Finding the gold standard in PE valuations


Tim Mundy

In the past 10 years, private equity deal activity has more than doubled while the number of companies listed on U.S. stock exchanges has fallen by 50 percent over two decades. This corresponds with the changing dynamics in how companies are raising capital. PE continues to play an important role in the global economy and is shaping the way capital markets operate. As dealmaking activity continues to rise, the valuation process followed by PE firms in valuing their investments will continue to face increasing scrutiny by various stakeholders.

Valuation, the process of estimating a company’s current net worth, is arguably the single most important component of PE financial reporting—and yet, there is no single, standardized methodology for investors to derive these numbers. Not only does this lack of consistency make valuing and benchmarking private companies challenging, but it also makes it harder to report on fund performance. Exacerbating this is the tendency among PE firms to determine valuations in-house, which puts them at a transparency disadvantage to public company counterparts who routinely outsource valuation to third parties to strengthen confidence in their numbers.

George Psarianos

As a result of a lack of standardized methodology, regulators, industry organizations and investors are calling for more transparency into how fund managers establish, govern and carry out valuation processes. In August, the American Institute of CPAs released its new guide, Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies. The guide provides a framework for investment companies on how to fair-value their portfolio company investments and is intended to harmonize views of industry participants, auditors and valuation specialists.

Regardless of whether PE firms are bullish on valuations, one cannot deny the spotlight on valuation methods. If the PE investor base continues to expand, over the next several years valuations (and realizations) will likely continue to be the most important metric of PE performance. But how will leading firms be setting them? Here are three general approaches to valuation:

Guideline Public Company (GPC) Method: The GPC method values similar companies using financial metrics such as price-to-earnings and price-to-book ratios. The process involves comparing the target company against a set of public peers—in which peers are selected for comparability by business line, geography, customer base, etc.—in order to derive the price of what an individual share could look like. While GPC is a popular method, there can be challenges to applying it, depending on the size of the target company and availability of enough public competitors to run the model, so PE investors will need to decide whether this or another method is more suitable to their portfolios.

Discounted Cash Flow (DCF) Model: Perhaps the best-known methodology in the industry is the DCF. It takes a more forward-looking, subjective view, in which valuation is assigned based on the company’s expectations for business growth. DCF analysis finds the present value of expected future cash flows using a discount rate. A present value estimate is then used to evaluate a potential investment.

Comparable Transaction Analysis: This practice is commonly used to value companies that are M&A targets. This approach examines recent transactions that involve companies with similar business models to that of the target in effort to derive a fair valuation — although doing this with private companies can be tricky given the more limited data available for them compared to publicly listed businesses. For this reason, this methodology is often used in conjunction with other valuation methods, such as a DCF model.

Firms, where available, should employ a combination of these and/or other methods. For example, based on the facts and circumstances, a valuation for a single company could be calculated using GPC, DCF and comparable transaction models, with each assigned a 33-percent weighted value in the final valuation.

An overarching consideration for firms in setting valuations is the need and stakeholder expectation for firms to apply a consistent process driven by relevant valuation policies and procedures. This approach presumes that the outcome should not be a predetermined number. Instead, if the process is solid, confidence in the valuation is greater.

PE firms can expect increased scrutiny as they expand their portfolios, pursue returns and cultivate new investors. Valuation provides a clear measure of how well a PE firm identifies investment opportunities, attracts and retains investors, elevates portfolio company performance, and, ultimately, delivers value. The methods a PE firm employs to arrive at its valuation, the objectivity and transparency of its approach, and the ability to stand up to rigorous operational due diligence will become increasingly important in the next few years. With that, an auditor’s role and that of a third-party valuation specialist in the valuation process is also becoming significantly important as accounting and valuation gold-standard processes and procedures become more relevant.

Tim Mundy is the national managing partner for the Audit & Assurance Private Equity Portfolio Company practice at Deloitte & Touche LLP. He can be reached at tmundy@deloitte.com.

George Psarianos is a Deloitte Risk & Financial Advisory managing director and Deloitte’s US Portfolio Valuation Services practice leader, Deloitte Transactions and Business Analytics LLP. He can be reached at gpsarianos@deloitte.com .