Portfolio Valuation During Uncertain Times
by David Turney, CFA | 11 Jan 2021
The COVID-19 outbreak contributed to market volatility initially causing substantial declines in market capitalization for public companies and potentially negatively impacting companies’ financial performance through supply chain and production disruptions, workforce restrictions, travel restrictions, reduced consumer spending and sentiment, among other factors.
Given the heightened degree of uncertainty, we have had some insightful conversations with our private equity clients over the last several months. Whether portfolio valuations were performed internally or by a third-party provider, there were several common questions.
- How do you create projections?
- What multiples do we select?
- Which methods do we weight?
- What should our discount rates be?
- How do we feel confident about our conclusions with so much uncertainty?
- How should we report to our LPs?
It seems that in periods of relative growth and stability, these questions fade in importance when, in reality, these questions are at the heart of portfolio valuation. Turbulent market circumstances can often expose practice policies and procedures that might be inadequate. In the case of portfolio valuation, the questions that kept arising suggested that many private equity firms are seeking the right answers. While uncertain times are just that – uncertain – portfolio valuations can still be conducted with confidence by remaining steadfast in fundamental valuation theory and careful consideration of value-driving factors.
Don’t lose sight of “Fair Value”.
ASC Topic 820 defines fair value as “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.”
Therefore, fair value is the price that would be received in an orderly transaction:
- Based on market participant assumptions
- Reflecting current market environment even when dislocated or volatile
- Based on what is known and knowable at the measurement date
Fair value is not:
- A distressed or “fire sale” price
- The most recent transaction price, without significant supporting analysis
- The price in a “normal” market
Within this framework, firms should continue to follow a consistent valuation process that complies with the definition of fair value and guidelines set forth by the AICPA and International Private Equity and Venture Capital board. However, certain valuation assumptions and methods may require different considerations for systematic risk during periods of unusually high market volatility.
How Do We Create Projections?
Fundamental valuation approaches such as discounted cash flow approaches rely on the expected cash flows of a portfolio company. In fact, cash flows to be discounted should be probability-weighted cash flows that consider a distribution of possible cash flows. This is an important concept to keep in mind when preparing or reviewing cash flow forecasts. When uncertain economic and market conditions exist, it poses an interesting conundrum:
How am I supposed to forecast expected cash flows when I don’t know what to expect?
Our advice is to rely on your operating partners and portfolio company management. It is important to leverage the experience of these individuals given their innate understanding of industry forces – that is what makes them good executives. It is likely that they will have a unique perspective on the potential opportunities and pitfalls that the industry and portfolio company face, which makes them best-suited project-free cash flow.
In uncertain times, it is a helpful exercise to sit down with these individuals and work through the financial projections line by line. Ensure that updated financial projections reflect anticipated impacts on revenue/customers, supply chains, costs, and operations, carefully considering what drives each line item and relying on management’s instincts on how the current situation might affect the business.
While always a useful exercise, in times of increased uncertainty it can be imperative to create and review multiple forecasts. While it is typical for a company to estimate a single set of expected cash flow projections the expected case is theoretically a probability-weighted cash flow projection. Further, cash flow projections do not need to be limited to a base, downside, and upside case. As you are working through the income statement, you will notice that the type of economic recovery which might occur has a large impact in the company’s cash flow forecasts.
Creating additional scenarios which factor in different economic environments, varying timeframes for the crisis to continue, industry forces, and company positions will help you understand the company’s operations. This means a better understanding of the company’s customer relationships, vendor relationships, cost structure, capital needs, and working capital requirements. Ultimately, it means a better understanding of the company’s expected cash flows.
What Multiples Do We Select?
If projected financial information has been adjusted to take into account lower expected performance, there are potential pitfalls in applying the market approach. Consider the comparability of data within the analysis and do not apply unadjusted multiples to adjusted financial metrics. An appropriate multiple should be applied, that considers the updated financial expectations, rather than a multiple derived from comparable public companies where results do not yet reflect lower expected performance.
Further, appropriate multiples must be estimated, which should reflect the environment at the measurement date including risk/uncertainty in projections and historical financial results. Required rate of return commensurate with increased risk, which would generally indicate that multiples will decrease (even in absence of recent transaction data).
As a sanity check, considering the percentage change in enterprise value or market capitalization of comparable public companies may provide a reasonable proxy for the magnitude of the change to be expected in the selected multiple. Revenue and earnings metrics must be evaluated in the context of market participant perspectives. Generally, market participants focus on sustainable earnings or revenue. Therefore, if it is determined that the financials include one-time impacts an adjustment should be made to exclude them from the metric to which the multiple is applied.
What Methods Do We Weight?
The guidance suggests that once a valuation method or methods have been selected, they should be applied consistently at each measurement date. However, a change in technique can be appropriate if it results in an estimate that is more representative of fair value in the circumstances. Unprecedented events driving economic uncertainty would qualify as a circumstance where adjusting the application of valuation methods is warranted. While the appropriate weighting of valuation methodologies is case-specific it can be useful in this context to consider the information available to perform the valuation at the measurement date.
The starting point for many portfolio valuations is to calibrate various valuation approaches to the price paid/value implied at inception (assuming the transaction was deemed to be fair value) using market inputs on that date. Subsequent measurement dates would utilize the calibrated valuation approaches with current market inputs, which would reflect current market conditions.
The discounted cash flow method allows for the flexibility to evaluate value-driving factors on an individual basis and sensitize a variety of inputs. This flexibility allows the discounted cash flow method to be applied in situations where other methods might have difficulty addressing. If you run through the exercise of working through the financial projections with your portfolio company as described above, then you are well-positioned to utilize this approach.
Multiples that are based on LTM financial metrics are likely meaningless if forward expectations have changed dramatically. If uncertain times have had a material impact on the business’s prospects, it might not make sense to base the valuation of the business on historical financial metrics. The LTM period may contain one-time impacts to the business, and it can be difficult to normalize these financials. Basing multiples of future financial metrics might be more appealing – but once again, you would need to rely on the financial forecast and ensure that public company estimates have incorporated expectations consistent with the current environment.
Assuming an updated set of financial projections that considers current expectations is available, the discounted cash flow method is likely the best option to estimate fair value in times of increased uncertainty. Multiples should be used to corroborate the results of the discounted cash flow method, but caution must be used to ensure applicability of multiples to the adjusted financial metrics.
What Should Our Discount Rates Be?
Generally, risk increases as uncertainty increases and therefore market participants required rates of return increase. However, if future cash flows have been adjusted downward the required increase in the discount rate may be less than the increase in the discount rate if cash flows have not been adjusted for the impact of higher uncertainty. It is critical to be aware of what assumptions are being adjusted within the valuation analysis to avoid potential “double-counting” for the increased uncertainty.
How Do We Feel Confident About Our Conclusions With So Much Uncertainty?
Assuming the previous information has been considered, you should feel confident in the estimated fair value. It might be appropriate to use multiple approaches and calibrate to multiple dates to triangulate an estimate of fair value. It can also be helpful to take a step back and consider how the investor would underwrite the investment in the current environment. This can be a useful guide in ensuring that the valuation analysis is appropriately considering underlying assumptions within the context of the current environment.
How Should We Report Our LPs?
Private capital managers may be required to perform periodic valuations of investments in the funds they manage when reporting performance to limited partners. Investors in private capital funds need timely and robust fair value information to:
- Exercise their fiduciary duty in monitoring deployed investment capital
- Report periodic performance to investors
- Comply with financial reporting requirements
- Make asset allocation decisions
- Make manager selection decisions
- Make investor level incentive compensation decisions
During times on increased uncertainty, firms will need to report well-documented, defensible, independent estimates of investment fair value to withstand the elevated scrutiny of investors, auditors, and regulators.
With Intrinsic’s involvement, the burden of thoughtfully crafting a portfolio company valuation and preparing adequate supporting files is shifted off of our client’s shoulders. Further, an independent, third-party valuation can provide LPs with additional confidence, as the results are prepared by a disinterested party who performs hundreds of valuations annually.
Many of our PE clients find the rigor, responsiveness, and r substantially benefit their LP relationships, while improving the financial reporting processes of their portfolio companies. We would be glad to connect with your firm to discuss how we can be a partner to you.
For a discussion regarding the above or investments that might require a fair value assessment, please reach out to myself or any of our valuation team members.
// ABOUT THE AUTHOR
David Turney, CFA
David serves as a Managing Director and head of Intrinsic’s Financial Reporting Valuation practice. He leads the firm’s activities regarding financial reporting technical issues and resolution, as well as interactions with professional and industry associations. In addition, David focuses on business development and relationship management across the firm’s private equity, venture capital, and operating company clients. He has over 13 years of experience working with senior management of both public and private companies, including many Fortune 500 clients. David has executed and managed over 1,000 valuation engagements for a variety of purposes, including financial reporting, financial opinions, corporate tax, gift and estate, litigation and dispute resolution, reorganizations, and divestitures. His experience includes assisting multinational corporations with their valuation requirements due to acquisitions and divestitures (with several deal sizes in excess of $2.5 billion) across various industries, including industrial products, consumer products, technology, materials, healthcare, communication, and sports and entertainment. Further, he has extensive experience with professional sports franchise valuations, including franchises in the NBA, NHL, MLB, NFL, and the English Premier League.
Prior to joining Intrinsic, David was a member of the Duff & Phelps’ Valuation Advisory Services practice and a Manager at Willamette Management Associates. While at Duff & Phelps and Willamette Management Associates, he focused on providing valuation services, expertise, and advice to corporations, private equity firms, law firms, and other clients. David began his career in financial services at Ibbotson Associates, serving as a member of the asset allocation consulting team before transitioning into valuation services.