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Valuing private equity portfolio in times of significant uncertainty
27 April 2020
The uncertainty associated with the global COVID-19 pandemic has
caused unprecedented public market volatility. While business
activities in Mainland China have shown recent signs of recovery,
many parts of the world were still under lockdown in April. People
fear there will be second or third waves of outbreak, and the
economic outlook remains uncertain.
Valuation professionals look at what is known and knowable as of
a measurement date and apply appropriate inputs to valuation
models. Yet, many inputs for valuing private investments are
unobservable and inferred from market data or traded securities. In
turbulent times, market volatility, government actions and rapidly
changing business environments should all be considered when
determining fair value.
Market conditions can impact all valuation approaches. The
following is an example to illustrate considerations for
calibration and adjustments in the valuation model in times of
significant market uncertainty. These approaches are widely used in
business valuations and are adjusted for current market conditions
and market prices.
Example
Amazing Trip is a fast-growing online travel platform selling
local experience tours in Mainland China. In the year to 30 June
2019, it recorded US $5 million in revenue. It forecast revenues of
US $6 million for the next 12 months.
Since the outbreak of COVID-19, revenue from travel-related
products have gone down by 90 percent due to travel restrictions
and decreased demand on travel. The company diversified its revenue
source by selling gourmet groceries on its platform. This new
source of revenue has moderately offset the loss of its primary
source of income from travel products. Its newly diversified
business helps it weather the storm better than its peers and in
the year to 31 March 2020 it recorded revenue of US $5 million.
However, it only expected next twelve months revenues of US $4
million.
The company closed its last preferred financing round in June
2019. The implied equity value of the latest transaction is US $4
million. How should the previously calibrated inputs be adjusted on
31 March 2020?
Calibration of unobservable inputs
Calibration is the process of using transaction price (usually
the company's securities) as of transaction date to solve for
certain unobservable inputs, which are then rolled forward and
adjusted for subsequent measurement dates. Assuming the transaction
price is at arm's length, the implied company value would be
considered as the fair value as of transaction date.
The transaction price and reported and expected revenues lead to
an enterprise value/last 12 months (EV/LTM) revenue multiple of 8x
and enterprise value/next 12 months (EV/NTM) revenue multiples of
6.67x on 30 June 2019. The calibration indicated market
participants valued the company at the median of the guideline
comparable companies' EV/LTM revenue multiples at the transaction
date.
The company value is re-measured subsequently on 31 March 2020.
Both the economic environment and company's prospects have changed
since the transaction date, and market participants may not pay the
same price as they would have before. Hence, the previous
assumptions from calibration and inputs must be updated. Below are
some factors (but not limited to) we can consider during this
exercise:
What are the known and knowable elements as of the
re-measurement date?
What are the impacts of COVID-19 on the company's revenue,
customers, supply chain and operations?
What are the company's milestone progress, performance and
liquidity?
Is there any change in the exit plan due to the pandemic?
How insulated the company is to COVID-19 against its
peers?
As Amazing Trip appears to be less susceptible to COVID-19 than
its peers due to a more diversified business, a higher than median
multiples can be used for guideline comparable companies, say the
third quartile EV/LTM revenue multiples on 31 March 2020.
Avoid double dipping of valuation inputs
The valuer should avoid considering the same set of valuation
inputs twice ineffectively. In this case, NTM revenue on 31 March
2020 has been revised downward to account for the lower expectation
due to the near-term impact of COVID-19. If a lower revenue or a
larger discount of lack of marketability (DLOM) is applied, the
result would appear to be punitive.
Review the result
Estimating fair value is not an exact science. Valuation from
different methods do not necessarily reconcile. More than one
valuation method should be used to corroborate with each other. If
one approach results in a significant difference from the others,
valuers should understand the differences and revisit the valuation
inputs and models if necessary.
As uncertainty abounds, what is "known and knowable" as of
measurement date can become less subjective or obvious. Valuation
assumptions and rationales should be documented in detail.
Until a vaccine has been found and widely applied, economic
uncertainties remain. However, the pandemic does not change the
framework of fair value and valuation policy. Valuers need to
exercise better judgement and establish a robust valuation policy
to deal with the upcoming challenges in valuation.
To learn more about how you can take control of your private
investment valuations, contact our valuation professionals at
pcmglobalsales@ihsmarkit.com.
Lydia Leung, Associate Director, Valuations Services at
IHS Markit.
IHS Markit provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.