Valuations in the New Normal: A Virtual Roundtable Discussion with ACG

November 24, 2020

In the face of the COVID-19 pandemic, and the ensuing volatility and uncertainty, private equity firms struggled to report valuations in the same way as during the past decade of impressive and stable growth. Recently, Stout portfolio valuation professionals, Jamie Spaman and Colin Gray, joined Joshua Cherry Seto, CFO of Blue Wolf Capital Partners and Blinn Cirella, CFO of Saw Mill Capital for an ACG virtual roundtable discussion to share their perspective on how middle market private equity firms have handled valuations for the first three quarters of 2020. Topics discussed at the roundtable included:

  • Use of public comps during periods of high volatility
  • Use of precedent transactions post-COVID-19
  • Impact of COVID-19 on discounted cash flow methodology and considering increased scenario planning
  • Thoughts on add-backs due to COVID-19
  • Use of forward-adjusted earnings in the market approach

During the roundtable discussion, ACG members asked several questions – many which were addressed by panelists during the discussion and the remainder following the discussion. All questions and responses are shared below:

In private offerings, aren't deal terms more important than the pre-money valuation? In other words, terms like price ratchets, liquidation preferences, etc. can dramatically alter the relative positions of shareholders. For example, shareholders who nominally own 20% of the shares can end up with over 50% of the ownership payoff.

Colin Gray: The rights and preferences of any new investment are certainly key to their fair value. When a company has a complex capital structure the initial calibration of the valuation should be based on a valuation method that can capture the value of a security's rights and preferences. Such a valuation method would likely be a forward-looking method, such as an option pricing model.

Have you dealt with businesses for whom COVID-19 led to better than normal results and what have COVID-19 adjustment discussions been like for them?

Jamie Spaman: Yes we have. In just the same way as when COVID-19 has negatively impacted a company's performance, the key questions are: 1) Is the change in performance indicative of a new, normalized level? 2) If the change in performance is temporary, how long is it expected to last and why? We have found that investors have, in general, been very aware that positive performance related to COVID-19 may well be temporary and have been keen to analyze long-term impacts.

Are Paycheck Protection Program (PPP) loans, their transferability and potential forgiveness complicating valuations and deal closings? If so, what can buyers/sellers do to prepare for this in the M&A process?

Colin Gray: Yes, the uncertainties of PPP loans have certainly impacted our fair value analyses. Most companies seem to have a pretty good idea as to whether or not their PPP loans will have to be repaid. If this is not known then further analysis of the rules of the loans as they relate to the subject company is necessary. And if there remain uncertainties then risk adjustments to PPP loan-related valuation inputs should be considered.

Any change in engaging with advisors like investment bankers or attorneys?

Joshua Cherry Seto: We have looked to increase our dialogue with bankers to better understand the perspective on our company values, with a big grain of salt with respect to banker expectations.

Blinn Cirella: Agree with Josh. Nothing has changed with the way we deal with the bankers or the attorneys related to valuations.

How are you treating the PPP loans that are assumed to be forgivable? If the client expects 100% to be forgivable, do you remove the debt or take some other approach?

Jamie Spaman: If the loans are expected to be 100% forgivable then yes, we would remove the balance from net debt.

Any guidance on making offers on new opportunities?

Joshua Cherry Seto: The market is certainly open with many actionable processes and capital market support. Valuations are strong in essential businesses and deals are getting done.

Blinn Cirella: Agree with Josh.

From perspective of sell-side M&A - If you were evaluating an acquisition, how likely would you entertain an earnout structure to bridge the uncertainty? To what degree would multiple scenario modeling be utilized for buyer/seller to settle on a "shared view" of the future? If doing that, how much would macroeconomic forecast data, i.e. from the Fed, be built into that modeling?

Joshua Cherry Seto: In uncertainty as well as the past year when valuation expectations are high, we see a ripe space for earnouts to bridge the expectation gap. It is not easy to adjust for exogenous impacts like COVID and we have not found an answer, but certainly we continue to have earnout discussions in our processes, both buy and sell.

Blinn Cirella: I am not sure there is a “template” for how to model earnouts, now or ever. Given the fact that the other party has to agree on the economics, I think it has to be evaluated on a case by case basis.

How do you measure management team performance in a COVID-19 environment?

Colin Gray: This has certainly been a challenge for many portfolio companies.  In terms of payments relating to performance, the most common approach that we have seen is to continue to follow the performance framework that is in place.  However, in some cases, when there is perceived to be a risk of losing important team members, the framework has been getting reassessed

Have you seen decreased leverage from banks and mezzanine funds? Have deals been equitized heavier to compensate?

Jamie Spaman: Obviously deal volume has been lighter so there is not a ton of evidence but yes, there does appear to be a somewhat lower appetite for highly levered deals.

What are the characteristics of industries that use multiple of sales vs multiple of EBITDA for valuations? Has COVID-19 impacted shifted the use of either method?

Colin Gray: The most common reasons for using a sales multiple rather than an EBITDA multiple are:

  1. the company/industry is fast growing and well-funded, and profitability is likely years away as top line growth is aggressively pursued (e.g. many tech sectors); and
  2. subject company profitability has been temporarily hit and the expectation is that over the longer term, profitability will return to more normal levels for the industry it is in.

COVID-19 has led to more instances relating to point #2 above. Alternatives to switching to a sales multiple might be to use a forward multiple which is more indicative of a normalized level of performance.

For those who use Discounted Cash Flows (DCFs) for their valuations, is anybody adjusting Weighted Average Cost of Capital (WACC) due to the uncertainty and change in market conditions that may lead to changes to the beta and rate of return on equity and debt?

Jamie Spaman: Yes, we have been adjusting WACCs to reflect the changes in risk profiles of projections due to COVID-19 -related factors. Obviously market-based adjustments such as the risk-free rate of return used in a Capital Asset Pricing Model (CAPM) and a market-participant cost of debt had an impact, but there were also adjustments to various selected inputs including company-specific risk premiums and, in the first quarter, a "current market risk" adjustment.

What’s the valuation range of multiples of Trailing Twelve Month (TTM) EBITDA?

Colin Gray: This varies so much by industry/segment/company that we would not want to offer a general range.

I wondered what the panel's view was on the correlation between intellectual property valuations and business valuations. For example, we were doing a brand valuation for a client who also had a top1 0 firm doing a business valuation. That firm wanted to know our brand valuation number to understand if our analysis / opinion helped the client and the business valuation firm justify a higher tier 1 brand / business earnings "multiple" in their business valuation rather than using a lower tier 2 "multiple" because they may consider the brand may be outside the top tier brands in the sector and so warrant a lower earnings multiple?

Jamie Spaman: We commonly look at IP valuations as part of purchase price allocations after a company/business is acquired. The transaction defines the fair value of the enterprise and the sum of the recognized asset values (including the "plug", goodwill) equals that enterprise fair value. The potential value of a brand name should certainly be assessed as part of a business valuation (and should be reflected in the profitability of the company). We would expect to make that assessment ourselves as part of a business valuation although a third-party valuation would be relevant background info.

How are you handling due diligence, especially with travel restrictions and quarantine requirements?

Joshua Cherry Seto: Leveraging partners on the ground who can share video, arranging special travel when needed, and abiding by quarantine upon return.

Blinn Cirello: We do a lot of Zoom and Team calls. In cases where folks are coming to our office we practice social distancing and everyone wears a mask. We also have special air filters in our conference rooms. Travel is restricted and if someone does travel they do their best to get in and out in the same day. If they travel to a hot spot they have to quarantine when they get back.

Are clients now asking for more Orderly Liquidation Values (OLV)or Forced Liquidation Values (FLV) valuations in addition to fair value?

Colin Gray: The most common instance when OLV or FLV required in our work is when the subject company is performing poorly enough that the sale of its underlying hard assets becomes a rational liquidation option. OLV or FLV then become reflections of fair value. Obviously, this is more likely in hard asset-intensive industries.

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