The spread of COVID-19 has materially weakened the operating results of many companies in Q2 and Q3. Adding insult to injury, a portion of these companies are also servicing heavy debt loads, which is further constraining liquidity. When declining operating results meet heavy debt service obligations, the result is often down round financing. Of course, there is not only significant concern on the part of both boards and existing investor groups with regard to the pricing of such a financing round, but also potential biases that may understandably exist between new and old investor groups. The goal of this article is to highlight some key concepts from financial valuation theory and practice that may be helpful in ascertaining fair equity valuations in such circumstances in the current environment.
Key Concepts in the Current Environment for the Discounted Cash Flow Method
Re-levering of Beta is a key concept in estimating the near-term required rate of return on equity.
With regard to a reasonable cost of equity estimate, modern financial theory and practice suggests that we ought to focus on Beta within the capital asset pricing method (CAPM) framework (specifically, first estimating an unlevered Beta, and then re-levering it at the subject company’s debt-to-equity (D/E) ratio). Unlevered Beta reflects only relative systematic volatility of equity (in a debt-free environment), while re-levered Beta reflects the incremental equity volatility that reasonably manifests due to the existing debt load. The other components of CAPM, while by no means a “given,” are arguably somewhat less prone to material swings in interpretation, application, and magnitude than Beta.
The effort to estimate a reasonable unlevered Beta for any subject privately-held company typically comes from an analysis of a sample set of guideline publicly-traded companies (GPCs), where such Betas are often readily observable. However, the key concept of re-levering Beta is then optimally conducted as an iterative process on expected-value projections within the discounted cash flow method, which is able to directly address the D/E ratio necessary for the calculation itself. In times of crisis such as the current climate with the COVID-19 pandemic, it is not unusual for an iterative, re-levered Beta to indicate costs of equity capital that are in line with those sought on an ex-ante basis by venture capital (VC) investors (i.e., 30% to 50% per annum or higher). In light of that analogy to VC investments, it should be fairly obvious that such relatively higher costs of equity reflect a relatively higher probability of loss to shareholders.
Marginal cost of debt is a key concept in estimating the subject company’s near-term WACC.
While it may seem reasonable to use a firm’s actual cost of debt in the traditional WACC formula, the appropriate rate would be the firm’s marginal cost of debt, which can be understood as the yield demanded on the next dollar of borrowings. For firms that are contemplating down-round investments, it is not unusual for the marginal cost of debt to be materially higher than the cost of existing debt. The estimate of marginal cost of debt may come from an observation of a recent debt financing of a guideline firm with comparable operations and credit quality, or it may come from a broader yield analysis of multiple debt securities of firms exhibiting similar ratios/ratings, or perhaps some other source obtained by the management team. Furthermore, as the implicit debt-to-capital (D/C) ratio of the subject company increases, the marginal cost of debt also increases, and, as a practical matter, at very high D/C levels this marginal cost of debt is understood to approach the unlevered cost of equity. Indeed, alluding to the prior analogy to VC investments, it is not unusual to observe venture debt rates in the range of 10% to 14% or higher, which, as noted, are understood to be approaching those subject firms’ unlevered costs of equity. Of course, and as expected, for firms with relatively high D/C ratios the post-tax marginal cost of debt will by definition dominate the WACC calculation over the near-term, so a heightened level of rigor on the pre-tax marginal cost of debt estimate (as well as the post-tax estimate, through consideration of the limitations on tax-deductibility of interest in light of the TCJA and current CARES Act allowances) is warranted.
Finite time horizons are a key concept of abnormal (venture-like) costs of capital.
As previously alluded to, costs of capital that approach the ex-ante required rates of VC investors imply a relatively higher probability of loss to investors over the near-term, which for discussion purposes might reasonably be estimated at three to five years. However, these costs of capital also contemplate a material probability that the firm is ultimately “successful” at the end of the venture investors’ holding period, at which time the cost of capital is expected to “normalize” into perpetuity. Accordingly, a modeling of a normalization of the cost of capital as a terminal condition is warranted in such circumstances, and may in fact imply exit valuations of, and exit multiples on, the subject company at that future date that are in line with the broader expectations of market participants. In contrast to the prior discussion of WACC, a normalized WACC will likely be dominated by the estimated cost of equity (at a much lower re-levered Beta), with an attendant assumption of a perpetual, sustainable debt load to reduce the overall cost of capital through the tax deductibility of interest.
Key Concepts in the Current Environment Regarding Market Multiples
Revenue multiples are a key concept during operational downturns.
When operating metrics such as EBITDA decline materially for a given company or industry, the instructiveness of observed EBITDA multiples, such as the commonly used business enterprise value (BEV)/EBITDA multiple, is often reduced. However, while the instructiveness of BEV/EBITDA multiples may be reduced in such scenarios, the instructiveness of observed BEV/revenues multiples (BEV/R) is often quite strong by way of their frequent correlation with relevant performance data such as EBITDA margins. From a statistical perspective, the confidence achieved from such analyses increases with the number of observations utilized, and thus analyses of market multiples that consider more observations are typically preferable to those that consider fewer.
The appropriate treatment of operating leases is a key concept with regard to “debt,” BEV, and EBITDA.
In the wake of the adoption of Accounting Standards Codification (ASC) Topic 842 – Leases, capitalized operating leases (COLs) are now being recorded on the balance sheet as debt. Accordingly, and literally overnight, the BEV of many GPCs appeared to “jump” materially on various financial information databases due to the significant amount of COLs now on the balance sheet. For many industries, such as retail chains, the amount of COLs on the balance sheet can be large, and this has caused some confusion with regard to the calculation of BEV multiples, among other things. Notably, we observed one prominent database service proposing that the proper way to respond to this new accounting treatment was to formulate BEV multiples by i) removing COLs from BEV, and simultaneously ii) removing rent expense from EBITDA (i.e., EBITDAR). This, of course, only compounded the original confusion of having COLs in the BEV calculation in the first place, and caused a brand new mismatch error altogether. The analytical preference here would be to exclude COLs from BEV (while leaving rent expense in EBITDA), but an alternative treatment of leaving COLs in BEV while utilizing EBITDAR appears to be gaining a following and may also be acceptable.
Reduced relevance of historical M&A multiples is a key concept during market disruptions.
In contrast to the market multiples observed above from GPCs, which at least reflect contemporaneous investor sentiment, M&A multiples observed in pre-pandemic time periods may be viewed as somewhat less relevant in the current environment due to the changes in the risk sentiment and growth outlooks that began in late Q1. In other words, the primary drivers of multiples can be boiled down for illustration purposes to risk (i.e., cost of capital) and growth, and either an increase in risk or a decrease in growth expectations (or perhaps such changes simultaneously) can reasonably be expected to result in relatively lower multiples. Conversely, a decrease in risk, or an increase in growth expectations (or perhaps both changes simultaneously) can reasonably be expected to result in relatively higher multiples. In either case, the pre-pandemic levels of risk and growth expectations embedded in historical M&A multiples may no longer reflect current sentiment, thus rendering historical M&A multiples less relevant.
When operating results weaken for highly leveraged companies, equity valuations require a heightened awareness of how to best use and interpret the tools of financial valuation. Both Beta (unlevered and re-levered) and the firm’s marginal cost of debt are key concepts in estimating the near-term, ex-ante weighted average cost of capital, as part of an iterative process, when the near-term post-tax marginal cost of debt may dominate the WACC calculation. However, the relatively high WACC estimates that result from such calculations are only appropriate over finite time horizons, analogous to the near-term, ex-ante holding period expectations of venture equity and debt investors, with more normalized costs of capital observed into perpetuity where, in contrast, the normalized cost of equity will then likely dominate the WACC calculation. Contemporaneous BEV/R multiples observed for GPCs, as well as a thorough understanding of the appropriate treatments of COLs and rent expense (for BEV and EBITDA margin, respectively) under the new accounting guidance, are likely to be informative for further confirming such down round equity valuation estimates in the current environment.
 BEV = Equity + Debt - Cash Equivalents