The recent publication of a Centre for Management Buyout Research (CMBOR) study is timely in view of the number of UK private equity houses that have stepped up their activity in Continental European markets and the re-emergence of a strong US presence in both the UK and Continental Europe during the last year or so.
Venture Capital Firms and Equity Investment Appraisal in the US, UK, France and Holland*, which builds on an empirical European study of venture capitalistsO investment appraisals that appeared in condensed form as the Cover Story in the February/March edition of EVCJ, finds there are important differences between countries with respect to the rates of return investors look for from the different stages of venture capital investment and the relative importance of accounting information.
Over 200 private equity firms across the five countries supplied answers to questions concerning their approach to due diligence, valuation methods, information used for valuations, benchmark rates-of-return and approaches to assessing the risk profile of investment opportunities.
The survey found that investors in the older private equity markets in the US and UK, were inclined to rely more heavily on their own due diligence and market reports than their Continental counterparts. CMBOR remarks that this finding is consistent with evidence that venture capitalists in the less mature private equity markets in general have greater financial than industrial skills.
Valuation methods used to combine information on risk and required returns differed widely across the markets surveyed (Tables 1 and 2). However, these variations did not appear, as might have been expected, to be directly related to the maturity and development of the countries’ private equity and capital markets. Surprisingly, apparently similar systems and markets appear to place varying importance on different valuation methods. PE ratios, for instance, which could be expected to be widely used in the countries with more developed capital markets, were most important in the UK, but not the US.
One factor which emerged as common to all markets was the contribution of management skills in reducing the perceived risk of an investment proposal. By contrast, though, the importance of the level of funding contributed by management emerged as a significant differentiating factor between countries, particularly notable in the US and France but less so in other European markets, especially the UK.
The legal and fiscal infrastructure of the individual countries apparently influenced the target rates of return required by investors in those markets (Table 3).
Investors in the more established UK and US venture markets were found to require higher returns for later stage investments than investors in the other European markets surveyed (Table 4). These findings suggest that the expected IRR increases in step with the development of private equity markets, since the maturer markets are able to provide more detailed information for past performance. However, this does seem somewhat paradoxical, given the findings for Belgium and the Netherlands, Continental Europe’s oldest established venture markets, and anecdotal evidence from the UK market to suggest that return expectations are being forced downwards at present by intense competition for deals.
Across all countries surveyed, the most important influences on target return were related to the market conditions of a particular investment proposal, the expected length of the investment, whether an exit route had been planned from the outset and the degree of market innovation of the company.
This survey serves to emphasise once again the lack of homogeneity of the different venture markets in Europe. CMBOR points out that differences between practices in the individual markets persisted even after controlling for variations in the relative importance of different investment stages and venture capitalist types in each market.
Continuing internationalisation of the private equity industry may lead over time to greater harmonisation of investment practices. CMBOR concludes that, until then, venture capital firms entering non-domestic markets “need to invest considerably effort in understanding the operation of these markets if they are to exploit fully their perceived competitive advantages and avoid the problems experienced by some previous foreign entrants in the late 1980s”.
Table 1: Methods Used in Valuing Potential Investments
Mean US UK Belgium & France
Netherlands
(N=73 (N=66) (N=38) (N=32)
capitalised maintainable earning
(PE multiple) (prospective basis) 3.6 4.3 3.6 4.3
capitalised maintainable earning
(EBIT multiple) 3.8 3.9 3.8 4.1
recent transaction prices for
acquisitions in the sector 3.8 3.6 3.6 4.2
capitalised maintainable earning
(PE multiple) (historic basis) 3.6 3.9 3.7
pay-back period 3.3 4.3 3.0 4.2
industry’s special “rule of thumb”
pricing ratios (e.g. turnover ratios) 3.5 2.9 2.2
discounted future cash flows 3.7 3.2 3.7 3.8
responses to attempts to solicit bids
for the potential investee 2.9 2.7 2.8 3.3
historic cost book value 2.1 2.4 2.6 2.1
liquidation value of assets (orderly sale)
2.8 2.1 2.3 2.4
dividend yield basis 2.1 2.2 3.0 2.5
liquidation value of assets (forced sale)
2.7 2.0 2.1 2.0
recent PE ratio of the parent
company’s shares 2.3 2.0 3.2
replacement cost asset value 2.2 1.9 2.2 2.3
Source: CMBOPR/BZW Private Equity/Deloitte & Touche Corporate Finance
Table 2: Selection of Final Benchmark/Valuation
Mean US UK Belgium & France
Netherlands
(N=73 (N=66) (N=38) (N=32)
place greatest weight on one particular
method and use others as a check 3.4 4.2 3.5 3.8
use the average valuation 3.1 2.6 2.8 2.8
use the weighted average valuation 2.5 3.3 2.8
use the median value 2.7 2.3 2.0 2.3
use the lowest value 2.5 2.3 1.9 2.3
use the highest valuation 2.1 1.7 1.7 1.6
Source: CMBOPR/BZW Private Equity/Deloitte & Touche Corporate Finance
Table 3: Required Rate of Return on Equity
Mean US UK Belgium & France
Netherlands
(N=73 (N=66) (N=38 (N=32)
IRR 30% 30% 15% 25%
IRR early-stage 46-55% 46-55% 31-35% 36-45%
IRR expansion development 31-35% 31-35% 21-25% 21-25%
IRR acquisition/buyout 26-30% 31-35% 21-25% 26-30%
Source: CMBOPR/BZW Private Equity/Deloitte & Touche Corporate Finance
Table 4: Target Rates of Return
Mean US UK Belgium & France
Netherlands
(N=73 (N=66) (N=38) (N=32)
we require the investment to
meet a specific required IRR
on equity according to the
characteristics of each investment 3.6 3.6 4.0 4.2
we require the investment to meet
a standard required IRR according
to the risk band of the investment 3.3 3.3 3.9 4.8
we require an IRR which yields a
total cash return commensurate
with the amount invested 4.0 3.4 2.9 3.0
we require the funding structure to
meet gearing ratios appropriate to
each investment 2.5 3.4 3.4 3.5
we require the investment to meet a
standard required IRR, regardless of
the investeeOs risk profile 2.8 2.3 3.0 2.9
we require the funding structure to
meet a standard gearing ratio according
to the risk band of the investment 2.0 2.4 3.4 3.6
we require the funding structure to
meet standard gearing ratios 1.7 2.1 2.9 2.7
Source: CMBOPR/BZW Private Equity/Deloitte & Touche Corporate Finance
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