From hero to zero: a fair-value nightmare

It’s the scepter now haunting the private equity industry: Under what scenario might the value of an otherwise healthy LBO deal be written down to zero? David Snow presents some math that many GPs are hoping to avoid.

A new regime is encroaching on the hide-bound, obscure world of private equity fund accounting. Its name is FAS 157 and its ideology is fair value.

Fair value’s arrival in private equity has come at the worst-possible time. GPs are flummoxed as to how, exactly, fair value should be applied to their portfolio companies. There is a growing awareness that in the current market, if strictly applied fair value would force many GPs to declare as worthless equity invested during the LBO boom.

Effective for fiscal years beginning after November 15, 2007, the Financial Standards Accounting Board mandates that assets be measured at “fair value”, described as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” In other words, you need to find out what your portfolio company would be worth if you sold it right now. And then you need to do it again next quarter.

This is a pain, but it’s a pain that private equity is going to have to learn to live with. Most general partners wouldn’t dream of selling an asset until they felt both the asset and the exit path were as strong as possible. That’s the optionality advantage inherent to private equity. But FAS 157’s fair value approach requires the GPs to imagine selling their portfolio items each quarter, and to identify the factors that would play into the value that would be fetched in such a sale.

Buyout general partners like to think of themselves as conservative when it comes to valuations. They don’t want to write anything up until there’s a damn good reason to do so. Until then they’d prefer to modestly hold the investment at cost, thank you. But in a down market this policy doesn’t look so conservative. It looks delusional. Venture capitalists were so accused by not writing down investment values quickly enough as the tech bubble imploded during the early 2000s.

Granted, the buyout-backed companies in question today are mature, cash-producing entities, not speculative dotcom startups. But, in fact, owning a real company in a real industry makes the fair-value spotlight shine even brighter. Owning a mature company means it probably has several public-market comparables, which are often measured to help determine the value of their privately held cousins. The thinking here is that, since a public listing is often the exit of choice for a big LBO firm, it makes sense to look to current public-market valuations to determine the value of a similar private company if you sold it today. If a listed pet-food supplier with $100 million in EBITDA is worth $1 billion, then a private pet-food supplier with $100 million in EBITDA is probably also worth about $1 billion, one would imagine.

Here’s the rub: Mega-buyout GPs were paying premiums for highly leveraged public companies just over a year ago, and now the markets have fallen dramatically. What should be the fair value of the equity put into those deals? Under several scenarios, the fair value today should be zero.

Here’s just one hero-to-zero scenario: In the roaring first half of 2007, a buyout firm buys Widget Services Corp. for $1 billion. The company has EBITDA of $100 million, and the buyout firm agrees to pay a 10x multiple – at the high end of a range of multiples within the widget sector. The deal involves $300 million in equity and $700 million in debt, in line with the average 7 times EBITDA debt multiple banks are offering at the time.

Then things change. Assuming no debt is yet paid down, the public market for widgets falls, and now the median multiple is hovering around 8 times EBITDA, as evidenced by the trading price of a competitor of roughly the same size called Widget Products. Widget Services earnings are holding steady at $100 million, but now according to the buyout firm’s exacting application of fair value (and enforced by their fastidious auditors), the public-market comparable multiple means Widget Services is valued at $800 million, which values the equity in the deal at $100 million – a 66 percent decline from cost.

Things change again. Still assuming no debt has been paid down, the economy hits a bump and Widget Services sees a slight decline in earnings. This, plus a restructuring cost tied to the buyout sponsor’s ambitious plans for the company means a new EBITDA of $85 million. Widget Products is still trading in the lowered range of 8 times EBITDA, and so the firm assigns to Widget Services a fair value of $680 million. The buyout firm now reckons that its portfolio company is worth less than its debt. Dear investors, we’re really excited about the future of this great portfolio company, and by the way your equity in the deal is worth less than zero.

The above is admittedly a fictitious scenario. In the real world, the factors that go into valuing a private equity portfolio company are far more complicated, and the general partners behind the valuation process are often disdainful of methodologies that result in huge fluctuations in investments that will be held for the long term. The GPs know their investments are not worth zero, and they’ve got a set of data points to prove it.

For starters, many GPs may argue that a sale in the current market would not constitute fair value’s definition of an “orderly transaction”. Says one secondary market specialist: “I don’t think FAS 157 says what an investment is worth in a fire sale.”

Ultimately, the owner of a private company is in charge of valuing that company, and where one valuation “story” might put the value of the deal at zero, another story keeps its value closer to cost – for example, the company has better operations than its competitors; it deserves to be valued at the highest end of the multiples range; it has valuable, misunderstood assets that its public market comparables do not; it’s about to launch a new product; an investment banker has privately delivered news of a highly interested potential buyer, etc.

Perhaps more importantly, in the Wild West of “unobservable”, so-called Level-3 valuations, there are no clear laws and no clear sheriffs. Auditors may choose to “get tough” with GP clients and ask them to be more robust in describing how they have arrived at the fair values of their portfolio holdings, but the auditors can’t dictate the values. At the end of the quarter, the GPs themselves are the valuation experts within their chosen strategies. One partner at a US middle-market buyout shop puts it this way: “A 28-year-old auditor walks into the office of the 58-year-old founder of the firm and says, ‘You need to write down the value of this portfolio company.’ And the founder says, ‘You child. You don’t know my business at all.’ And that’s the end of the discussion.”