Macroeconomic turbulence and big declines in public market indexes since the start of 2022 are complicating private equity firms' year-end process of placing valuations on portfolio companies, said Craig Ter Boss, a partner in accounting firm EisnerAmper's valuation service group.
A widespread slowdown in mergers and acquisitions means there is less data on comparable company sales available to valuation teams. In the third quarter, the aggregate value of U.S. M&A activity declined for the fifth consecutive quarter.
The lack of transactions leaves private equity firms leaning more on comparisons to publicly traded companies when trying to value businesses in their portfolios, Ter Boss said. But that is particularly tricky in a year when public markets have been so volatile.
Metrics typically used by private equity firms to measure and compare business performance, such as the last 12 months' revenue and EBITDA — or earnings before interest, taxes, depreciation and amortization, a proxy for profitability — "can be a little deceiving," Ter Boss said, since some sectors of the economy have experienced significant swings in 2022.
"You could have had a lot of growth in the first six months [of the year] and not a lot of growth in the last six months. That's part of the problem. Certain industries have slowed down dramatically, where others haven't," Ter Boss explained.
'Sharpening the pencil'
The value of a business is not just based on a performance statistic like revenue or EBITDA; a buyer will ultimately pay some multiple of that statistic for the company. Exactly how big or small of a multiple is in flux across industries as macroeconomic turbulence hampers performance and clouds the outlook for the global economy.
Those fluctuations are apparent in the recent deal for software-as-a-service business Zendesk Inc., which in February turned down a take-private bid from a private equity consortium that reportedly totaled $16 billion. The price was reduced to $10.2 billion by November, when Zendesk agreed to sell to an investor group led by private equity firm Hellman & Friedman LLC and Permira Advisers LLC.
"You have a lot of volatility in the multiples in certain industries, especially in tech," Ter Boss said.
Of the 15 listed companies that lost the most market capitalization between Jan. 1 and Nov. 23, five were in the technology, media and telecommunications industry, according to S&P Global Market Intelligence data.
It is a situation that calls for "sharpening the pencil," as Ter Boss put it. Basically, private equity valuations teams need to dissect the performance of both their portfolio companies and the businesses they are being measured against to make certain the comparisons hold up. Differences in the relative size of the businesses, their revenue models, amount of cash on hand, debt and profit margins become even more significant, the accounting firm partner said.
Lagging updates
Total return performance of the S&P 500 plunged 16.39% during the second quarter. The large, publicly traded alternative asset managers, however, reported comparatively modest hits to their private equity portfolios.
KKR & Co. Inc. absorbed the worst losses in its peer group, writing down the value of its private equity portfolio 7% in the second quarter, while The Carlyle Group Inc. reported no change to the value of its corporate private equity investment during the same period. The authors of a Preqin investor outlook report released after the year's midpoint opined that private equity managers "have done comparatively little to mark positions down to reflect market conditions."
"That's always kind of been the sentiment [private equity firms] have had, that they're not subject to volatility," Ter Boss said, adding that their confidence stems in part from a strategy of buying companies at a discount to the multiples paid by strategic buyers.
Ter Boss said valuations teams may also assign higher values to private equity portfolio companies that are attracting offers from potential buyers. That interest from potential buyers, "is not public knowledge, it's not something that you can really hang your hat on, but it's definitely something that they [consider]," Ter Boss said.