Many RSM clients with portfolio companies have recently completed their year-end audits and are now preparing to do their first-quarter valuations. But while that has been a relatively straightforward proposition in recent years, it is anything but this year. How do private equity firms determine the fair value of their holdings when those values seem to change by the day, or even the hour, amid the economic havoc caused by the coronavirus?
What has been a relatively straightforward proposition in recent years is anything but this year amid the economic upheaval.
This challenge goes beyond the boilerplate language found in all GAAP reports, “Actual results may vary from estimates.” This year, general partners and limited partners alike understand that this phrase, as important as it is, does not come close to capturing the economic disruption caused by the coronavirus. What was considered fair value as of December 31 – coming off a period of stability and prosperity – is likely to be vastly different today, and in a far greater state of flux.
Indeed, in the history of fair value reporting, there may never have been a more sudden and material market shakeup like that which we are experiencing. So what’s the best way to figure how much companies are worth?
To begin with, it is important to remember the definition of fair value: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
Not only is an orderly transaction required, but also that a market participant would take into account current market conditions and all relevant known and knowable information as of the measurement date.
By definition, an orderly transaction assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities. For this reason, a “fire sale” does not represent fair value.
Given that, there are a number of ways to measure fair value. Consider two of these: the income model and the market model.
- Income model – Many clients are preparing income models at March 31 in place of market models because the income model enables a firm to forecast business income based on revised forecasts following business dislocations caused by coronavirus. To put it in more concrete terms, nearly all of our clients’ priority investment industries suffered value losses – none less than 10%, and some as much as 19%. The benefit of using an income approach is that it applies a discount rate that captures the risk of getting this income on time and in full measure. And when determining risk rates, rates are expected to increase since December 31 because not even the smartest economists or deal professionals have a clear idea of how and when a business may rebound.
- Market model – Those firms that prefer the market model should increasingly perform calibration. Calibration is a technique used where an observed transaction price is used to back into certain identified but unobservable input assumptions. These assumptions are then updated and rolled-forward for subsequent measurement dates. In this example, one would expect to observe directional consistencies between cited comparable market multiples and the fund’s implied multiple.
Regardless of the approach decided by management, groups must be mindful to follow the policies and procedures that were already in place. Diverging from a documented valuation policy raises questions from any regulatory agency, and applying consistent methodologies from period to period not only is necessary, but also paints a clearer picture of value over time.
In instances where new weightings or models are used, the manager must be clear about the rationale and support it with documentation to avoid scrutiny.
As the median forecasted enterprise value/EBITDA has fallen …
Source: Bloomberg
… so has the mean, across industries
Source: Bloomberg
Looking ahead
Even as funds try to cope with the economic disruption of the coronavirus, many are still sitting on significant amounts of cash that can be put to work in this period of dislocation. Some of the hardest hit industries – like industrials and consumer products – have had forecasted EBITDA multiple declines of 19% and 16% since December 31 and might provide a place to put that cash to work.
Selective deals are still getting done, including in sectors that may see higher demand because of the pandemic. But other potential buyers may choose to wait out the crisis before making any big moves, instead holding onto much-needed cash and focusing on running their own businesses.
Regardless of the path chosen, middle market businesses must evaluate their impact cycle and carefully consider qualitative attributes of the industries they invest in to determine the ultimate impact in valuing their positions.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
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