Hi guys,
I am valuing a private equity investment in one of our funds. We have a disagreement on the best valuation methodology for a DCF.
A. Discount your cash flows with a 5% extra risk premium, discount the equity value by an additional 20% for lack of marketability
B. Discount your cash flows without the extra risk premium, discount the equity value by an additional 20% for lack of marketability
C. Discount your cash flows with a 5% extra risk premium, no additional discount.
What is the most accepted methodology? Do we consider that the extra 5% compensates for both the lack of diversification and the illiquidity so that no further discount is required?
Thank you for your help.
Based on the most helpful WSO content, the approach to valuing private equity investments using a DCF depends on ensuring consistency in your assumptions and methodology. Here's how the options stack up:
Risk Premium on Cost of Equity: Adding a 5% extra risk premium to the discount rate can account for the lack of diversification and the illiquidity of the investment. This is a common approach as it integrates these risks directly into the discount rate, which aligns with the principle of consistency in DCF valuations.
Discount for Lack of Marketability: Applying a separate 20% discount to the equity value for lack of marketability is another method, but it risks double-counting if you've already adjusted the discount rate for illiquidity.
Combining Both: Using both a 5% risk premium and a 20% marketability discount (Option A) could lead to over-penalizing the valuation unless you can justify that the 5% premium does not fully capture the illiquidity and lack of diversification.
No Extra Risk Premium, Only Marketability Discount: Option B assumes the 20% discount alone is sufficient to account for illiquidity, which might not fully reflect the risk profile of private equity investments.
Risk Premium Only, No Marketability Discount: Option C is often seen as the cleanest approach, as it avoids double-counting and integrates all risks into the discount rate.
Recommendation:
The most accepted methodology would typically lean towards Option C, where the 5% extra risk premium compensates for both lack of diversification and illiquidity. This ensures consistency in your DCF assumptions and avoids the risk of double-counting. However, the choice ultimately depends on the specific context of the investment and the preferences of your fund or valuation team.
For further insights, you can explore discussions on DCF methodologies and consistency tests here:
- url: https://www.wallstreetoasis.com/forum/private-equity/dcf-myth-1-if-you-…
Sources: DCF Myth 1: If you have a D(discount rate) and a CF (cash flow), you have a DCF!, Biotech finance part 2: valuation methodologies and modeling considerations, DCF Myth 1: If you have a D(discount rate) and a CF (cash flow), you have a DCF!, DCF Modeling Course ~ Pre-training text.pdf, Walk me through a DCF
Before I answer, I think this is a bit of an insane question. Why 5%? Why not 8%? Or 2%? Why not 3% when there is an odd number of elephants in the world and 5% when there is an even number of elephants? I guess what I'm getting to is that with such an arbitrary approach to valuation, it's difficult to come up with a "standard" or best practice. (Sorry to give you a hard time - maybe you have good rationale for those numbers not explained in the text body!)
That said, theoretically the lack of marketability should not impact your discount rate. Why? Because I could hold your business forever, and never sell it, and the lack of marketability doesn't impact the risk profile of the cash flows themselves. Lack of diversification does.
The marketability thing is much more proper as a cut to the equity value. For exactly the reverse reason as above. If I don't ever sell the business, that shouldn't impact the equity value.
Thank you for your answer.
I tried to simplify the question as much as possible. The 5% CSRP and 20% DLOM are for the sake of example. Both numbers are calculated based on the characteristics of the private company and have a broader range of outcomes. We use size, management quality, industry dynamics, financial risk.... to assess the specific risk of the investment and determine a theoretical increase in required rate of return and illiquidity risk.
I asked the question because we tend to do C. (and use the discount for multiples), but I have seen a valuer use A. for one of my investees. However, it looks like you are suggesting B. instead! Is that the methodology you see the most in the industry?
Thank you
Fair enough on the 5% and 20% - I trust your judgments on those specific numbers!
Sorry I was suggesting A.
If you had a well-diversified company which was difficult to market, then you could just hold it forever and enjoy the cash. Marketability itself does not create any risk in the cash flows, and so you shouldn't add a risk premium for that.
If you had a highly marketable company but which was not diversified (say, highly dependent on one customer), then there's a big risk in those cash flows over and above a comparable company with a well-diversified customer base, and so we should add a risk premium for it.
You have both, so you should do both.
HOWEVER, if the company lacks marketability BECAUSE it isn't diversified, then you might be double counting, but I'd still say you should have both discounts. Why? Because you're at a PE fund and you won't be holding this asset forever. You need to sell it. If you were at a corporate and this was a subsidiary, I'd feel differently, but you need to sell.
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