Part II - Private Equity & Valuation
Before unveiling what our chapters are about, I couldn't find
more interesting words than those of Luis E. Pereiro to introduce the toughness
of the issue in his preface of «Valuation of Companies in Emerging
Markets» (Wiley, 2001):
«Valuation is the point at which theoretical finance hits
the harsh road of reality. You may be one of the many managers, advisors, or
researchers faced with appraising the economic value of a new investment
project, a merger, an acquisition, or a corporate divestment. You may have
attended formal finance courses; you may even hold an MBA or an MFA; and still
you are puzzled and frustrated when you attempt to implement the elegant
theories of corporate finance in real life valuation exercise. This is hardly
surprising, for financial theory and practice have formed an easy partnership
that often ends in dissolution. On one side, of this partnership are the
academics, who have their sophisticated risk-return models; on the other side
the practitioners, who stand by their expertise in crafting real-life
acquisition deals. The professional appraiser sits uneasily between the two
groups, often being squeezed uncomfortably by both. All the while, the crucial
problem - how to sensibly and plausibly value a real asset- remains at best
only partially solved.»
After reading these words, I guess the tone is set up for what
will follow. How the PE industry deals with the valuation of companies is a
tremendous issue. In this part, we will not be able to dig into the details of
the valuation techniques but rather point out how the industry tackles that.
Hence, the first chapter will give an insight about how PE funds
deal with the valuation of companies across their «value chain»;
whether at the pre acquisition or at the post acquisition stage (chapter 2). It
will also point out what are the practices of PE funds regarding valuation as a
daily management issue.
The second chapter will rather emphasize the notion of
«Corporate Value creation» and the so called «Value Based
Management», and stresses the standpoint of PE funds toward these notions
and concepts.
Chapter 4: Private Equity Value Chain &
Valuation
Before delving into the core of this chapter, we need to quickly
explain where PE funds conduct their business, in other words, what are the
domains where PE funds thrive.
PE funds as we said earlier are hybrid vehicles sitting between
classical corporations and asset management investment funds. This is also the
case from the standpoint of their acquisitions. Indeed, PE funds have two
targets of firms:
1- Closely held companies, non publicly traded stocks
2- Publicly held and traded companies
A simplistic definition would say that usually the PE funds
involving in the acquisition of the first type of companies are called
«Venture Funds» and «Generalist Funds»; whereas those
involving in the second type of companies are called «Buyout
Funds».
Venture & Generalist Funds have a clear exposure to early and
growth stage companies thus almost always invest in closely held corporations;
whereas Buyout Funds have more exposure on traded stocks in the way that they
structure their deals to extract the publicly held company from the stock
market and make it go private with the Buyout Fund as the main shareholder.
This being presented, we can assume that these two types of PE
funds have different practical approaches to how to appraise their targets but
remain convergent regarding the financial techniques and models used for that.
Hence, we will not present in this chapter their differences but rather the
common ground in valuation between them.
Usually, in developed countries and markets, the valuation of
public or closely held companies is a precise endeavor: the classical models of
corporate finance must be considered and adapted when dealing with real-life
valuations. In the US, considered the most efficient financial market, the use
of well established frameworks such as the CAPM, the arbitrage pricing theory
(APT), or the real options, poses serious challenges to the practitioner. No
agreement exists among academics and practitioners concerning many crucially
important issues, issues as basic as deciding on the market risk premium to be
used, whether an option is truly embedded in a real asset, or how precise the
multiple method is compared to DCF analysis. This demonstrates how perilous is
the appraisal exercise for professionals dealing with real assets, which is our
case for the PE industry.
Now, for the PE funds, and according to the «Value
Chain» we described in chapter 2, we can safely confirm that the most
important valuation exercise concerns the «Pre Acquisition» stage,
what we called «Pre Valuation». Obviously, before taking the last
decision to put money in a company, the fund should be profoundly aware about
the exact value of this company. Since the investment will be carried out for a
period of about five years, the «Pre Valuation» will be the
masterpiece of the transaction process. We need to keep in mind to understand
this, that the PE fund doesn't know well the company at the Pre Acquisition
stage, sometimes neither its specific products, nor its top management. The
issue evolves differently at the Post Acquisition stage, when the PE fund had
the time to better know the firm, its core business and its management style.
Obviously, the Post Acquisition will also require a new valuation
of the portfolio company after a number of years in the fund portfolio, but
this will be a «light» version of the «Pre Valuation»
mission. So rather than the «Pre Valuation» which involves a precise
and thorough deployment of the «Valuation Process», the «Post
Acquisition» will be more or less a monitoring of the value appraised at
the Pre acquisition stage.
Now that the differences between the Pre and Post Valuation
highlighted, let's set a framework for this «Valuation Process». The
one that will be presented here after is more suited for the Venture &n
Generalist Funds and their closely held early and growth stage companies than
for the public companies targeted by Buyout Funds. Although, the differences
are sometimes thin, we preferred to focus more on the closely held companies
case and the inherent practices of the Venture and Generalist PE funds, and
less on the Buyout Funds practices that target public listed companies since
there is plenty literature for valuation of public stocks here in the US and
also because this thesis is more about private equity in the sense of privately
held companies by opposition to publicly held companies.
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