not deemed to beappropriate, the most representative pointestimate in the bid/ask spread may be used.The Valuer should consistently use either the bidprice or the most representative point estimatein the bid/ask spread.For certain Quoted Instruments there is only one marketprice quoted, representing, for example, the value at whichthe most recent trade in the instrument was transacted.For other Quoted Instruments there are two market pricesat any one time: the lower ‘bid’ price quoted by a marketmaker, which he will pay an investor for a holding (i.e.the investor’s disposal price), and the higher ‘ask’ price,which an investor can expect to pay to acquire a holding.However, as an alternative to the bid price (where notrequired by regulation), is the mid-market price (i.e. theaverage of the bid and ask prices), where this is consideredthe most representative point estimate in the bid/ask spread.This methodology should apply when the prices are set onan Active Market.Discounts should not be applied to prices quotedon an Active Market, unless there is somecontractual, Governmental or other legallyenforceable restriction that would impactthe value realised at the Reporting Date.In determining the level of discount to apply, the Valuershould consider the extent of compensation a holderwould require when comparing the Investment in questionwith an identical but unrestricted holding.A Valuer may consider using an option pricing modelto value the impact of this restriction on realisation,however in practice for restrictions which only covera limited number of reporting periods, this is simplifiedto a simple mathematical discount to the quoted price.The discount applied should appropriately reflect the timevalue of money and the enhanced risk arising from thereduced liquidity. The discount rate used is a matter ofjudgement influenced by expected volatility which shouldreduce to zero at the end of the period.22 I NTERNATIONAL P RIVATE E QUITY A ND V ENTURE C APITAL VALUATION G UIDELINESI NTERNATIONAL P RIVATE E QUITY A ND V ENTURE C APITAL VALUATION G UIDELINES 23
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