European GPs turn to discounted cash flow valuations

With the release of year-end results looming, some European private equity firms are following the lead of their US counterparts by considering applying a controversial accounting method.

Some European private equity firms are increasingly inclined to use discounted cash flow as an alternative where marking to market provides valuations that are considered unfair, unrealistic and likely to severely depress portfolio company valuations.
Recent examples of firms that have written investments down as a result of marking to market have included The Blackstone Group, Electra Private Equity and Kohlberg Kravis Roberts.   

“Most private equity houses prefer to continue using a market approach when valuing their investments. But in a market like this, the standard approach without further detailed review of comparable companies might lead to unreasonable results,” said Mathias Schumacher, London-based managing director at Duff & Phelps, an independent financial adviser which provides valuation services to the private equity industry.  

He added: “US houses have often used discounted cash flow as a secondary approach and have been prepared to consider whether it provides a better indication of fair value. Now, some GPs in Europe are considering it as well.”

Discounted cash flow analysis uses future cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value.

Sceptics of the discounted cash flow method say it is too subjective and that small changes in inputs can result in large changes in the value of a company. As one independent valuation specialist said: “The old joke with discounted cash flow is that you tell me the value you want and we’ll get you there.”

Valuation specialists say that, given the normal level of information provided by a GP, an LP would not necessarily be aware that discounted cash flow was being applied to a portfolio company’s valuation rather than market principles. Nor, however, is it thought likely that GPs would do this as a way of deliberately misleading their investors.

One valuation expert said: “Discounted cash flow should not be used just to increase the value. That would be an abuse of the system, and I don’t think GPs would try to do that.”

The consideration being given to alternative valuation methods indicates how concerned many GPs are about their year-end results as economic pressures take their toll on highly leveraged assets. Many are said to be seeking independent advice for the first time, not least as a way of trying to gain insights into common practices currently being used by market rivals.

Valuation professionals say, rather than switching to discounted cash flow methods, many GPs are focusing on extracting as much flexibility from marking to market as they can – for example by varying the time period over which the average stock market price of a comparable company is measured in an effort to reduce the volatility.