As any private equity CFO knows, 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.
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.
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 of 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 example, their 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”, socalled Level-3 valuations, there are no clear laws and no clear sheriffs. To be sure, there will be shouting matches over valuations in the coming months, with certain auditors refusing to sign off on numbers that they feel are unrealistically high. 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 mid-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.”
KURT GEIGER CHANGES HANDS IN SECONDARY
UK mid-market private equity firm Graphite Capital has bought Kurt Geiger for £95 million (€126 million; $186.5 million) from Barclays Private Equity (BPE), according to Steven Silvester, a director at the European mid-market vendor. BPE made a two and a half times return, according to a source close to the deal. Silvester said: “It's difficult to sell any retailer at the moment. Kurt Geiger was different because its track record is strong, as is management. With retailers you've got winners and losers all the time and at the moment this is exaggerated.” Kurt Geiger sells its own and third-party luxury footwear brands including Prada, Gucci and Jimmy Choo. It sells through UK department stores such as Harrods, John Lewis and Liberty. It also has 16 own-brand stores, six airport outlets as well as international concessions in French department store Printemps and Italian department store La Rinascente. Management will be reinvesting in the company. UK banks Lloyds TSB and RBS provided debt facilities.
SECURE DEAL FOR SGAM
SGAM Alternative Investments has bought a majority stake in security company Agencya Ochrony Skorpion Security for an undisclosed sum. The company provides security guards, electronic alarm monitoring and cash transport throughout Poland. Skorpion had turnover of around PLN92 million (€25.7 million; $38.7 million) in 2007. SGAM said it intends to expand the company rapidly by consolidating the security market in Poland. The deal follows the fund's first acquisition, the buyout of Polish food company Fornetti Wroclaw in December. SGAM AI raised its first CEE fund last year with €156 million ($231.9 million) of commitments. Bill Watson, chief investment officer for Eastern European private equity at SGAM, told sister website PrivateEquityOnline.com in November he felt the region was ready for leveraged buyouts in its mid-market as well as in the region's more established larger buyout arena.
HIG NOTCHES DEBUT UK DEAL
HIG Europe, the European arm of global mid-market firm HIG Capital, has taken a stake in Europa Facility Holdings. It has also backed Europa's acquisition of United Utilities FM, a rival facilities management company. It is HIG's first investment in the UK since opening a London office last year and closing its dedicated European fund, HIG European Partners, at €600 million ($912 million) in July 2007. Paul Canning, a managing director at HIG, said Europa's takeover of United Utilities FM was the first step in a buy and build programme typical of HIG's strategy. In addition to taking a stake in Europa, HIG has made a significant capital commitment to support Europa's acquisition programme. The overall value of the transaction is £25 million. Growing by some 4.2 percent since 2003 according to a 2007 report by Market & Business Development, which specialises in business-to-business market research reports, the UK facilities management market is currently worth £110 billion per year and is expected to reach £128 billion by 2011.
AIG UNIT IN FIRST TURKEY SALE
AIG Capital, the direct investment arm of AIG Investments, has exited the first investment from its Turkish fund with the sale of its stake in AFM Uluslararasi Film Produksiyon (AFM Cinemas). AIG was part of a consortium that sold a 51.91 percent stake in the cinema chain to A1 Group, an emerging markets direct investment operation within Russia's Alfa Group Consortium, for $28.5 million (€18.8 million). AIG's Blue Voyage fund held roughly 14.15 percent of AFM, which is the largest cinema chain in Turkey with 32 theatres and 183 screens across 12 cities. Though financial details of the original purchase price were not disclosed, a Turkish private equity industry blog estimated Blue Voyage paid $7 million in 2000 for its stake. An AIG spokeswoman declined to comment.
BUY-AND-BUILD SURGE MAY LOSE MOMENTUM
In 2007 there was a record number of buy-and-build acquisitions with 385 bolt-on deals carried out by European private equity-backed companies, according to research by London-based mid-market firm PPM Capital. The strategy has boomed alongside the advance of the industry since the turn of the millennium. Since 2000 the number of bolt-on deals has increased more than tenfold. The strategy has been on a continuous growth path since 2002 and in 2004, portfolio companies carried out more than 100 bolt-ons for the first time. PPM Capital managing partner Neil MacDougall said: “Historically many follow-on deals were funded with debt so the current turmoil in the debt market will make the pursuit of buy-and-build transactions harder.” Some portfolio companies without excessive leverage may still be able to pursue the strategy but many companies will find it harder to pursue, he said.
DISA FITS MID EUROPA MOULD
Central and Eastern European buyout firm Mid Europa Partners has bought moulding company DISA from Scandinavian firm Procuritas Capital Investors for an undisclosed sum. The company has revenues of around €400 million ($613 million), according to Zbigniew Rekusz, a partner at Mid Europa. DISA has around 1,400 employees and provides moulding and metal surface preparation equipment. Procuritas bought DISA in April 2005, when it had a turnover of Dkr1.2 billion ($246 million; €161 million). Rekusz said: “What we like about DISA is its high exposure to Asian markets.”The firm will look for synergies between DISA and portfolio company Wheelabrator, which has less exposure to Asia, he said. Mid Europa bought Wheelabrator in February 2006. The change of ownership is subject to approval from antitrust authorities in the first half of 2008.
IK SELLS ELFA TO TRADE
Industri Kapital (IK), a European buyout firm, has sold ELFA, a distributor of electronic components, to Daetwyler, a Swiss-based international rival, after just 18 months.
IK is set to triple its original investment, recording a 90 percent internal rate of return on the SEK 2.1 billion (€222m) sale. Michael Rosenlew, a partner at IK, said: “ELFA has been a very good investment for IK. We had two tasks: to try and make the company more efficient and then to grow it. We very successful in both and slightly faster than we expected.” He said the growth in the underlying business, which had come partly through a series of small acquisitions, was the most important contribution to the return. The acquisitions included Tevalo Group in the Baltic states and Ukraine, CLL in Sweden and Øistein Røed in Norway.