According to a study of 224 family offices, private equity represented 22 percent of assets on average, more than any other asset class except listed equities. Most family offices invest directly (61%) versus indirectly through a private equity fund.
This is not a surprise as many family offices are created by people who may have been entrepreneurs themselves or managed family businesses. Leaders of family offices are often sophisticated investors who are familiar with leading companies and many seek to take an active role, especially with companies in their own industry. Further, family office investors are often courted by companies as patient investors willing to commit capital for longer periods versus seeking a short-term exit, rather than a traditional fund that has a pre-defined exit date.
The liquidity premium generated by private equity is particularly attractive to family offices; their ability to commit capital with greater control can lead to significantly higher returns over time. For many family offices direct investment in private equity can also allow them to time investments to their own time horizon, creating tax or estate planning benefits.
However, private equity investments can be complex, hard-to-value investments. They typically contain options and market conditions such as return multiples or thresholds, and specific internal rate of return (IRR) and price-performance targets that alter the cash flows over the life of the investments. The complexity arises in connection with corporate transactions, external financings, capital raises and the implementation of incentive compensation plans or awards.
Family Matters: Valuation Considerations
Family offices making private equity investments need to be aware of a number of valuation issues related to investments in more complex structures:
Valuation Method and Financial Model Selection
Making direct company investments requires selecting the proper valuation approaches and using an accurate financial model. Approaches considered most applicable for going-concern companies include the income approach and the market approach (the cost approach is more appropriate for holding companies or businesses that may be contemplating liquidation of some or all of its assets). The income approach requires robust financial projections, usually prepared by the subject company’s management, which may or may not be available to family office investors. The market approach relies on guideline publicly-traded companies or guideline change-of-control transactions – the key to these methods is to find sufficiently comparable companies from an operational, financial and size standpoint, which is often difficult for niche businesses. Each of these approaches are more or less meaningful depending on the subject company and market data available for analysis.
Once the proper methods are decided upon to value the subject company as a whole, family office investors may also need to consider a financial model that captures the unique feature(s) specific to the security’s structure. Such models may be statistical in nature, employ a numerical method versus a closed-form solution, and dynamically capture feature interactions in the context of the total instrument. For more complex securities such as stock options, profits interests or other derivatives (discussed below), these components may be modeled with simulation and lattice approaches to arrive at an expected value, capturing security-specific and market inputs.
Many family office investors want to know what their investment is worth at a particular point in time. The FASB Accounting Standards Codification Topic 820 (ASC 820) provides guidelines for determining the fair value of portfolio investments on a periodic basis, usually quarterly. Prior to ASC 820, private equity investments were typically held at cost unless there was a “milestone event,” such as another round of financing or an offer or sale. Often, there was no write-down unless a bankruptcy or down round occurred.
The valuation of restricted stock and the valuation of profit interests are topics VRC has addressed in past articles. Restricted stock awards are granted in a variety of forms as incentive compensation to management and other investors or interested parties. Profit interests are equity incentives made available to executives, management, key employees and service providers similar to stock options but issued by limited liability corporations. Many privately-owned firms are required by Internal Revenue Code Section 409A to value incentive options to support option grants for tax purposes.
Patience is a Family Virtue
The data suggests family offices are increasingly participating directly in private equity deals. While many family offices have the patient capital and time horizon to take advantage of private equity, they may not have the staff to address more complex valuation issues when making direct investments in illiquid companies. An independent valuation provider can be an important partner to support the investment decision or provide critical information for tax or estate planning purposes.
For a more in-depth conversation about how VRC can develop a valuation assessment for your business, please feel free to contact your VRC professional.