Private Equity Valuation - Discount Dilemmas
Commentary by Doug Miles, CEO of Globalprivatequity.com, Inc.
For the first 15 years of my investment banking career, the typical rule of thumb for pricing private equity assets was to apply a 25 percent discount to a publicly traded comparable company or adjust the relevant industry multiple. New accounting rules such as FAS 157 make it difficult to take this easy way out.
An analyst is sometimes hard pressed to find data about public offerings that closely mirror the economic characteristics of a particular private equity investment. When that occurs, news announcements that convey buying interest can be helpful. Recent headlines about CALPERS' purchase of a 9.9 percent stake in technology buyout fund Silver Lake Partners illustrate. No longer sitting on the sidelines, CALPERS has a chance to recover 10 percent (or more) of its net cost in allocating to non-public companies by participating in deal-related income such as acquisition loans originated by Silver Lake.
Playing the role of private equity banker is not new. Ontario Teachers illustrates this "soup to nuts" with its furnishing of both debt and equity for Bell Canada. (See "Bell Canada Agrees to Purchase by Ontario Teachers - July 2, 2007.) General partners save on fees they pay. Moreover, they have flexibility to take a company public again or sell to a strategic buyer for many times the original commitment. Being an operator additionally empowers the "new paradigm" owner on the governance front. Did the Bell Canada deal improve the IRR for Ontario's plan participants? You bet.
Capital market players benefit too since such deals arguably enhance liquidity and promote valuation transparency. Given the brave new world of valuation compliance (FAS 157 and international equivalents), anything that gets us closer to marketability is a good thing. Anecdotally, we see an emerging consensus among our private investor clients to access better numbers. Applying arbitrary discounts is ill-advised. Being open to better process may explain why we've seen recent private company discounts narrow to 6.5 to 7 percent, relative to public comparables, for some sectors. In our own work (creating synthetic data prices for "hard to value" instruments such as whole loans), we employ an algorithm that estimates the private-public company differential by examining factors such as the rate of completed private company asset buyouts, how they are financed and the change in IPO values over the last twelve months.
Discounts vary over time. The current environment (i.e. depressed high yield bond prices and fewer M&A transactions) could lead to the widening of lack of marketability discounts, particularly in those industries hard hit by credit problems. Monitoring performance by industry or sector, and for a variety of cycles and calendar time periods, is paramount. Global consolidation when steel or aluminum production sectors are hot (e.g. RUSAL) reduces the liquidity premium attached to public companies as increased deal flow sheds light on when and where buyers are willing to sign checks. Will this be true next year? Only time will tell. That is why it is so important to track the changing behavior of valuation adjustments.
With a need to enhance returns, alternatives like private equity will continue to attract retirement plan money. Look for more announcements as other pension funds follow the lead of CALPERS and Ontario Teachers. Hedge funds may even seek to organize groups of pension funds to execute large M&A deals, thereby adding to their treasure chest.
Editor's Note: As pension plans become even bigger players in global capital markets, it will be interesting to watch the inevitable fiduciary schizophrenia unfold. How will pension general partners deal with doing the right thing for limited partners when doing so conflicts with their duties to plan participants?
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