The Valuation Rollercoaster: Lessons from a Complex Acquisition

Let me share a deal I worked on that really drove home the complexities of valuation, risk, and how outside events can turn things upside down. I advised a fund in acquiring a company, splitting the purchase between an equity fund I was part of, and a separate fund focused on debt. Everything seemed straightforward initially: $500 million total value, we put in $200 million of equity, and they took on $300 million in debt.

Things got messy when the company hit rough waters. Suddenly, the debt wasn't looking so secure, and those original valuations were out the window. This is where it hit me – debt and equity investors live in different worlds. As the equity fund, were still hoping for a turnaround, even if it took time. The debt holders were laser-focused on if they'd get their money back, and the sooner the better.

Then, a curveball: a potential buyout offer! This changed the game again. For our equity position, it meant possible massive upside, but hinged on the deal closing. The debt guys were excited too, since it meant a faster, almost certain, repayment. But there was still that nagging "what if the deal falls apart?" question.

The biggest lessons I took away were:

• Type of Investment = Type of Mindset:?Debt is about minimizing losses, equity is about maximizing gains. That's the core tension driving how each side approached the situation.
• Markets Price In the Future:?The company's potential value wasn't just about its current financials, but what everyone BELIEVED could happen. News of the potential sale sent those valuations swinging.
• "Fair" is in the Eye of the Beholder:?We used multiple valuation methods, all with some level of guesswork involved. This is where having advisors who understand the nuances is worth its weight in gold.

Transaction Details

In December 2017, two investment funds acquired a company for $500 million, splitting the purchase into $200 million in equity (owned by Fund X) and $300 million in debt (owned by Fund Y). The debt has a maturity of five years with a repayment plan that varies depending on when a change in control occurs, offering higher repayment earlier in the term. The valuation of both the equity and debt was performed separately, with the fair value of the debt set at $300 million and the equity at $200 million. The management of each fund, although possibly under the same investment company, operates independently to avoid conflicts of interest, focusing on the best interests of their respective investors.

• The Question: If each fund needs to report the value of their investment, what methods should they use?
• Key Point: The funds are managed separately, so the debt and the equity need to be valued independently.

Insight: Conflicts of Interest

• I like to emphasise that even if the two funds have the same parent company, different managers are responsible for getting the best outcomes for their specific investors.
• Reason: A debt investor benefits if the company takes less risk and prioritizes repaying its loans. An equity investor wants a company to grow, even if that means taking on more debt!

Let's focus on the debt repayment provisions mentioned for Fund Y. Suppose a change of control occurs in the second year after acquisition. The debt of $300 million would be repaid at 105% of par value.

• Original Debt: $300 million
• Repayment Percentage: 105%
• Repayment Amount: $300 million * 105% = $315 million

Explanation: If the company undergoes a change of control in the second year, Fund Y, which owns the debt, would receive $315 million instead of the original $300 million. This provision incentivizes the debt fund by providing a return above the principal amount if certain conditions are met early in the investment term.

Key Takeaways

• Investment Type Matters: How you value something depends heavily on what rights you have as an investor, and your risk tolerance. Understanding the specific terms of an investment, such as change in control provisions for debt, is crucial. These details can significantly impact the expected return, especially in scenarios involving early changes in company ownership.
• It's Not Just the Numbers: Market factors beyond the specific company, like interest rates for debt, affect how much an outsider would pay for these investments. When evaluating investments, it's important to consider not only the fair value at acquisition but also the specific terms and conditions that could affect future valuations, such as repayment terms and the expected time horizon for the investment.
• Fairness to Investors: Separate valuations help ensure that Fund X's success doesn't come at the expense of Fund Y investors, and vice versa. Maintaining separate fund managers for debt and equity investments is a wise practice to avoid conflicts of interest, ensuring that decisions are always aligned with the best interests of the investors.

In summary, the strategic division of investment into equity and debt, careful valuation, and dedicated fund management are critical for maximizing returns and maintaining investor trust. Understanding the nuances of each investment component can provide strategic advantages in financial planning and risk management.

Crisis Hits

Two years after acquiring a company, the value of both the debt and equity investments has changed due to the company facing significant challenges. The debt, now valued at 80% of its original amount ($240 million), and the equity, valued at $80 million, reflect these difficulties. The overall value of the company has decreased to $350 million. Various methods are used to calculate these valuations, considering factors like market conditions, cash flows, and negotiations over debt payoff. Despite these challenges, the management structure of the funds remains focused on avoiding conflicts of interest, ensuring decisions benefit the investors.

The company's debt is valued at 80% of par, resulting in a fair value of $240 million from an original $300 million (reflecting the company's challenges).

• Original Debt Value: $300 million
• Fair Value After Challenges: $240 million (80% of par)

For equity, considering the cash flows and market conditions:

• Original Enterprise Value: $500 million
• Current Enterprise Value: $350 million
• Debt Valuation for Equity Calculation: $240 million
• Calculated Equity Value: $350 million (enterprise value) - $240 million (debt value) = $110 million
• Discount for Illiquidity: $30 million
• Final Equity Value: $80 million

Debt: It's About Trust

• Payoff Amount: This is what the contract says. The company borrowed $300 million, they OWE $300 million (plus interest). That can only change if they renegotiate with lenders.
• Fair Value: Imagine the loan could be traded like a stock. What would someone pay for it?
• Key questions: Will the company survive long enough to repay the debt when due? If the company goes bankrupt, will there be enough assets left to cover the loan?
• The Bad News Impact: The company's struggles make it less likely they'll have the money to repay in full. This makes the debt LESS appealing to potential buyers, so the price drops.

Equity: It's About the Future

• The Pie Shrinks: The company's total value is now lower ($350 million vs. the original $500 million). Equity holders get whatever's left AFTER debt is paid, so their slice gets smaller.
• Less Upside: Investors were hoping the company would grow massively. Now, even if things turn around, the potential payoff isn't nearly as exciting.
• The Bad News Impact: A struggling company has a tougher path to future success. This translates directly to lower expected returns for equity investors.

Insights

• Bad News Travels Down: The equity investors (Fund X) took the biggest hit. The company's value shrinking primarily affects them, not the debt holders.
• Market Realities Matter: Even though, in theory, the business is worth $350 million and the debt is for less than that, a buyer for Fund X's shares wouldn't pay full value knowing it's difficult to sell the company right away.
• Valuation Isn't Perfect: The three approaches for valuing equity show that even professionals might disagree, as they all involve some level of prediction about the future.

Three ways of valuing the equity (Fund X's investment) in the struggling company, highlighting the pros, cons, and underlying assumptions of each.

Option 1: The Fundamentals

• Focus: How much cash is the company likely to generate in the future, after paying operating expenses, interest on the debt, etc. ? This is the money ultimately available to equity investors.
• Logic: A stock is fundamentally a claim on future earnings. A complex model might be used, but the core idea is 'adding up' these expected cash flows.
• Pros: Directly tied to the company's performance. If they can turn things around, this value will improve, even if the debt situation is messy.
• Cons: Requires forecasting, which is inherently uncertain. Also, ignores the one-time boost to value that might occur if the whole company was sold.

Option 2: The Buyout Scenario

• Focus: What's the company worth as a whole, and what COULD the debt be renegotiated down to in a sale? This gives the theoretical maximum for equity holders. Here, the fair value of debt is $240 million and at the EV of $350 million, the equity holders will get $110 million.
• Logic: A new buyer for the whole company might be able to get better interest rates, cut costs, etc. This means they could pay off the old debt at a discount.
• Pros: Captures the upside potential if a radical change happens. Good for investors arguing for aggressive steps to make the company more attractive for sale.
• Cons: UNREALISTIC in the near-term. Fund X can't force a sale, and lenders won't easily agree to take less than what they're owed.

Option 3: Bridging the Gap

• Focus: Starts with the gap between total company value and the debt's fair value (not its payoff amount). Then applies a discount to that number.
• Logic: Acknowledges that on paper, there's value for equity holders, BUT investors know that getting that full value quickly isn't possible.
• Pros: More realistic than Option 2, while still considering that the equity isn't worthless. The size of the discount is where judgment calls come in. Here, i gave an illiquidity discount of $30 million making the fair value of equity as $80 million.
• Cons: The hardest to explain to a non-finance person. It's a "fudge factor" to adjust for the imperfections in the market.

Key Takeaways

• No Perfect Answer: That's why I show all three! Different investors might favor different approaches based on their goals.
• Time Matters: Option 1 is suited for a long-term investor. Option 2 is what an activist investor pushing for a quick sale would use.
• "Fairness" is Subjective: Fund X managers will obviously want the highest valuation, Fund Y managers will try to argue it's much lower. This is where professional valuation experts come in.

Enter the Buyout Scenario

Four years after the original acquisition, the fund plans to sell the company for $800 million, but there's a 25% chance the sale might not happen. If the sale falls through, the company's value would be $700 million. The debt's payoff is slightly above its original amount ($303 million) if the sale occurs, but it's expected to be exactly the original amount ($300 million) if the sale doesn't happen. The debt's current market value is just a bit over the original ($300.9 million), indicating how debt investors view the situation.

• Impact on Value: This potential sale dramatically changes the outlook for both the debt (Fund Y) and equity (Fund X) investments. HOWEVER, uncertainty remains.
• Key Point: Valuations must now consider two possible scenarios – the deal closing, or the company continuing on its own.

Let's break down how these two possible futures dramatically change the outlook for the debt (Fund Y) and equity (Fund X) investments.

Scenario 1: Deal Closes

• Debt: Lenders get their full money back, plus a little extra due to the 'change of control' clause. This is the best-case scenario for them, as their risk is essentially eliminated.
• Equity: This is where the big payoff potential lies. Let's look at some numbers:
• Purchase Price: $800 million
• Debt Payoff: $303 million
• Remainder for Equity: $497 million
• Original Equity Investment: $200 million
• Profit: Roughly $297 million

Important Note: The profit isn't guaranteed. If the deal takes months to close, time-value-of-money must be factored in, decreasing the present-day value of that potential profit

Scenario 2: Deal Fails

• Debt: Things become more 'normal'. Lenders are likely to get paid in full eventually, but lose the chance for the quick premium. The debt's value will probably dip, but how much depends on how healthy the company looks on its own.
• Equity: They avoid total disaster, but miss out on the big payday. Let's imagine:
• Company value drops to: $700 million
• Debt is still: $300 million
• Equity Value: $400 million

The Upside: Still DOUBLE their investment at its lowest point. This highlights why equity investors took the risk in the first place.

Given a 75% chance the sale happens and a 25% chance it doesn't:

Fair value of equity = ($497 million 75%) + ($400 million *25%) = $372.75 million + $100 million = $472.75 million

• Par Value of Debt: $300 million (the amount initially borrowed).
• Traded Price of Debt: 100.3% of par (indicating a slight premium over the borrowed amount).
• Calculated Fair Value: $300 million * 100.3% = $300.9 million.

Key Insights

• Risk vs. Reward: The deal puts things into sharp focus. Equity holders have much bigger potential gains, but also the chance things go wrong. Debt holders sacrifice some upside in exchange for more security.
• Market Perception is Key: If investors think the deal is VERY likely to close, the debt might already be trading close to its payoff value, and the equity may be valued near its 'deal close' price.
• It's Not Over Until It's Over: Until the papers are signed, there's risk. A surprise announcement (bad earnings, competitor lawsuit, etc.) could derail the deal and drastically change the valuations overnight.

• Before the Deal: Investors in the debt were focused on whether the company could repay the loan over time, based on its cash flow, etc.
• With the Deal: The focus shifts almost entirely to the probability the deal closes. If it's seen as a sure thing, the debt is basically as good as cash at the payoff amount.

Numbers Illustrating This:

• Struggling Company: Debt fair value trades at $240 million (discount due to risk)
• Potential Sale: Debt fair values close to $300 million (reflects high likelihood of full repayment)

Why It Matters for Debt

• Time to Repayment: If the company stays independent, lenders might wait years for their full money back. In a quick sale, they get it with a bonus MUCH sooner.
• Investor Psychology: Debt markets are often dominated by 'buy and hold' investors – pension funds, etc. They crave certainty, which the deal provides. This drives up demand, increasing the price beyond the raw numbers.

Equity: The Bet Gets Bigger

• Before the Deal: Investors were hoping for a turnaround. A slow, steady increase in the company's value would benefit them over time.
• With the Deal: The potential payoff is massive and immediate. However, it now hinges heavily on something outside the company's direct control – whether the deal closes.

Upside AND Downside:

• Deal Closes: Equity value might more than double in a matter of months.
• Deal Fails: Their investment still likely grows, but the huge windfall is gone. This highlights the risk they take on for that potential.

Key Insights

• The Market is Forward-Looking: Valuations aren't just based on the present, but on what investors THINK will happen. This uncertainty is baked into the price.
• Different Buyers, Different Needs: Someone buying the equity now is a speculator on the deal. The debt buyer might just want safe, short-term returns.
• "Value" is Relative: The same debt, on paper, can have wildly different valuations depending on the external circumstances.

Wrapping Up

This deal hammered home several core truths about investing:

• Investment Type Dictates Perspective:?The equity vs. debt split wasn't just about who put in what money. It created fundamentally opposing viewpoints on how to handle the company's struggles, and even more so when the buyout possibility emerged.
• The Illusion of "Fair Value":?Market upheavals exposed how subjective valuations can be. Three different methods resulted in widely different equity valuations – a reminder that even the most sophisticated models require judgment calls.
• External Events Trump Fundamentals:?The company's potential, while important, ultimately mattered less to the current values than the market's perception of the deal happening or not. This highlights the unpredictable nature of investing, even with careful due diligence.
• Risk Tolerance is the True Divide:?This wasn't just debt being "safe" and equity being "risky". Both faced risks, but of different sorts. The debt holders were laser-focused on minimizing downside, while equity was a bet on an uncertain, but potentially huge, upside.

Lessons for the Future:

Working through this situation reinforced some valuable principles:

• Communication is Key:?Managing investor expectations, especially in volatile situations, was crucial. Balancing transparency with avoiding undue panic was an ongoing challenge.
• Adaptability Matters:?The original investment thesis went out the window quickly. Staying flexible and recognizing when your strategy needs to change is vital for survival, let alone success.
• Know Your Counterparts:?Building a strong understanding of how the debt holders approached the situation was essential. This helped anticipate their actions and negotiate effectively on behalf of the equity fund.

This deal was a rollercoaster, but ultimately an invaluable learning experience!