Friday, 17 April 2020

Covid-19: Valuation challenges and opportunities

That Covid-19 will have a significant impact on the financing of companies is quite clear (for more details on tackling financial distress, click here). While some businesses / sectors struggle with (minor) liquidity issues, others face more severe issues as the lockdown means a complete standstill to oppose the Covid-19-crisis, which might bring them in a situation of financial distress and render them insolvable in the end.

Start-ups, for instance, are fighting for their lives as they, most of the time, do not yet have a stable customer base and no reserves were built up yet. Indeed, they are mainly focuses on making new sales which under current circumstances is even harder given that businesses are reluctant to purchase / invest as cash is king at the moment. Private Equity firms (“PE”) invested in start-ups could offer liquidity assistance via debt instruments for instance, but also via additional equity funding. Current market conditions might provide opportunities in respect of the latter.

Additionally, M&A activity declined considerably in the first quarter of 2020 while it was only impacted at the end of the quarter by the Covid-19-crisis (for instance, January was the quietest month with respect to M&A in 7 years according to the Financial Times due to geopolitical uncertainty – e.g. 2020 being a US presidential election year as well as the continuing US-China trade war). Again, there might be some opportunities in the market, not only from an M&A perspective, but also to reorganize your business.

Challenges concerning valuation uncertainty

The International Valuation Standards Council (“IVSC”) provided insight in how to deal with valuation uncertainty. First of all, the difference between market risk and valuation uncertainty is clarified. Indeed, these 2 concepts should not be confused – while the valuation of quoted stock has little uncertainty, the stock itself, by its nature of doing business in certain sectors, may still carry a more than conventional market risk. IVSC defines market risk as “the exposure that the owner of an asset has to potential future gains or losses”. Risk, therefore, should under any circumstances, be taken into account by informed buyers/sellers. Moreover, under a common Discount Cash Flow (“DCF”) valuation approach, market risks should be reflected in a valuation via the determination of an appropriate discount rate.

On the other hand, the main issue when dealing with valuation uncertainty is that a valuation is not a fact, but it is the estimate of the most likely point of a range of possible outcomes based on assumptions made in the valuation process. The IVSC state that valuation uncertainty can be divided into the following categories:

  • Market disruption – both macroeconomic events (e.g. the 2009 financial crisis or Brexit) as well as microeconomic events (change in law or natural disaster) can cause market disruption. The market disruption caused by Covid-19 might be seen as microeconomic at first, but could very well sustain macroeconomic implications in the future as well. Disruptions lead to significant valuation uncertainty as the only inputs available to perform a valuation exercise are likely to relate to the market before the event occurred and therefore have limited relevance on valuation date. Although market disruption is rarely quantifiable, it can manifest itself in input availability (see below).
  • Input availability – Besides market disruptions, lack of relevant input data can also originate because assets are unique or because of an illiquid market. Due to lack of relevant input data, inputs will probably need to be extrapolated or to rely on unobservable inputs which are developed based on assumptions of the market / asset involved. Both extrapolated inputs and unobservable inputs are a source of valuation uncertainty. However, the valuation method used might adjust for this uncertainty. For instance, when applying an income approach such as a DCF model, although the cash flow inputs are based on expectations of future performance / reward and hence uncertain, the potential reward implied by those expected cash flows differing from those that actually occur in the future can often be reflected in the discount rate applied.
  • Choice of method or model – Typically, in view of equity valuation, various methods or models may be used in a valuation. However, as those methods and models do not necessarily lead to the same point estimate, the selection of the most appropriate method itself is a source of valuation uncertainty. In view of the current market condition, according to the IVSC valuation guidelines, when performing a valuation, one should consider using more than 1 approach or method to estimate the fair market value “particularly when there are insufficient factual or observable inputs for a single method to produce a reliable conclusion”.

In order to quantify valuation uncertainty, one could use a sensitivity analysis when there is a sufficient amount of reasonably possible alternative numeric inputs that could have been selected on valuation date. However, it does not merely involve forecasting a worst-case scenario. The objective is not to stress test a valuation but to address the impact on the reported outcome of reasonable and likely alternative assumptions – indeed selection needs to be made among possibilities that are not located in the tail of the distributions (where events are very unlikely to happen) but rather in the central areas (where events are likely to occur).

Although it is recommended, when performing a valuation, to disclose significant elements of uncertainty, the existence of such uncertainty does not mean that no valuation can be performed. However, it does mean that the assumptions and inputs made in the valuation process taking into account the (multiple) valuation approach(es) and methodology/ies used, should also be disclosed in the valuation report. The documentation of the assumptions and inputs used, certainly under current market conditions, supports the (envisaged) equity transaction and would make it much harder for parties involved (e.g. tax authorities) to disagree with the outcome of the valuation process – typically years later, when impact of the Covid-19-crisis will be crystallized (potentially much more positive or negative compared to the expected cash flows used).

Opportunities due to lower valuation outcomes

While certain transactions were too expensive as prices were potentially exaggerated due to the ongoing bull market in the last few years, fair market values of businesses today will be impacted by the Covid-19 crisis and could result in a better negotiating position for some parties when considering (additional) equity stakes.

As mentioned above, in the application of a DCF model valuation uncertainty might be reflected in the discount rate applied causing it to be higher and hence, value would be lower even if the forecasted cash flows in the DCF model are not impacted. These expected cash flows are likely also impacted and value will be lower still. Especially for businesses that had to close down in certain countries to oppose Covid-19, impact on expected cash flows, probably relatively more changes are expected in the near future compared to the terminal value, are to be considered in the forecast as well.

Forecasting future cash flows becomes increasingly more difficult as there is still no view on the length of the Covid-19 crisis, the length of public health actions, particularly those limiting physical movement, the length of government (economic) actions to combat the crisis and hence accompanying economic impact. Therefore, forecasts on expected cash flows should be adjusted to the extent possible, and discount rates should be adjusted to take into account the additional risk based on best information per valuation date. One should be careful, however, to avoid a double counting of certain risks (i.e. to take into account impact on risk – reward of the business both at the level of the expected cash flows as well as at the level of the discount rate). As to forecast future cash flows in these uncertain times, scenario analysis weighting various outcomes might be of assistance.

Furthermore, the discount rate may not be able to take into account all risks or outcomes. Nevertheless, the addition of a risk premium may be justified taking into account the specific company with its assumptions related to the discount rate such as risk-free rate, size premium, country risk and equity risk premiums to determine an appropriate discount rate. Indeed, when valuing a business, both forecasting (expected cash flows) as well as the determination of an appropriate discount rate should be done simultaneously so that an appropriate risk premium to be added to determine an appropriate discount rate is still in line with, without double-counting, the expected cash flows of a business.

Application of the “easy to compile” market approach

With respect to the market approach (use of multiples), which is used very often in practice as it requires few explicit assumptions, is easily compiled and simple to understand and present, is, however, also impacted. Appropriate multiples must be determined reflecting current market environment including risk and uncertainty in projections and historical results and, therefore, adjustments are required for differences between the multiples derived from the market (identified comparable businesses/assets) and the business/assets being valued.

Given that the private equity market rely rather heavily on the use of multiples, The International Private Equity and Venture Capital Valuation (“IPEV”) provided special guidance given the magnitude of the current crisis. It states the following[1]:

  • An appropriate multiple would be congruent with the metric to which it is applied. The percentage change in market capitalization of comparable public companies may provide a good proxy for the magnitude of the change to be expected in the multiple.
  • If the metric has been adjusted for current conditions and future expectations and the public comparable company results do not yet reflect the change in results and expectations, then there would be less of an expected relative change in the multiple applied. If the metric has not been adjusted, then more of the relative change in public comparable companies would be applied.
  • Greater uncertainty translates into greater risk and increased required rates of return, which generally would indicate that multiples will decrease, even in the absence of recent transaction data.
  • Revenue and earnings metrics must be evaluated in the context of market participant perspectives. Generally, market participants focus on maintainable earnings or maintainable revenue. Therefore, one-time impacts would be excluded from the metric to which the multiple is applied.
  • Notwithstanding the previous point, expected adverse performance in Q1 and Q2 2020 and beyond, if deemed one-time, would still impact cash balances and would be reflected as a deduction from enterprise value in estimating fair value.
  • The selection of metrics base on last twelve months (“LTM”) or next twelve months (“NTM”) would be determined based on market participant expectations and the availability of applicable multiples.
  • Liquidity needs must be evaluated; what is the likelihood of a debt covenant breach? What is the impact of extended reduced cash flow? What is the source of working capital required to “restart” the business if impacted by the crisis?
  • Scenario analysis is likely to be necessary to assess and incorporate the probability of the crisis extending for 3-, 6-, 12-, 18-months or longer

It is clear that Covid-19 crisis might have a significant impact on the value of businesses. Although there might be valuation uncertainty, these market conditions do not mean that no valuation can be performed. However, appropriate documentation and support of the whole valuation process including explanation of the assumptions and inputs used, as well as the potential adjustments to market data, would be necessary / highly recommendable. As current Covid-19 crisis could result in lower expected cash flows, higher discount rates and lower multiples, it might be the time to rethink the reorganization which was deemed too expensive just few months ago or to rethink to acquire your takeover target. Even though cash is king at the moment as the end of the Covid-19 crisis is in the unpredictable future, start planning your M&A activity now in order to be able to act swiftly after the crisis.   

Andy Neuteleers - Partner (

Kenny Van Tulder - Sr. Manager (

1 IPEV Board, Special Valuation Guidance, 31 March 2020