The International Private Equity and Venture Capital (“IPEV”) Valuation Guidelines (“the Guidelines”) have been updated and the December 2015 edition has been released.
The changes include clarifying edits and technical edits. The main technical are in respect of the following topics:
The note accompanying the release of the updated Guidelines describes one of the technical clarifications as having “removed the negative bias towards DCF”.
The shift in preference for multiples-based valuations over DCF-based valuations has been a gradual evolution over a number of years and a number of editions of the Guidelines.
While the December 2015 edition of the Guidelines states that the “negative bias” towards the DCF has been removed and the “use of multiple valuation techniques is encouraged”, much of the wording remains unchanged:
In all editions, including the most recent, this aversion to the DCF is ascribed to the “substantial subjective judgements” which are required and the “high level of subjectivity”.
In highly developed markets, there may be a number of listed companies to choose from which are truly comparable with the company being valued with respect to industry or sector, jurisdiction, size and growth prospects. Where this is the case, giving preference to the use of market multiples may be appropriate.
However, in smaller markets, and especially emerging markets, finding a truly comparable listed company in the same jurisdiction can be difficult, if not impossible. As a result, market multiples are typically derived from listed companies in other countries and adjusted for points of difference, of which there are many.
While the DCF is described as requiring a high degree of subjectivity, these adjustments required to the market multiples are often more subjective. By way of example, the difference in country risk can be observed with reference to traded Government bonds and accounted for in the discount rate applied in the DCF. Similarly reliable information informing the Valuer on the adjustment to make to the market multiple is not available.
Despite the negative bias towards the DCF that persists in the Guidelines, in our view the DCF generally remains a more accurate valuation technique.
An update has been made regarding the value of debt to be deducted in arriving at the value of equity.
Essentially, the question is whether to deduct the face value of debt or the fair value of debt. Where the terms of the debt are significantly more favourable or onerous than those that the company being valued could negotiate on an arms’ length basis at the measurement date (on a standalone basis), the fair value may differ from the face value of the debt. Since the definition of fair value assumes a hypothetical realisation, a hypothetical change of control is assumed as at the measurement date in most cases. Therefore, the treatment of debt is based on what would happen during a change of control. If the debt in question would be repaid in the event of a change of control, the value of debt to be deducted is generally equal to the face value of the debt. Previously, the Guidelines considered whether the debt “must” be repaid (i.e. a requirement to repay) – this has been updated to “would” be repaid (i.e. an expectation of repayment, rather than a requirement).
The guidance on the value of debt has been expanded to give consideration to the treatment of penalties for early payment e.g. breakage fees. The Guidelines now allow such penalties to be incorporated into the value of debt based on the probability of them being paid.
Revenue multiples have been discussed in previous versions of the Guidelines, but were presented as an industry valuation benchmark technique and described as applying to only limited industries.
The discussion of revenue multiples has now been included in the section dealing with multiples (now both revenue- and earnings-based multiples) with more detailed guidance being provided. Instead of confining revenue multiples to only certain industries, they are now considered to be appropriate for companies which have not yet reached sustainable profits but have established operations.
After having been introduced in the August 2010 edition, the concept of calibration was significantly expanded upon in the December 2012 edition of the Guidelines. The December 2015 edition of the Guidelines have now introduced the concept of “backtesting”.
The objective of backtesting is for a valuer to measure his or her most recent valuation against the proceeds actually received on exit and understand the reasons for points of difference. Such reasons are likely to include new information which became available since the most recent measurement date, changes in the business being valued as well as significant macro-economic changes. The valuer should consider whether the information at hand at the measurement date was properly considered and properly treated in the fair value estimation, given the actual exit price achieved. This process should assist the valuer in refining their approach and/or assumptions in fair value estimates going forward in order to continuously improve the valuation process.
A new section has been included in the Guidelines to take account of a situation where a minority or non-controlling shareholding is acquired and the interests of the non-controlling shareholders are not aligned with the interests of the controlling shareholders.
While the subject is raised, the guidance essentially reverts to a consideration of how a market participant would view the situation rather than instructing the valuer on how this should be treated.
Various other changes have been made to the Guidelines, primarily to clarify wording surrounding existing concepts.
In the South African context, where lock-in discounts for BEE shareholders are common, the reference to contractual restrictions on trading – and whether this allows the valuer to apply a discount to a listed share price – are particularly relevant. The Guidelines have expanded the wording regarding contractual restrictions to include an examples of what would be considered to be restrictions attributable to the holder of the share vs restrictions attributable to the share itself. Unfortunately, these examples do not provide much additional insight to assist in evaluating the issue of BEE lock-in discounts. In our view, arguments can still be made to support BEE lock-ins as being either a restriction on the share itself or a restriction on the holder.
The Guidelines have seen a significant evolution over the past ten years with welcome additional detailed guidance being provided on how to practically apply the relevant accounting rules to the valuation issues faced in the Private Equity environment. In addition, the introduction of concepts such as calibration and back testing show a desire to continuously improve the valuation process and set a high standard for valuation practitioners.