How can Private Equity firms handle elevated valuation and credit crises?

2023 has witnessed unprecedented inflation, with some developed economies exceeding the inflation rate in the last 40 years. US and UK Inflation rates are around 8% & 10%, respectively, the highest in the previous four decades; similarly, the world is facing rising prices. The onset of COVID-19, excessive credit after the COVID-19 breakout, and the Ukraine war have caused excess cash flow, disruption in the supply chain, and uncertainty of business environments, disturbing the supply-demand equation of the global market. Company valuations are no exception to this.

Rising Prices & Investment Decision: Lessons from SVB Crisis

For private equity managers, rising prices do not end with valuation issues. As per McKee from KPMG's interview with Institutional Investors, inflation and high corporate valuation also come with the uncertainty of cash flow, credit crunch, rising interest rates, and higher expected hurdle rates from investors due to increased risk from the investment into Private Equity deals.

Most of the SVB bank collapse pivoted around excessive prices paid for portfolio companies, liquidity mismatch, and mismanagement of risk vis a vis the market conditions.

What does market performance indicate?

As per Pitchbook and Morningstar, while the public market increased by 19% between Q1 to Q3 2020, the PE portfolio inflated by 85% in the same period. This 66% difference in valuation is not only unexplained but also very concerning and misleading.

In 2022, S&P and Dow Jones fell by 19% & 9%, respectively, while major PE firms reported their NAV down by less than 1%. Furthermore, this is not a once-off example.

Not surprisingly, a Commonfund Survey confirms that 68% of investors are very concerned with the valuation in 2022 and 2023.

So, what is the mantra to continue with the buyouts of portfolios in the era of elevated valuation?

1.????? It follows global standards such as International Financial Reporting Standards, a more harmonized set of accounting rules and global approach, but is also suitable for pre-empting any international audit issues with investors. Accounting standards such as IFRS 13 and ASC 820 in IFRS and US GAAP are prepared after multiple years of research on valuation requirements to ensure transparent reporting of fair value. This is also consistent with International Private Equity and Venture Capital (IPEVC).

2.????? Use multiple valuation methodologies, such as market multiple, recent transaction method, comparable company method, and DCF, to avoid being tripped over by any one method to over-valuation. Thus, The differences in valuation should be reconciled and explained before moving further.

3.????? PE managers must apply appropriate discounts for factors that may reduce the company's value. For example, if the cash flow of the portfolio company is not robust and may breach the covenant, there will be legal and reputation loss in the future. Covenant breach may also result in further liquidity need, which could be a potential liability for the PE firm. Hence, matters related to future cash issues warants more scrutiny and call for a higher discount factor in valuation to reflect the appropriate level of risk.?

Engaging an independent third-party valuation provider can enhance the reliability of data and information. Using expert valuation agencies can also make LPs feel more confident about the information provided, suggest a research report by Grant Thornton.?

4.????? The dry powder of $ 1.2 trillion can be deployed instead of raising expensive capital outside during the high-interest environment. PE managers are expected to raise capital when the liquidity improves and use dry powder to buy out the cash-deprived good portfolios in the market.

The dry powder can help PE managers buy the company, gain control, acquire the board, align the incentive to long-term value creation, and change the capital structure as required at the right time. ?

5.????? To increase the investors' and banks' confidence in the portfolio company, & raise funds for Leveraged Buyouts, PE managers can use Compulsorily Convertible Debenture (CCD) coupled with Put. The loan through CCD is more attractive to investors since it will convert into equity shares after a specific timeframe. With a Put option, CCD will help sell those equities back to the portfolio firm at a predetermined price if the over-valued company does not provide the expected returns.

6.????? Strategically carved out Exit plan – While PE managers are employing risk management tools to avoid fallouts such as SVB bank, it is imperative that they also have a clear plan, time, and triggers to exit the investment to avoid escalation of investment commitment. Successful PE managers have exited the investment if they do not work out reasonably rather than investing further to justify the decision.

While the credit crunch and funding winter prolongs in 2023, it is also an excellent opportunity for PE firms to seek out good deals at competitive pricing and majority controls since there are great chances of finding good portfolio companies desperately looking for a cash injection. In such a situation, getting a controlling stake in a high-potential company and managing them to profitability is easier.

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