May 21, 2014
Interviewed by: David Snow
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Do You “Calibrate” Your Valuations?

The latest buzzword in valuations is “calibration.” Whether or not private equity CFOs know it, many of them already calibrate, according to experts from RSM, EIF and W Capital Partners.

The latest buzzword in valuations is “calibration.” Whether or not private equity CFOs know it, many of them already calibrate, according to experts from RSM, EIF and W Capital Partners.

Do You “Calibrate” Your Valuations?
Valuations in Private Equity

David Snow, Privcap: Today, we’re joined by John Lambrech of W Capital Partners, Mitch Coddington of Energy Investors Funds, and Kevin Vannucci of RSM. Gentlemen, welcome to Privcap. Thanks for being here.

All of you are valuation experts. It’s a hot topic, so I’m glad you’re here. I’d like to learn more about what’s going on in the world of private equity valuation. To start, a question for Kevin.

You say there’s a buzzword going around the world of valuation in general and that’s “calibration.” I’d never heard of it and neither had the two of you. Yet, it turns out that everybody is and should be calibrating. Can you define it and tell us why it’s a hot buzzword now?

Kevin Vannucci, RSM: A lot of the funds are calibrating, they just don’t know they’re doing it. It’s going to be refined over time as their audit firms are putting more pressure onthemtomakesuretheinvestmentsarefollowing market‐participant assumption.

Initially, calibration upon origination when an investment is made, you’re going through your different valuation models, whether you’re using a guideline publiccompany method when you buy that company or just cash flowing. At the same time, you should be benchmarking against market-participant assumptions at the date of the investment. Throughout that whole period on that investment, you should always go back and look at marketparticipantassumptionstomakesureit’sfollowingthesame trajectoryandthesamedifferencesyouhadatinitialrecognition.

  For instance, if you bought a company at five times EBITDA, you have identified four or five market participants at that time, and they are trading roughly at eight times EBITDA, it had a three times-­‐term difference. All things being equal, that should remain the same over time, unless you have more growth in the subject than the market participants, or different margins, or other qualitative or quantitative factors that have occurred.

Calibration helps identify red flags when your investment is not following the market-­‐participant assumptions you originally identified when you made that investment. That’s really what calibration is.

Snow: John from W Capital, is that something your firm does as its tracking valuations?

John Lambrech, W Capital Partners: Absolutely. We’re always looking back at the whole story and understanding what our base-­‐case thesis was on the investment and how it’s moved over time. My understanding of the valuation rules and requirements is that you need to look at it at a particular point in time.

As you start to move further away from that initial investment, looking back and calibrating where it was in the initial model is less relevant over time. It’s something we absolutely consider and we’re always looking back and saying, “What did we think this company was going to do and what’s changed over time?”

Vannucci: That’s the difference. Funds are considering that, but maybe they’re not presenting it in the work papers they provide the audit firms. You’re exactly right, John. Over time, the investments are going to change. One would think as you’re coming towards your exit event, then the initial acquisition is going to change. Auditors are looking for the color around that and why it’s changed to make sure everything’s been identified to help them get comfort that it is a true, fairvalue mark to market with marketparticipant assumptions.

Lambrech: Okay. Then we are doing it.

Snow: Mitch, is there a variation of that that your firm practices?

Mitch Coddington, Energy Investors Funds: It’s interesting because we’re valuing a stream of cash flows over a 10, 15, or 20year period. For a power plant, for example, a power purchase agreement may have 15 years remaining in its term. From the day we acquire an asset through the period that we own it, our valuation technique doesn’t really change. The discounted cash flow methodology and the inputs don’t change. When I say they don’t change, the important inputs can be impacted by gas

prices or energy prices. For example, there could be a fuel contract that was in place when we acquired an asset and then, three years later, you execute a new fuel contract. In terms of calibration, what’s relevant for us is that we use the same inputs, the same metrics, fuel prices or the power contract being the critical one or, typically, it’s a project finance structured investment so you have debt that’s in place. There may have been a refinancing. The variables may change, but the items themselves are consistent from the acquisition. The revenues are supported by the power contract. Your fuel costs are supported, typically, by a longterm fuel supply agreement and those kinds of things.

Vannucci: For discounted cash flow, calibration would come back to how you built up your weighted average cost capital at date of acquisition. Then, how you’re building that up through the whole period and how you’re benchmarking it against market-­‐participant assumptions to build up that weight at date of acquisition versus throughout that lifecycle. Then, you’re using an “x” multiple for terminal, what that “x” multiple is at date of acquisition over that time and how you’re gauging that and benchmarking against market participants.

Coddington: Right. As we discussed earlier, for us, the exit multiple or terminal value is the last input. If we have a 15year discounted cash-­‐flow model because we have 15 years remaining on a particular power purchase agreement, the last input at the end of year 15 will be a terminal value. That’s a value consistent with when we acquire an asset or, when we’re valuing it; we will look to market transactions to justify a particular terminal value, often a certain number of dollars per kilowatthour. That exit value or terminal value is a piece of our puzzle where we do look to market activity. That’s consistent with our acquisition model as well.

Vannucci: It comes back to calibration—everyone’s doing it. Well, not everyone but hopefully most people are doing it. But it’s as simple as if you buy a company at five times EBITDA at date of acquisition and market participants are trading at eight times and then three years down the road, the market participants are trading at six times, but you’ve marked it at nine times, that calibration is going to tell you either you hit a homerun with your portfolio company or something’s going on and you have to give that color to the auditors and to your LPs to help explain that, to help them get comfortable with that market. That’s what calibration is all about. How does it track against marketparticipant assumptions over time, based upon how you’ve benchmarked it at date of acquisition?

Snow: Would you say the focus on calibration or this becoming a buzzword is part of a broader theme of firms needing to provide more documentation and more color around their valuations and, of course, that requires more work and explaining on your parts?

Vannucci: Without a doubt. The audit firms—unfortunately for our clients and all audit-­‐firm clients—are asking for more documentation to get comfortable with marks because there is increased scrutiny on the marks right now, which will continue. ASCPA is coming out with guidelines that hopefully will help the funds become better at marking or following what the auditors are asking for. Because, right now, we’re in a flux where audit firm ABC is asking you to do one thing and audit firm CDX is asking you to do another. There are no real guidelines as it relates to how to mark to market certain investments.

Lambrech: Kevin, do you see that trend continuing for the foreseeable future?

Do you see it slowing down or plateauing?

Vannucci: The ASCPA has formed a taskforce and they’re going to issue a practice aid within a couple of years similar to what they did with goodwill impairment and purchaseprice allocation, where before they issued that practice aid, there was a lot of grey, there were different firms suggesting you do different things. That’s why the ASCPA has formed a taskforce around this—to help provide some better guidance, so there won’t be the grey area and everyone will be marching to the same beat. That should help all the clients and all the funds eventually.

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