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Using the Private Cost of Capital Model


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Authors John Paglia and Robert Slee offer an alternative to using methodology designed for privately-trade companies as a means to valuate privately-traded companies. The article was originally published in the May/June 2011 issue of The Value Examiner. It is provided courtesy of The National Association of Certified Valuators and Analysts (http://www.nacva.com)

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Using the Private Cost of Capital Model

  1. 1. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S v a l u a t i o n • Using the Private Cost of Capital Model • By John K. Paglia, PhD, CFA, CPA; and Robert T. Slee, CBA, CM&AAU sing public company stock price return data to estimate discount rates Given the answers to these questions, it for privately held companies has become increasingly complex over the then seems apparent that Shannon Pratt is past decade. Definitive answers to fundamental questions surrounding correct in saying that cost of capital is the the topic of adjusting public returns to apply to privately held compa- expected rate of return that the relevantnies remain in debate. Among those questions that consume a considerable amount market requires in order to attract funds to a particular investment.2 In other words,of intellectual resources and bandwidth, lion and $100 million.1 It appears the cost of capital estimates for privately heldin no particular order: uncertainty surrounding answers to the companies should be taken from the mar- questions above has created a lack of kets in which they raise capital.• What is an appropriate size premium? confidence with the application of pub- In an earlier article,3 we made the ar-• How much is a discount for lack of licly traded stock data to privately held guments for using a model that captured marketability? companies. This raises an even more discount rates from the markets in which• What is the difference between mar- fundamental question: privately held companies fund based ketability and liquidity, and how do upon actual investment checks written I determine an adjustment for each? Should we be using publicly traded by the providers of that capital. We also• How do I adjust for a controlling in- company stock return data as the unveiled the private cost of capital model terest? primary basis for estimating cost of to be used to estimate discount rates for• Should I use a historical equity risk pre- capital for privately held companies? businesses that are not publicly traded.4 mium or one that is forward-looking? The purpose of this article is to offer• Is Beta or Total Beta more appropri- To help answer that question, we re- guidance on the application of the pri- ate when using the capital asset pric- flect on the following: vate cost of capital model and to address ing model? questions that have arisen in regard to• Should I tax-effect or not? • Do privately held firms obtain capi- the usage of this model. tal from the public markets? [No.] The complexity and confusion is re- • Do the majority of privately held PRIVATE CAPITAL ACCESSflected in recent survey data. In fact, companies go public? [No.] DRIVES DISCOUNT RATEjust 39 percent of business appraisers • Do we have robust sources for ob- The broad categories of capital avail-reported a level of comfort with us- taining capital in the private capital able in the private capital markets areing public data to estimate discount markets? [Yes.] called capital types. The capital typesrates for privately held companies in • Do these capital sources price risk in 2 Valuing a Business, 5th Edition, by Shannon P.the range of $5 million to $25 million their particular segments? [Yes.] Pratt, McGraw-Hill, 2008, Page 182.in revenues, while 60 percent indicated • Is it possible to learn what these return 3 Robert T. Slee, Private Capital Markets: Valuation, Capitalization, and Transfer of Privatesome level of comfort when estimating expectations are by segment? [Yes.] Business Interests, John Wiley & Sons, 2004.cost of capital for privately held com- 4 Robert T. Slee and John K. Paglia, “The Privatepanies with revenues between $25 mil- 1 Pepperdine Private Capital Markets Project, Cost of Capital Model,” The Value Examiner, Summer 2010 Report (http://bschool.pepperdine. NACVA, March/April 2010. edu/privatecapital).The Value Examiner May/June 2011 7
  2. 2. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S are bank lending, asset-based lending, mezzanine financing, private equity, factoring, angel investment, and ven- ture capital. These capital types corre- spond to institutional capital offerings in the marketplace. When investments are made or credit is extended in the private capital markets, it is with a certain return expectation. That is, capital providers will write investment checks or grant credit to those companies that offer the best expected returns given risk appetite, size preferences, industry preferences, geographical considerations, and other unique influences. We stress the importance of using expected rates of return. First, this re- turn is the expected rate of return the provider would accord the investment at hand, given the provider’s capital type. In other words, capital providers require Source: Pepperdine Private Capital Markets Project Winter 2011 Report, December 2010. a certain “all-in” return to compensate them for taking the risk of extending the credit or making the investment. This ex- ing future cash flows with historical costs simultaneous, and ongoing investiga- pected return is the effective cost to the of capital may result in significant errors. tion of the decision-making behavior borrower or investee as it is inclusive of Third, because of the limited amount of private capital providers. The survey various transactions costs. For example, of capital deployed and constrained re- specifically examines the activity and the borrower may incur legal, brokerage, sources in the capital allocation process, behavior of senior (cash flow) lenders, environmental, and other costs in effect- investors will frequently invest capital asset-based lenders, factors, mezzanine ing the transaction. These costs are con- at an expected return that exceeds their funds, private equity groups, venture sidered when calculating an effective or hurdle rate. So in order for companies capital firms, and angel investors, in ad- all-in cost to the borrower or investee. to obtain capital in these markets, they dition to other groups involved in the Second, cost of capital should be must transact with the capital sources at private capital markets including busi- based on expected rather than realized the providers’ expected return levels, not ness owners, intermediaries, limited returns, even though there are often hurdle rates or required rates of return. partners, and appraisers. substantial differences between the two Expected returns for newly issued The Pepperdine PCOC survey investi- rates. Expected returns are used because investment or credit checks can be ob- gated, for each major private capital type, capital providers offer credit and struc- tained through direct inquiry. One such the important benchmarks that must be ture deals based on what they expect to source of this information is the Pep- met in order to qualify for capital,,  how receive from the investment. Therefore perdine Private Capital Markets Project much capital is typically accessible, and expected returns on new investments or private cost of capital surveys. what the expected returns are for ex- credit most accurately reflect the eco- tending capital in the current economic nomics of the private capital markets. PEPPERDINE SURVEyS environment. Four survey cycles have This forward-looking assessment of all- The Pepperdine private cost of capi- been completed thus far. The first survey in capital costs is essential when evaluat- tal (PCOC) survey project, launched report, based on 627 responses from pri- ing future benefit streams. Simply assess- in 2007, is the first comprehensive, vate capital market participants, was pub-8 May/June 2011 The Value Examiner
  3. 3. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E STABLE 1: Private Cost of CaPital Data lished in August 2009. The fourth report,(gross annualizeD rates %) which yielded nearly 2,000 responses, was published in December 2010.5 The next Capital Type / Segment 1st Quartile Median 3rd Quartile report will be released in May 2011. The Bank ($1M Cash flow loan) 5.4 6.5 7.1 web-based surveys are administered semi- Bank ($5M Cash flow loan) 5.0 6.0 6.8 annually, each having 25 to 50 questions. Bank ($10M Cash flow loan) 4.5 5.5% 6.6 In these surveys, return expectations are captured from the various segments Bank ($25M Cash flow loan) 3.8 5.0 7.0 of the private capital markets along with Bank ($50M Cash flow loan) 3.8 5.0 6.3 the credit boxes, which are the criteria Bank ($100M Cash flow loan) 3.6 4.8 6.1 prospects must display in order to qual- aBl ($1M loan) 6.5 12.0 18.0 ify for an investment. Return expecta- 5.5 7.0 10.0 tions can be plotted on a graph, which, aBl ($5M loan) in the case of using the Pepperdine sur- aBl ($10M loan) 4.4 5.5 7.4 veys, is the Pepperdine Private Capital aBl ($25M loan) 3.0 3.5 4.5 Market Line (PPCML). This graph con- aBl ($50M loan) 3.0 3.3 4.0 tains seven major capital types, and it aBl ($100M loan) 2.8 3.0 3.5 appears on page 8. The PPCML encompasses various Mezz ($1M eBitDa) 18.0 20.0 22.0 capital types in terms of the provider’s Mezz ($5M eBitDa) 17.0 19.5 22.1 all-in expected returns. The PPCML is Mezz ($10M eBitDa) 17.3 18.9 20.0 described as median, pre-tax expected Mezz ($25M eBitDa) 17.9 18.5 19.0 returns for institutional capital provid- Peg ($1M eBitDa) 25.0 30.0 30.8 ers. The PPCML is stated on a pre-tax basis, both from a provider and from a Peg ($5M eBitDa) 25.0 30.0 30.0 user perspective. In other words, capi- Peg ($10M eBitDa) 24.5 30.0 31.3 tal providers offer deals to the market- Peg ($25M eBitDa) 25.0 28.0 30.0 place on a pre-tax basis. For example, if Peg ($50M eBitDa) 22.0 25.0 30.0 a private equity investor requires a 25 35.0 40.0 50.0 percent return, this is stated as a pre- vC (startup) tax return. Also, the PPCML does not vC (early stage) 30.0 35.0 45.0 assume a tax rate to the investee, even vC (expansion) 20.0 30.0 40.0 though some of the capital types use in- vC (later stage) 20.0 30.0 35.0 terest rates that generate deductible in- angel (seed) 30.0 50.0 100.0 terest expense for the borrower. Capital types are not tax-effected because many angel (startup) 30.0 40.0 75.0 owners of private companies manage angel (early stage) 25.0 35.0 50.0 their company’s tax bill through vari- angel (expansion) 20.0 30.0 40.0 ous aggressive techniques. It is virtually angel (later stage) 20.0 30.0 40.0 impossible to estimate a generalized ap- factor $100K/mo. 58.5 74.5 88.2 propriate tax rate for this market. Table 1 contains the expected return factor $250K/mo. 48.8 58.5 74.5 data used to generate the PPCML. This factor $500K/mo. 48.8 48.8 67.2 factor $1M/mo. 35.4 41.2 53.6 5 Pepperdine Private Capital Markets Project Survey Report, December 2010, John K. Paglia, factor $5M/mo. 31.3 32.7 35.4 http://bschool.pepperdine.edu/privatecapital.Source: Pepperdine Private Capital Markets Project Winter 2011 Report, December 2010.The Value Examiner May/June 2011 9
  4. 4. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S table outlines median (50th percentile) TABLE 2: senior (Cash flow) lenDer CreDit analysis returns, 1st quartile (25th percentile), BenChMarKs (fall 2010) and 3rd quartile (75th percentile) ex- pected returns by capital type and for various segments of each. For instance, Financial Indicator Average Approval Importance according to the table, a $10 million Borrower Limits Score (0-4) bank loan based upon cash flow has a Current ratio 1.4 1.3 1.7 median all-in rate of 5.5 percent, while senior debt service coverage 1.3 1.3 3.2 the median cost of capital for a private (or fCC) ratio equity investment to a company with total debt service coverage 1.3 1.3 3.7 approximately $50 million in earnings (or fCC) ratio before interest, taxes, depreciation, and amortization (EBITDA) is 25.0 percent. senior debt to cash flow 2.5 3.0 3.0 It should be noted that each capital total debt to cash flow 3.0 3.5 3.2 type has its own rules regarding capital Debt to net worth 2.0 2.4 2.5 access. These rules are important for cre- revenue growth rate 3.0% 2.1% 1.8 ating a capital structure for our subject company. Specifically, the major “rules” utilized by banks, asset-based lenders, mezzanine funds, private equity, venture TABLE 3: senior leverage MultiPles for ManufaCturing capital, angel investors, and factors are CoMPanies (fall 2010) identified in the following sections. Manufacturing EBITDA 1st Quartile Median 3rd Quartile $1M eBitDa 1.3 1.3 2.0 SENIOR CASH FLOW LENDERS Senior cash flow lenders generally $5M eBitDa 2.1 2.5 3.0 lend up to an amount that is primar- $10M eBitDa 2.4 2.5 3.0 ily a function of an EBITDA multiple $25M eBitDa 2.6 3.0 3.0 after meeting fixed charge or debt ser- vice coverage threshold tests. The vari- $50M eBitDa 2.5 3.0 3.0 ous ratios, their limits, and their im- $100M eBitDa 2.3 3.0 3.2 portance are outlined in Table 2. For instance, the median approval limit for the senior debt service coverage ratio is 1.3x. More detailed information on ASSET-BASED LENDERS ABLs establish certain thresholds these ratios can be found in the most Asset-based lenders (ABLs) generally for amount of loan based on advance recent Pepperdine Private Capital lend against certain assets the company rates, which vary by collateral class Market Project reports. owns up to certain limits or advance and quality of collateral. For instance, The loan amounts extended are gen- rates. A company will generally choose the loan limit for accounts receivable erally based on a multiple of historical asset-based lending for any of the fol- asset backed loans will generally be recast (or adjusted) EBITDA. Median lowing three reasons: they don’t qualify between 80 and 85 percent of the face senior leverage EBITDA multiples for for a loan against cash flow, they have an value of those receivables. High qual- a manufacturing company, for instance, asset backed borrowing capacity that ex- ity inventory will produce a loan size range from 1.3x for a company produc- ceeds a loan amount obtainable from its of approximately 55 to 60 cents on the ing $1 million in EBITDA to 3.0x for a cash flow, or if the all-in rate is cheaper dollar at an orderly liquidation value. company with $100 million in EBITDA than that offered by a cash flow based Other classes of collateral produce dif- (see Table 3). loan. As a result, ABLs may also hold a ferent advance rates. These are noted senior position in the capital structure. in Table 4.10 May/June 2011 The Value Examiner
  5. 5. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S As a general rule, but not in all cases,TABLE 4: asset-BaseD lenDer aDvanCe rates (fall 2010) mezzanine funds will invest debt after it has been determined how much seniorCollateral type typical loan upper limit debt can be raised, since senior debt is (Median advance %) (Median advance %) commonly the cheaper source. Mezza- Marketable securities 80 90 nine funds will then invest an amount that brings the investee company up to accounts receivable 80 85 the specified threshold. As an example, inventory - low Quality 25 40 the median maximum mezzanine in- inventory - intermediate Quality 40 50 vestment threshold is 4.0x EBITDA for inventory - high Quality 55 60 a company with approximately $10 mil- lion in EBITDA. If we look back at cash equipment 60 80 flow lender size limits, we find a 2.5x real estate 60 70 EBITDA threshold for companies of land 50 50 approximately $10 million in EBITDA. Because a mezzanine fund will lend up to a total limit of 4.0x, there remainsTABLE 5: asset-BaseD lenDer CreDit analysis BenChMarKs 1.5x EBITDA in lending capacity. So(fall 2010) the mezzanine fund can deploy 1.5x EBITDA in loan amount to hit that 4.0x threshold. Other lending thresholds, Financial Indicator Average Approval Importance expressed in EBITDA multiples, can be Borrower Limits Score (0-4) found in Table 6 (page 12). Similar to cash flow and asset-based Current ratio 1.0 1.0 1.1 lenders, mezzanine investors also focus total debt service coverage ratio 1.2 1.0 2.6 on certain financial indicators to deter- total debt to cash flow 3.5 3.8 2.4 mine if a company qualifies for invest- Debt to net worth 2.1 2.5 2.1 ment. Among those that are considered revenue growth rate 1.1% 1.0% 1.5 most important are senior debt service coverage ratio, funded debt service cov- erage ratio (based upon amount funded by a particular provider), and senior debt to cash flow ratio. Table 7 (page 12) Because of the pledged collateral, ABLs are slightly less concerned than cash flow shows the various indicators along withlenders about the various ratios that typically guide an evaluation of credit access. their importance scores.The most important ratio is the debt service coverage ratio, but at an importancelevel of 2.6 it is significantly less weighty than the 3.7 rating reported by cash flow PRIVATE EQUITylenders. Table 5 shows the various indicators along with their importance scores. Private equity groups generally make equity investments in companiesMEzzANINE that are generating a positive cash flow Mezzanine funds invest in companies that are generating a positive cash of at least $1 million EBITDA on a re-flow of at least $1 million on a recast basis. A large percentage of mezzanine cast basis. A large percentage of privatefund investments get deployed in manufacturing, services, and healthcare equity fund investments get deployedbusinesses. The amount a mezzanine fund is willing to invest depends largely in manufacturing, services, and health-upon a multiple of EBITDA, which is generally expressed on a historical and care businesses. Company valuationsrecast basis. are largely based on a multiple of recastThe Value Examiner May/June 2011 11
  6. 6. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S attractive and addressable markets, TABLE 6: Mezzanine funDs lenDing CaPaCity significant competitive advantages, (eBitDa Multiples) By CoMPany eBitDa size and scalable and capital-efficient busi- ness models. Table 10 shows those and $1M $5M $10M $25M other factors along with their weights Statistic EBITDA EBITDA EBITDA EBITDA and overall scores. 1st Q 2.9 3.5 3.5 4.4 Venture capital funds report that Median 3.5 3.5 4.0 4.8 median company values at time of in- 3rd Q 4.1 4.0 4.0 5.0 vestment range from $3 million for seed/startup companies to $35 million for later-stage investments. Additional details can be found in Table 11. TABLE 7: Mezzanine investMent analysis BenChMarKs (fall 2010) ANGEL Angel investors invest in high- Financial Indicator Average Approval Importance growth companies that span the range Borrower Limits Score (0-4) from startups to later-stage companies, Current ratio 2.0 1.3 2.9 but most of their focus is on the seed, senior debt service coverage ratio 1.6 1.3 3.3 startup, and early stages. Angel inves- funded debt service coverage ratio 1.3 1.2 3.4 tors report median company values total debt service coverage ratio 1.3 1.2 2.7 at time of investment of $1 million for seed investments, $2 million for senior debt to cash flow 2.5 3.0 3.4 startup companies, and $3 million for total debt to cash flow 3.5 4.0 1.4 early stage investments. Companies Debt to net worth 2.1 2.3 2.4 that typically qualify for angel invest- revenue growth rate 10% 2.5% 1.3 ments have great growth prospects, top-tier management teams, attractive and addressable markets, significant competitive advantages, and scalable EBITDA. Median deal multiples reported range from 4x EBITDA for companies and capital-efficient business models. with approximately $1 million in EBITDA to 7.5x for companies with approxi- These and other factors along with mately $50 million in EBITDA. These deal multiples and others can be located in their weights and overall scores can be Table 8 (page 13). located in Table 12 (page 14). Private equity funds consider many factors when evaluating an investment opportunity. In terms of importance of various attributes, aside from having posi- FACTORS tive cash flow and positive growth prospects, they report that the management Factors generally provide capital team and future prospects of the company are among the most important con- against accounts receivable assets. Gen- siderations when deciding to write an investment check. They also indicate that erally as long as a company has accounts historical operating performance and a general lack of customer concentrations receivable that are collectable with a high are items that guide their investment analysis. Other factors along with their degree of certainty, a company can ob- weights and overall scores can be located in Table 9. tain capital from factors. Median advance rates range from 80 to 90 percent where VENTURE CAPITAL the advanced amounts generally increase Venture capital as an asset class invests in high-growth companies that span with increases in monthly volume. Cur- the range from startups to later-stage companies. Companies that typically qual- rent median advance rates are shown in ify for venture capital have great growth prospects, top-tier management teams, Table 13 (page 14).12 May/June 2011 The Value Examiner
  7. 7. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E STABLE 8: Private eQuity grouP Deal MultiPles (fall 2010)Company Size 1st Quartile Median 3rd Quartile$1M eBitDa 3.9 4.0 5.3$5M eBitDa 4.5 5.0 5.7$10M eBitDa 5.0 6.0 7.0$25M eBitDa 5.5 6.0 7.8$50M eBitDa 7.5 7.5 8.0TABLE 9: Private eQuity grouP iMPortant faCtors When investing (fall 2010) Of little Moderately Very ScoreFactors Unimportant importance important Important important (0–4)firm size 6.0% 10.3% 46.2% 29.9% 7.7% 2.2Customer concentrations 0.8% 3.4% 13.4% 42.0% 40.3% 3.2Market leadership 0.8% 5.9% 33.9% 40.7% 18.6% 2.7historical operating performance 0.0% 3.4% 13.6% 53.4% 29.7% 3.1industry sector 0.9% 5.1% 22.2% 41.9% 29.9% 2.9future prospects of company 0.0% 0.0% 3.4% 22.0% 74.6% 3.7Management team 0.0% 0.0% 7.2% 25.3% 67.5% 3.6TABLE 10: venture CaPital iMPortant faCtors When investing (fall 2010) Of little Moderately Very ScoreFactors Unimportant importance important Important important (0–4)top tier management teams 0.0% 2.0% 2.0% 36.7% 59.2% 3.5attractive addressable markets 0.0% 0.0% 6.1% 38.8% 55.1% 3.5significant competitive advantages 0.0% 2.0% 4.1% 34.7% 59.2% 3.5investment syndicates with aligned interests 2.1% 8.3% 25.0% 33.3% 31.3% 2.8scalable and capital efficient business models 0.0% 0.0% 4.1% 36.7% 59.2% 3.6Deals that are not widely shopped 4.2% 12.5% 54.2% 22.9% 6.3% 2.1TABLE 11: venture CaPital: CoMPany value at tiMe of investMent (fall 2010) Startup/Seed Early stage Expansion Later stageStatistic ($ millions) ($ millions) ($ millions) ($ millions)1st quartile 2.0 4.0 12.3 25.0Median 3.0 8.0 20.0 35.03rd quartile 5.0 10.5 33.5 75.0The Value Examiner May/June 2011 13
  8. 8. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S TABLE 12: angel investors iMPortant faCtors When investing (fall 2010) Of little Moderately Very Score Factor Unimportant importance important Important important (0–4) top-tier management teams 2.5% 0.0% 7.5% 25.0% 65.0% 3.5 attractive addressable markets 0.0% 0.0% 2.5% 49.4% 48.1% 3.5 significant competitive advantages 0.0% 0.0% 7.5% 41.3% 51.3% 3.4 investment syndicates with aligned interests 6.3% 15.2% 38.0% 30.4% 10.1% 2.2 scalable and capital efficient business models 1.3% 0.0% 16.3% 42.5% 40.0% 3.2 Deals that are not widely shopped 12.7% 29.1% 30.4% 20.3% 7.6% 1.8 no vCs involved 26.7% 35.6% 13.3% 22.2% 2.2% 1.4 Where: TABLE 13: faCtor MeDian aDvanCe rates % (fall 2010) • N is the number of sources of capital. Monthly volume 1st quartile Median 3rd quartile • MVi is the market value of all out- $25,000 80.0 80.0 89.0 standing securities i. $50,000 80.0 80.0 90.0 • CAPi equals the median expected return for capital type i. $100,000 80.0 80.0 86.0 • SCAPi equals the specific CAP risk $250,000 80.0 80.0 86.0 adjustment for capital type i. $500,000 80.0 80.0 85.0 $1M 80.0 80.0 85.0 PCOC depends on private cost of 80.0 80.0 85.0 debt (PCOD), private cost of equity $5M (PCOE), and private cost of preferred $10M 80.0 80.0 87.5 (PCOP) where applicable. $25M 79.8 82.5 90.0 $50M 78.5 85.0 90.0 There are four steps to determining $100M 87.5 90.0 90.0 PCOC.6 > $100M 90.0 90.0 95.0 1. To determine the appropriate capi- tal types by which to compare, re- PRIVATE COST OF CAPITAL MODEL view the credit boxes described in A relevant private discount rate model should enable the user to determine the the most current Pepperdine survey. expected rate of return that the market of private capital providers requires in order Select the appropriate median CAP to attract funds to a particular subject or investment. The PCOC model yields such from the survey results for each a discount rate by positioning the user into the decision-making process of private qualifying capital type. capital providers. We created this model to empower users of private capital market 2. Determine the market value of each data, such as from the Pepperdine capital market surveys, to derive a discount rate capital type. that is generated from empirical data. 3. Apply a specific CAP risk adjust- ment (SCAP) to the selected median The PCOC model is as follows: capital type based on a comparison  ∑ MVi 6 Steps have been consolidated from the five PCOC = (CAPi + SCAPi ) x initially indicated in “The Private Cost of Capital ∑  Model” (2010) by Slee and Paglia. i=1 MVj i=114 May/June 2011 The Value Examiner
  9. 9. BEWARE! of subject results to the appropriate survey credit box. Use first and third quartile returns as a guide to this adjustment.4. Calculate the percentage of capital structure for each CAP. Multiply each weight of capital structure component by its CAP. Add the individual percentages to derive PCOC.The following example demonstrates the model’s usage. Example 1: Cost of Capital for PrivateCo Assuming Known Value and Optimal Capital Structure Already in Place PrivateCo’s discount rate will now be derived below.7 To deter-mine the appropriate capital types by which to compare, reviewthe credit boxes described in the appropriate Pepperdine survey.8Select the appropriate median CAP from the survey results. PrivateCo, reporting adjusted EBITDA of $5 million, has a 5 Things Yourelatively simple capital structure. CAP is found for each capitaltype from a recent Pepperdine survey. For existing debt, in lieu of Don’t Want To Do When Youusing the empirical data from the Pepperdine survey, the analystmay calculate the expected (all-in) return directly from the loanagreement.9 Table 14 (page 17) shows the market value capitalstructure along with the CAPs. By reviewing the PPCML and associated data, the CAP for Value Equipment...PrivateCo’s term loan and equity is 6.5 percent and 30 percent, 1. Don’t rely on the word of the owner.respectively. The equity CAP is 30 percent, the same number as 2. Don’t rely on the depreciation schedule.shown for equity on the PPCML, because PrivateCo fits within 3. Don’t rely on book value.the “$5M EBITDA” category of the Pepperdine survey. 4. Don’t you guess. 5. Don’t rely on the word of an auctioneer or dealer who Next we focus on a specific capital type (SCAP) risk adjust- is not Certified. They may have another agenda.ment for debt to the selected median capital type based on a com- “parison of subject results to the appropriate survey credit box. “ ALL of these methods are inaccurateUse first and third quartile returns as a guide to this adjustment. and filled with a tremendous amount of risk. To determine the SCAP risk adjustment, the appraiser must Not to mention these methods provide for ancompare surveyed and subject credit boxes for each capital type. unsubstantiated and skewed valuation!Table 15 shows this comparison for the term loan. The surveyed results represent the qualifying minimum (or If you are a Certified Machinery & Equipmentmaximum) threshold for loan approval. For example, in order Appraiser (CMEA), you’ll learn how to determineto make a loan, lenders require a minimum current ratio of 1.3, and report equipment values. You will be able tominimum fixed charge coverage of 1.3, and so on as a median. reduce your risk of liability and provide the substantiation you need to deliver a defensibleNot all credit box characteristics are considered equally im- Certified Equipment Appraisal that will withstandportant, as the “Very Important” and “Score” columns indicate. scrutiny. Not to mention, you’ll also enjoy increased business opportunities!7 PrivateCo is the fictitious company described in Slee’s Private Capital Marketsbook. The market valuation and other numbers specific to PrivateCo are taken from Isn’t it time that you deliver a defensible businessthat book. valuation which involves machinery and equipment8 With respect to the effective valuation date. that will withstand scrutiny? Call us today, you’ll9 This may be done if the debt was obtained at a point in time recent to the date be glad that you did!of valuation, was at arm’s length, and reflective of market conditions. Furthermore itmay be relevant only if the capital structure, financial position, or business prospectshave not changed materially since it was obtained. Toll Free (866) 632-2467 www.nebbi.orgThe Value Examiner
  10. 10. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S For instance, current ratio and debt to A. PEGs are rightly concerned The next step is to determine Pri- net worth are less important variables about customer concentrations. Pri- vateCo’s CAP by capital type, as shown to the lending decision than total debt vateCo has no single customer that in Table 17 (page 19). service ratio and senior debt to EBIT- represents more than 20 percent of an- By comparing survey results to Pri- DA. The Pepperdine survey asked re- nual sales. The top 10 customers rep- vateCo’s actual or expected results, spondents to score their responses on resent 40 percent of annual sales. The SCAP can be determined for PCOD and a four-point scale. Only senior fixed top 50 customers represent 70 percent PCOE. PrivateCo compares favorably charge coverage, total fixed charge of sales. This diversity of customers and to survey term debt results, as shown coverage, senior debt service, and to- lack of customer concentration would in Table 17, but the loan size is smaller tal debt service scored a 3.0 or above. be viewed as a positive by PEGs. than the $1 million minimum. Thus, For purposes of deciding PCOD SCAP, B. PEGs are less concerned than PCOD SCAP is 0.6 percent, which is the greater weight should be assigned to all of the other categories about mar- number needed to convert CAP to the these variables. ket leadership. PrivateCo is not viewed 3rd quartile survey result of 7.1 percent. As the last column in Table 15 as a market leader in its space. Rather, In other words, PrivateCo can expect to shows, PrivateCo compares favorably it is considered a well run, follow-the- pay an all-in PCOD of 7.1 percent. against median results for all metrics. leader company. Deriving PCOE SCAP requires Since PrivateCo generates a high level C. Historical operating perfor- comparing surveyed results from pri- of EBITDA relative to investment in mance is moderately important to pri- vate equity groups to PrivateCo’s actual the business, its leverage ratios are out- vate equity investors. PrivateCo has a and expected results. As this illustra- standing, as witnessed by a low total fairly stable operating performance over tion shows, PrivateCo would likely be debt to EBITDA of 0.6, which is sub- the past few years. viewed by PEGs as an average candi- stantially lower than median survey D. PEGs view industry sector as date. Thus, PCOE SCAP is 0, and PCOE results. Further, PrivateCo’s coverage moderately important. PrivateCo op- CAP is 30 percent. ratios indicate low debt in the business erates in a sector with relatively long Next we calculate the percentage yet high profitability. PCOD SCAP will periods of stability. This sector is not of capital structure for each CAP and reflect that PrivateCo’s financial results expected to change appreciably in the add the individual percentages to de- compare favorably to 1st quartile sur- foreseeable future. rive PCOC. Table 18 shows PrivateCo’s vey responses. E. PEGs are mostly concerned with PCOC calculation, assuming no taxes. The next step in determining PCOC the future prospects of a company. Pri- In this example, PrivateCo has a is to derive PCOE SCAP. This is accom- vateCo will perform well into the fu- pre-tax private cost of capital of 29 plished by comparing surveyed private ture, but not at a breakneck pace. This percent (rounded). equity group expectations to PrivateCo’s is mainly due to conservative policies The next example determines PCOC results. Table 16 makes this comparison. set by the owner of PrivateCo. given a more complicated capital structure. The surveyed results represent Pri- F. PrivateCo’s management team is vate Equity’s credit box; that is, the cri- seasoned, but mainly home grown. The Example 2: Arranging a Capital teria that prospects must display in or- average tenure of direct reports to the Structure and Calculating PCOC der to qualify for investment. PrivateCo owner is more than 20 years. While this for Middle Market Manufacturing is expected to perform well in revenue offers stability, it may present a problem and EBITDA growth when compared to if a PEG invested in the company and Next we calculate the cost of capital median expectations from the winter/ wished to make major changes. for Middle Market Manufacturing, Inc. spring 2010 survey. However, PrivateCo (MMM). MMM has recast EBITDA of is not expected to surpass 3rd quartile In summary, PrivateCo qualifies for $5 million, and it is determined that expectations in these areas. private equity investment, but would similar manufacturing companies are Private equity groups also scored likely be viewed as an average performer, selling at deal multiples of 7x EBITDA. various investment measures. Private- with average expectations. For this rea- This produces a market value of $5 mil- Co compares as follows: son, PCOE SCAP is zero. lion EBITDA x 7 = $35 million (ignor-16 May/June 2011 The Value Examiner
  11. 11. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E STABLE 14: PrivateCo CaPital struCture anD CaPsCapital Type Market Value PPCML CAPterm loan (cash flow loan) $500,000 6.5%equity $13,700,000 30.0%TABLE 15: CoMParison of surveyeD anD PrivateCo terM loan CreDit BoxesTerm Loan Pepperdine Survey 1st Quartile Median 3rd Quartile Very Import. Score (0-4) PrivateCoCurrent ratio 1.1 1.3 1.3 13.8% 1.7 2.5senior debt service or fixed charge 1.2 1.3 1.3 59.3% 3.2 3.5coveragetotal debt service or fixed charge 1.2 1.3 1.3 80.6% 3.7 2.5coveragesenior debt to eBitDa 2.0 3.0 3.0 46.4% 3.0 .2total debt to eBitDa 2.4 3.5 4.2 57.1% 3.2 .6Debt to net worth 1.9 2.4 3.3 20.7% 2.5 1.5revenue growth rate 0.8% 2.1% 4.5% 10.3% 1.8 7%TABLE 16: CoMParison of surveyeD anD PrivateCo Private eQuity CreDit BoxesPrivate Equity Pepperdine Survey 1st Quartile Median 3rd Quartile Very Import. Score PrivateCo (0-4)revenue growth rate (minimum) 5% 5% 10% 7%revenue growth rate (expected) 9% 10% 15% 7%eBitDa growth rate (min) 7% 10% 10% 12%eBitDa growth rate (exp) 10% 15% 19% 12%Customer concentrations 40.3% 3.2 AMarket leadership 18.6% 2.7 Bhistorical operating performance 29.7% 3.1 Cindustry sector 29.9% 2.9 Dfuture prospects of company 74.6% 3.7 EManagement team 67.5% 3.6 FThe Value Examiner May/June 2011 17
  12. 12. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S ing net working capital). We simplify the ditional adjustments are necessary when investors to report on expected pre-tax example by ignoring the impact of taxes valuing a control level of interest. cash on cash returns for new investments. and assume that MMM qualifies for the Because we collected pre-tax returns, maximum amounts of “cheap capital” Minority Interests discount rates from the survey should be at the median costs. So MMM would The evidence on minority interests applied to pre-tax net cash flows. qualify for 2.5x EBITDA in senior lend- continues to evolve. For middle market ing, which is $5 million EBITDA x 2.5 companies, private equity groups will Diversification = $12.5 million in bank loans. They also purchase minority interests and for doing Investors in the private capital mar- qualify for up to 3.5x in total debt when so, most do not demand a premium in ex- kets (i.e., private equity groups, mez- adding mezzanine financing. Since they pected rate of return as a result. Perhaps zanine funds, venture capital, etc.) gen- already qualify for 2.5x in senior lending, one of the contributing reasons is the com- erally leverage some special industry this leaves an additional 1x, or $5 mil- prehensive set of contracts put together to knowledge or contacts, concentrate in lion, for mezzanine. Finally, in order to protect the fund when making an invest- certain geographic areas, or focus on complete the capital structure at a value ment. These contracts typically include certain sizes of companies. Any one of 7x EBITDA, the private equity group employee agreements, shareholder agree- particular fund generally contains be- would contribute an additional 3.5x or ments, and buy/sell agreements. These tween eight and 25 different invest- $17.5 million in financing. agreements are necessary to entice a pri- ments once fully invested, and those Now that we have built the capital vate equity firm to purchase a minority investments have expected holding pe- structure, we can calculate the private interest in a privately held company. riods of between three and seven years. cost of capital as performed in Exhibit A While the Winter/Spring 2010 Pep- As a result, any particular fund is largely (page 19). For this example, assume that perdine Private Capital Markets Project undiversified when compared to profes- MMM qualifies for the median CAP, thus Survey (Report II) indicated that, for the sionally managed portfolios of assets in SCAP will not be incorporated into the 70 percent of private equity firms inter- the public markets. Furthermore, there PCOC calculation. ested in making minority investments, is a general inability to rebalance port- The private cost of capital in this ex- a median discount of 20 percent was ap- folios by entering/exiting investments ample is 19.75 percent. propriate, more recent data suggests most quickly. The implication is that a gen- are making minority investments with no eral lack of diversification discount, to SPECIAL TOPICS expected return premiums. This informa- the extent one exists, is largely priced in There are a number of clarifications tion puts into question whether a minor- the return expectations of institutional with regard to the application of the pri- ity interest discount should be applied for capital providers. vate cost of capital model. The guidance middle market companies that would be we provide is rooted in the decision- eligible for private equity investment in DLOMs making processes actually employed by today’s economic environment. Discounts for lack of marketability those who deploy capital in the private (inclusive of DLOLs) are assessed and capital markets. Based upon our knowl- Cash Flow Stream: Assets or Equity? calculated relative to the specific data edge of the activity and behavior in the The private cost of capital (PCOC) used in the valuation process. Because private capital markets at this time we rate is to be applied to the net pre-tax cash PCOC relies on expected returns de- offer commentary as guidance on the flows produced by the firm (free cash flows rived from new investments in privately following 10 items. from assets). In the case of using private held companies, DLOMs are largely un- cost of equity (PCOE) as the discount rate, necessary at the company level but may Adjustments for Control the relevant cash flows to be discounted be relevant at the specific interest level. The majority of investment data col- would be free cash flows to equity. lected for private equity group capital Circularity of Value and Cost of Capital deployments reflect control investments. Tax Value depends on cost of capital, Since the return expectations are already The Pepperdine Private Capital Mar- and cost of capital depends on capi- reflective of control transactions, no ad- kets Project survey asked institutional tal structure. In the private markets,18 May/June 2011 The Value Examiner
  13. 13. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E STABLE 17: DeterMination of PrivateCo’s CaP By CaPital tyPeCapital Type Market Value CAP 1st Quartile 3rd Quartile SCAP PCOD PCOECash flow loan $500,000 6.5% 5.4% 7.1% .6% 7.1%Private equity $13.7M 30.0% 25% 30% 0% 30%TABLE 18: PrivateCo Private Cost of CaPital CalCulationCapital Type Market Value % of Total Adjusted CAP Tax Effect Weight x CAPPCoD $500,000 4 7.1% 0% 0.25PCoe $13,700,000 96 30.0% 0% 28.95 Pre-tax Private cost of capital 29.2%ExHIBIT A: MiDDle MarKet ManufaCturing, inC. (Market value Balance sheet) Cost of Capitalassets $M liabilities and equity $M invest. size (CaP)net working capital 0.0long-lived assets 35.0 senior Debt 12.5 2.5x 5.5% subordinated Debt (Mezz) 5.0 1.0x 19.5% equity 17.5 3.5x 30.0%Total Assets $35.0 total liabilities & equity $35.0 7.0xeBitDa $5Multiple 7xMarket value $35MPCoC = (CaP * % market value) + …PCoC = [5.5% * (2.5/7)] + [19.5% * (1.0/7.0)] + [30.0% * (3.5 / 7.0)]Pre-tax PCoC = 19.75%deal values are obtained by applying Optimal Capital Structure It is likely that many companiesa multiple (most often of EBITDA) to In the private capital markets, each will not qualify for capital types lessa recast EBITDA stream. Then the at- capital structure is built one company at expensive than factoring. In thesetention turns to securing financing to a time. The strategy in arranging the op- cases, the appropriate volume level ofsupport the deal. Since that process is timal capital structure is to start with the factoring should be used. For exam-how capital structures are arranged, cheapest sources of financing and then to ple, companies that factor $250,000we recommend using deal multiples to move to the next most expensive source receivables per month have a medianfirst estimate the company value. This once the maximum amount of capital is CAP of 58.5 percent. We believe thatexercise will initially arrange the capi- obtained or after determining the com- most companies of size qualify fortal structure so that the PCOC can be pany wouldn’t qualify for that particular factoring, and that the high cost ofcalculated. Further refinement may be capital source. Repeat this process until factoring reflects its role as the capitalnecessary afterwards, however. all of the capital structure is arranged. provider of last resort.The Value Examiner May/June 2011 19
  14. 14. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S Friends and Family Investments For companies that are able to tap TABLE 19: ManufaCturing CoMPany friends and family as a financing source, Cost of equity Capital Comparison: Buildup vs. PCoC by size (spring 2010) it shouldn’t be assumed that the terms $1M $25M $250M are at arm’s length and in accordance risk-free (survey) 4.0% 4.0% 4.0% to “market” pricing of risk. Frequently equity risk Premium (survey) 6.2% 6.2% 6.2% friends-and-family financing is extend- ed at below market rates because of a industry adjustment (survey) 2.0% 2.0% 2.0% special relationship that exists. In these size Premium (survey) 6.8% 5.8% 4.0% instances, it is not appropriate to use Company specific (survey) 5.0% 3.8% 2.3% the terms of a friends-and-family loan Buildup equity rate (after-tax) 24.0% 21.8% 18.5% or investment. Buildup equity rate (pre-tax @ 30%) 34.3% 31.1% 26.4% Small Companies Small businesses (those that don’t DloM (survey) 20.7% 16.6% 14.0% qualify under any of the credit boxes in Buildup equity rate (Pre-tax, DloM-adjusted) 41.9% 36.4% 29.9% the survey) rely on a variety of financing PCoC (Pre-tax as reported) 30.0% 30.0% 25.0% sources that are not priced by institu- tional capital providers. Small business Difference 11.9% 6.4% 4.9% owners commonly rely on personal in- vestments (savings, investment portfolio, home equity), friends and family, credit and tax treatment, we observe lower net owners, lenders, investors, estate plan- cards, and loans with personal guaran- discount rates using PCOC. One poten- ners, and so forth—rely on valuation tees. As a result, the Pepperdine cost tial explanation for the difference is that methods that are specifically useful to of capital survey does not have market- PCOC rates may reflect costs of capital for making decisions in their markets. driven empirical data at this time to sup- higher quality privately held companies on Why do parties in the private capital port discount rates for this segment of the average.11 markets not employ public information economy. Any capital extended based on In any event, using PCOC as a start- in their decision-making process? Be- a requirement that personal income or ing point will result in significantly few- cause these parties have real money in assets be pledged will not reflect a pure er adjustments and is more aligned with the markets; valuation is not notional to business risk-adjusted cost of capital. the actual markets in which privately them. Making proper financing and in- held companies raise capital. vestment decisions requires using theo- COMPARISON TO CURRENT ries and methods that are appropriate to PRACTICE RAMIFICATIONS OF USING PCOC the subject’s market, such as choosing the One may wonder how PCOC compares The temptation to use readily avail- correct value world and resulting process to equity discount rates currently used in able public information to value private when making a valuation decision. practice. In Table 19, we compared PCOE companies is strong. Note that within the Using a discount rate that is derived estimates from PCOC to those median in- private capital markets, mainly academics from empirically derived, private data puts obtained from the business appraiser and business appraisers use the guideline could alter professional, legalistic, com- survey in the Pepperdine study.10 Once public company method. Other parties pliance business appraisal in four ways. adjusting for differences in DLOM usage in the private capital markets—business First, adjustments such as lack of mar- ketability discounts and control premi- 10 Appraiser results are reported in Pepperdine Private Capital Markets Project Summer 2010 11 We assumed rates reflected controlling ums may not be needed. These adjust- report with exception of the DLOM for controlling interests and also applied DLOMs based upon ments were originally created based on interests, which was not surveyed until Spring 2011. survey results for controlling interests. Final the faulty premise that public return Some of the reported differences, particularly in estimates ultimately depend on the facts and the $1M category, may be attributed to appraisers circumstances of the information pertaining to the expectations could be manipulated to estimating on revenues versus EBITDA. subject interest.20 May/June 2011 The Value Examiner
  15. 15. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E Sderive private values. Once risk is de- rently, an industry of business apprais- needs. This direct estimation processfined using private return expectations, ers inhabits mainly the notional value significantly reduces the need for manythese public-to-private adjustments are worlds. Business owners need more “public to private” adjustments such aslargely unnecessary. help in competing in a global economy. DLOMs and control premiums, and Second, PCOC provides a risk def- The value gap—the difference between more importantly, provides appraisersinition that can be applied across val- what owners want/need the market a framework for helping private com-ue worlds (standards of value). Each value of their businesses to be and the pany managers deal with value creationworld also has an authority, which is value the market assigns—has never measurement and management. VEthe agent or agents that govern the been larger. Tools like the PCOC modelworld. The authority decides whether will help the appraisal industry become John K. Paglia, Ph.D.,the intentions of the involved party are more value-added. CFA, CPA, is the Den-acceptable for use in that world, and ney Academic Chairprescribes the methods used in that CONCLUSION and associate professorworld. More specifically, authority The private capital markets offer of finance at Pepperdinerefers to agents or agencies with pri- market-based solutions to arranging University in Malibu,mary responsibility to develop, adopt, capital structures and determining pri- CA. He is also directorpromulgate, and administer stan- vately held company values. These mar- of the Pepperdine Pri-dards of practice within that world. kets evaluate risk, and price that risk, vate Capital Markets Project. E-mail:Authority decides which purposes in conjunction with granting credit or john.paglia@pepperdine.edu.are acceptable in its world, sanctions deploying investment capital. Despiteits decisions, develops methodology, the proliferation of the private capital Robert T. Slee, CBA,and provides a coherent set of rules market segments over the past couple CM&AA, is managingfor participants to follow. Author- of decades, there has been relatively director at Robertson &ity derives its influence or legitimacy little attention paid to the return expec- Foley, a middle-marketmainly from government action, com- tations of providers of capital as a basis investment banking firmpelling logic, and/or the utility of its for discount rates. in Charlotte, NC. He is thestandards. Authorities from the vari- With four survey cycles completed, founder of MidasNationous value worlds will finally have an the Pepperdine Private Capital Markets (www.midasnation.com),empirically derived method of defin- Project collects data on the activity and an online community for private businessing risk. Hopefully these authorities behavior of the private capital market owners. E-mail: rob@robertsonfoley.com.will prescribe use of PCOC in their segments. Data collected include creditrespective worlds. box statistics and return expectations Third, business owners will finally based upon actual investment checksbe able to determine their companies’ written. These empirical data points,cost of capital. This knowledge will help including return expectations, can nowthem learn whether they are creating be used to derive privately held com-economic value; that is, generating re- pany costs of capital. One such modelturns on invested capital greater than that employs the Pepperdine data is thethis cost. This should promote eco- private cost of capital model.nomic value creation as a practical and The PCOC model is a market-based,useful tool. Plus it opens an avenue for empirically driven solution for estimat-business valuators to consult with busi- ing discount rates for privately heldness owners to help them make better companies. PCOC makes the discountinvestment and financing decisions. rate estimation process relevant by ex- Finally, the PCOC model will make amining the actual markets where pri-business appraisal more relevant. Cur- vately held companies fund their capitalThe Value Examiner May/June 2011 21