My company insists on calculating equity multiples on investments using peak equity outstanding in the denominator. I keep trying to tell them that this approach is too conservative especially the way we invest. We close all equity and put debt on our investments a short time after. So theoretically if we close a deal all equity and put debt on in day 2, we still show our investors a completely unleveraged multiple when we report performance.
I’m trying to get them to consider using an average equity outstanding denominator and was wondering how common this is or what other methods folks use when the amount of equity outstanding can change depending on when debt is placed on an investment.
Not sure if we are talking about just plain vanilla public equities here, but if we are, here’s what I do…
You should glean as much as you can about the company’s capital raising / dilution tendencies and make your most educated guess on share count at the timeframe that aligns with your price target. Otherwise, the most recent shares outstanding is the next best guess.
For example, if you are trying to calculate a 12-month price target, and a company has 50mm shares outstanding today but 12 months frmo now, you think it will have needed to issue more equity and ends with 55mm shares, then your denominator should be 55mm shares. Many people don’t do this and that is what leads them to having a price target that is too optimistic.
Sounds like he’s dealing with RE or something, in which case I’d be curious to what extent the equity multiple valuation varies from the comps valuation, etc.
I also don’t understand why investors are being shown an unlevered multiple. So you close all equity, then put on debt. At that point, what does the capital structure look like? How much equity is still outstanding? I just don’t have enough details on what’s going on.
i’m talking about total returns on held investments basically, as in (“how much we made on such and such investment”) / (“how much equity we put into such and such investment”). specifically for a certain alternative asset class, but that is not so important i don’t think.
it’s not so much for valuation (we use IRR, although expected multiple gets some consideration, especially for short term holds) but for performance reporting.
So your company buys asset A for $1 million. Then a couple of days later gears up 50/50 by borrowing another $1 million. On your company accounts, you initially value the asset at $1 million. Over time, that value will grow as EBITDA increases and/or debt is paid down.
For private equity funds, they report performance typically using TVPI and IRR. What methodolgy are you using to calculate performance?
Can you give a simple example to explain how your firm is valuing the asset currently versus how you think it should be done?
We buy 150,000 pounds of pork bellies for $1 million using all equity. A day later we say, “hey, we can get a loan secured by this asset for 50% of the cost”. So we take out a loan for $500k and use the loan proceeds to return capital to our investors. A week later we sell the pork bellies for $1.5 million.
When we report how we did to our investors, the question becomes: what equity base do we use to calculate an equity multiple which equals (total money returned) / (equity invested).
Our current method:
We put out $1 million in equity, so $1 million is the denominator. The loan proceeds would be classified as an inflow so it goes in the numerator along with the sale proceeds after debt repayment. In this method our equity multiple is 1.5x (the same as if we had no leverage on at all).
My issue with this is the investment was leveraged for 85% of the hold period, yet we’re showing our investors performance that corresponds to an unleveraged investment.
If we’d put the debt on concurrently with the acquisition, the multiple would have been reported as ($1.5 MM - $500k) / $500k = 2.0x
I think a more representative calculation would be a weighted average of the two calculations based on how much of the hold period was leveraged and i was hoping some of you would be able to comment on whether or not that or some other method is used to address this issue.
That’s interesting alright. You could make a reasonable case for calling it a 2x return in your example. In a private equity fund I imagine what would happen is that the LPs would only ever get a capital call for $500k and hence they would see a 2x return. The other $500k would be temporarily paid for through a bridge loan or revolver facility until full bank financing was secure.
If you know at the time of making the investment that you are going to lever it and will do so effectively immediately, then I think it is reasonable to report the 2x return. If there is a significant time gap between the initial investment and the financing then I would consider that a dividend recap and report it as a 1.5x TVPI.
Your weighted average method seems logical as a compromise, but my only issue with it is that it isn’t the industry standard so clients will probably find it confusing and may question your methodology.
Unless the investor really is putting up 50% less capital, I think it’s hard to argue that you should use the levered return.
You can have your marketers explain to the client that because the return of half capital happens quickly, you can actually think of the investment as levered, but they still have to have the initial 100% liquid in order to participate in the investment, which is often a real concern for clients. If you use the un levered number, you save yourself having to explain that, and possibly a lot of headaches from compliance. If you were able to provide that initial financing yourself so that only 50% of the equity was required from the client, I think it would be much easier to use the levered numbers.
For recording historical performance, you’ll get many fewer questions about your trustworthiness if you use the unlevered numbers, plus your clients will get the benefit of thinking they are brilliant for deciding to levering up all on their own, which will likely make them more excited about investing with you.
thanks for the feedback. we do use a portfolio credit facility as a placeholder for asset level debt before it goes on most times, and the example i gave is extreme in the timing of putting on debt. sometimes we intend to hold unleveraged and later on the opportunity to put debt on makes sense. Our investors’ money is pre-committed and we have full discretion so it’s not like they’re writing a check every time we close something - i.e. there’s some grey area as to the timing of equity going in and out. that gives us more leway in how we choose to report performance.
Really the only reason to want to show a ‘more’ leveraged multiple is if competitors are using the more aggressive methodology. that could hurt us when investors compare our performance to our peers. in any case the consultants probably normalize managers’ calculations by using the raw cash flows to calculate it the same way accross managers, so the whole exercise may be moo (you know like a cow’s opinion, it doesn’t matter).