With the 31 March deadline having just passed, India-based private equity (PE) funds are required to compute the value of their investments as part of the reporting process to investors. Various accounting standards—such as the US GAAP, IFRS or the newly introduced AS-30 in India—require PE funds to compute the “fair value” of their investments. However, as there are a number of valuation methods to compute this, funds may arrive at different values using different methods. GAAP stands for generally accepted accounting principles, IFRS is international financial reporting standards and AS is accounting standards.
To illustrate, a portfolio company of a PE fund is engaged in the food and beverages business and has sales and profit after tax (PAT) of Rs700 crore and Rs50 crore, respectively. In this scenario, if the average price-earnings multiple for the food and beverages sector (of, say, 15) is applied, the equity value of the portfolio company would be Rs750 crore (that is, 15 times its PAT of 50 crore). But, when using the discounted cash flows (DCF) method (that computes the present value of future free cash flows) and after validating all assumptions contained in business projections, the equity value stands at Rs1,250 crore. If one looks into the balance sheet of the portfolio company and computes its net assets value (that is, excess of assets over liabilities), it stands at Rs200 crore. The PE fund could wonder whether to consider Rs750 crore or Rs1,250 crore or Rs200 crore as the equity value of the portfolio company.
The various accounting standards fail to earmark the methodology of valuation to be adopted under various circumstances, leaving the valuation method at the discretion of the PE manager. However, these standards do hint that market-related inputs should be used to the maximum and subjective inputs should be used minimally.
In order to ensure consistency, the European Private Equity and Venture Capital Association, British Venture Capital Association and Association Française des Investisseurs en Capital have prepared (with inputs and endorsements of key venture capital and PE associations across the world) international private equity and venture capital valuation guidelines (IPEVCVG). IPEVCVG hints at a pecking order that can be considered while selecting a valuation method for computing the value of such investments.
For quoted investments, the recommended technique is the available market prices as on the reporting date. In order to mitigate the perplexing valuation process for unquoted investments, the association has suggested various methods that can be adopted under varied circumstances.
Where the investment being valued is either made recently or there has been any recent investment in the investee company, the price of the recent investment can be used effectively as this will generally provide a good indication of the “fair value”. However, an exception can arise if a significant unexpected value-sensitive event has occurred after the recent investment.
The other approach recommended is the earnings multiple, which involves computing value by multiplying (market-computed) earnings multiple to the earnings of the business being valued. In our view, this methodology is likely to be appropriate for an investment in an established business that has a track record of making profits or where maintainable profits can be computed without material uncertainty. However, in the case of businesses that are not earning adequate return on assets and for which a greater value can be realized by selling assets, the ideal method would be one of evaluating net assets, which involves deriving the value of a business by reference to the value of its net assets.
In order to make the valuation reliable to the greatest degree, techniques for cross-checking the computed values may be used. DCF involves deriving the value of an asset by calculating the present value of expected future cash flows. Similarly, a number of industries have industry-specific valuation benchmarks, such as “price per tonne” (for instance, cement manufacturing companies). These industry norms are often based on the assumption that investors are willing to pay for turnover or market share, and that the normal profitability of businesses in the industry does not vary much. However, both these methods should be used very cautiously and selectively as primary valuation methods.
Generally, IPEVCVG is a more prescriptive guideline for valuation and by reference advises valuers to compute value as if the investment would be exited and the value is likely to be realized as of valuation date. It also suggests that a marketability discount in the range of 10-30% should be applied for unquoted investments, which the different accounting standards do not specifically mention and have left to the discretion of the valuer. Further, due to the high level of subjectivity in selecting inputs for computing value under the DCF method, IPEVCVG recommends that it be used minimally, while the accounting standards leave more room for the use of DCF.
To summarize, IPEVCVG provides a comparatively more defined approach to evaluating the value of an investment and covers various gaps left open by the accounting standards.
Sanjiv Agrawal is a partner and Mihir Gada is associate director, transaction advisory services, Ernst & Young. Views expressed here are personal. Comments are welcome at email@example.com