Hi all,
I work for an m&a team and we are currently working on a fairness opinion. The issue I’m facing is that we are valuing some private assets and end up getting an 8% wacc, however, our client gets roughly the same wacc and then he adds an operational premium of another 9% so his wacc is about 17%. I am struggling to find a way to increase our wacc but cannot find how to justify such operational premium and the clock is ticking, my md wants to see the model asap
Any thoughts or ideas?
Thanks in advance
Uh... ask your associate?
Shouldn't the operational risk be captured in your comps' cost of capital?
If not, and there's a unique and real operational risk to the assets your valuing, can't you quantify it, i.e. there's a pending regulatory action that has an X% chance of resulting in a $Y fine? If so, I'd model that separately and subtract the NPV of it from whatever your normal DCF yields.
It seems to be exactly that. There’s a unique operational risk to this firm and the client have quantified it by adding an “extra” op. Premium of 9%. I see the point of lowering the cash flows to end up having an EV near the clients’ with a much lower wacc... what about slightly decreasing EBITDA margin over time though?
I would NOT add a random percentage to the WACC and apply that to all the cashflows, even the ones that aren't subject to whatever this risk is.
Can't tell from your response if the operational risk is a binary thing (e.g. pending litigation or a regulatory action that will or won't happen, and if it will, it will only happen once) or something that affects some portion of the business on an ongoing basis.
But if you're rendering an opinion, you do not want to be sitting in a deposition someday explaining where an extra 9% WACC randomly came from. Much easier to say that management identified a certain portion of their future cashflows that were at higher risk than that of the rest of the business (and the comps), gave us a % likelihood of those cashflows actually materializing, and we applied our CAPM-based WACC to it after taking that risk into account.
Your client is using extended CAPM. The 9% premium is an alpha factor that's not included in standard CAPM. There's no way for you to get there with basic CAPM. You need to adjust your model/include additional factors.
Some factors that might help you out: Size premium; liquidity premium, country risk premiums.
As an FYI, you shouldn't use standard CAPM for private company valuations. Typically a build-up method/extended CAPM is relied on.
Thanks for the answer.
I have included country risk and size premiums but there is still this operational premium that I don’t really understand. Is lowering the cash flows a possibility to offset this effect?
Yes well that's what the company specific risk factor is trying to capture. Certain, company specific variability factors not related to general market risk. You could do it with probability adjustments but it likely won't be clean/will be complicated.
Also want to throw in that if this is going into Fairness, your figures will be further scrutinized by counsel and shareholders so may be best to have this conversation with your deal team on how to get to your target WACC
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