(Estimated reading time: 5 minutes)
The article in brief:
- From a private company valuation perspective, it may be useful to compare the COVID-19 market dislocation, not only to the Great Recession but also—inversely—to the “irrational exuberance” of the dot-com era.
- Private equity market participants should hold out for better information whenever possible, but will necessarily need to make some decisions and forecasts based on judgment.
- We share some thoughts on the role of judgment in both the market and income approaches to valuation as well as other features of the private equity markets amidst a pandemic.
Despite the unprecedented nature of the current economic crisis, lessons from past market disruptions can be helpful. The most frequently cited point of comparison—perhaps simply because of its proximity in time—is to the global financial crisis of 2008. That’s understandable—it’s only natural to look back at the most recent market dislocation for takeaways about the current one. But as we consult with clients in the private equity space about the impact of the pandemic on their business and portfolio company valuations, we’re finding it every bit as useful to reflect on another period of market extremes, the heady days of the dot-com economy.
While the extremes of the late 1990s were directionally different in that public market valuations were running up instead of cascading down, it is worth noting that both then and now, the large swings were irrational and based more on speculation about future business prospects than objective financial data. Those of us who advise privately held companies and their stakeholders on valuation are finding that, as in the era of Blackberry phones, Pets.com and company foosball tournaments, there is no substitute for experience and judgment when it comes to evaluating private companies in the age of the novel coronavirus.
Hard Data Is Always Better than Judgment
While good judgment is important, it should be stipulated upfront that the best advice we can offer clients given the ongoing uncertainty about the course of the pandemic and its long-term impact on the economy is, whenever possible, wait. Just as hospitals are postponing elective surgeries until the public health situation settles down, companies should consider holding off on elective financial analysis, such as impairment testing, until they have greater visibility on when the economy will reopen and what their business will look like when it does.
Of course, a delay isn’t always going to be an option. Accounting standard-setters, financial regulators, and limited partners have signaled that they are mindful of the challenges—both operational and conceptual—companies are facing. They are merely expecting a best effort, but there has been no meaningful relaxation of financial reporting timetables or requirements.
Thus, in many cases, there will necessarily be a need to augment data with judgment and experience.
As in the era of Blackberry phones there is no substitute for judgment when it comes to evaluating private companies in the age of the novel coronavirus.
Judgment In the Market Approach
The market approach to private company valuation entails using comparable company multiples from merger & acquisition activity and public market trading levels. Using M&A data is an option, but since this market reacts more slowly, relying on historical multiples may tend to overstate valuations until we have more completed deals, in a post-COVID-19 market. That may take time because deal activity has decreased dramatically. Relying on public market indications as of March 31 quarter-end is also problematic. There was still a great deal of fear, uncertainty, and volatility in the market. We have already seen some recovery in the markets though as the irrational “the sky is falling” panic that initially gripped investors has given way to more reasonable views on the impact of the pandemic. But still, and not dissimilar to the period leading up to the dot-com bust, we believe that perspective and seasoned judgment will be needed in applying public securities value indications to private companies. It certainly shouldn’t be done mechanically.
For example, recall that as of March 31 (an important “as of” date for financial reporting), the lockdown dial had been cranked hard to the right. Stocks had crashed, so public company multiples were suddenly some 25 to 40 percent lower than just six weeks prior as investors digested the news.
If the ultra-low public company multiples on March 31 were potentially an overdone reaction to the headlines, then mechanically applying them to private company valuations would be unreasonable. Instead, in most cases, we did what we did at the height of the dot-com era and tempered the data by factoring in historical multiples. Valuation always requires art as well as science, but never more so than times like these.
Judgment In the Income Approach
We’re also leaning a great deal on judgment as we work with companies to forecast and discount future cash flows. We are finding it useful to bucket categories of companies. At one end of the spectrum are companies with devastating impacts, up to and including complete elimination of business activity (e.g., gym concepts or movie theaters). Then there are companies where operations haven’t been completely upended but demand has fallen off; for example, restaurant concepts that have transitioned to takeout only. Or, similarly, there are companies with light demand impacts but other issues, such as supply-chain and employee strains, nonetheless causing a degree of harm.
Finally, some companies will actually benefit. From what we have seen so far, there are very few of these, and care is warranted in identifying them. One might have expected healthcare providers—hospitals and physician groups, for example—to be in this category. But to free up capacity for a wave of COVID-19 patients, many providers canceled all elective procedures. Demand for care has also fallen as people have taken more care with hygiene, stayed home, and, in all likelihood, simply avoided hospitals even when care was needed.
We are now starting to get a bit clearer perspective on the near-term impact on various businesses, as signs of economic reopening emerge. Of course, there could be a second wave of COVID-19. But concerning the lockdowns, it seems reasonably clear we are trending toward softening, not hardening. Less clear is the long-term impact. We know that behaviors will change, but how much? How much should a gym concept adjust its expected demand? How should an airline adjust its demand forecasts while still in the process of drawing up wholly new strategic plans?
Valuation always requires art as well as science, but never more so than times like these.
Our approach is to work closely with our clients. We have had many searching, and at times, difficult conversations over the last month as both they and we grapple with what’s appropriate for a point-in-time estimate that seeks to take into account unknowns, which may even prompt concern that a particular business may not be a going concern post-crisis, absent drastic measures, and additional equity infusion.
Here, too, there are no rules of thumb to apply. When point-in-time valuations are necessary for a particular date, as they are for investment managers, a purely mechanical approach to value will likely yield nonsensical value indications. The point-in-time data may need to be tempered based on reviews of historical data, and by leaning on judgment and experience gained throughout previous business cycles.
Other Considerations In Private Equity Markets
Beyond valuation, there have been other interesting impacts on the private equity landscape. A few observations:
- It is to everyone’s credit that both business managers at portfolio companies and investment managers at private equity firms themselves have well understood that valuations will be lower. Of course, the question is, “how much lower?” Many managers may face decisions about whether to direct dry powder to support existing portfolio companies or to make new investments. Those decisions may be agonizing, not only with respect to investment returns but also because of jobs and other “people” factors.
- In the industry as a whole, there is no shortage of dry powder. Younger funds—those with cash raised but relatively few purchases made—may have a somewhat easier time navigating the coming months than older vintage funds. But even funds flush with cash may find it challenging to take advantage of prime buying opportunities. To the extent sellers can hang on, they likely will, at least until the new post-crisis realities of altered behavior come clearer.
- Valuations for stock-option grant purposes—as required under IRS Section 409A rules—are another area of consideration during this time of stress. In some cases, companies may be able to put off §409A valuations for a few months, with a hope to see the other side of the crisis. But under applicable rules, let alone the potential for concern from would-be employees, there may not be much room for delay. Some companies (and employees) in earlier stages may not particularly mind low valuations if there is a perception of future upside potential.
Markets are the best source of valuation information unless the information they provide is compromised by fear of—or, as was the case in the dot-com era, irrational exuberance over—the unknown. At such times, we rely on experience, as much as models and data, to help make the necessary judgments.
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