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BARBARIC VALUES: The Civilised Way

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Investment techniques

The asset management industry, trading primarily in the public equity space, evaluates listed companies and estimates the future performance of such companies through proven methodologies and techniques. These are well known, such as the price/earnings (PE) ratio, headline earnings growth, EBIT and EBITDA margins and multiples, net asset value, quick and current ratios, net debt to equity, interest cover, return on equity, return on assets, book value per share, price to book, share price history (versus peers, sectors, all share indexes, etc.) and many more.

Sophisticated valuation techniques are also used, such as Monte Carlo simulations, Black–Scholes models and discounted cash flows. The highly sought after Chartered Financial Analyst qualification seeks to engrain a host of methods to value public equities.

The aim of these methodologies is to produce a targeted share price within a specific time frame, and recommend a “buy”, “hold” or “sell” recommendation in relation to the current share price. The desired outcome is to buy a specific share at the right time and then sell that share at the deemed appropriate time to achieve a satisfactory profit. In the public environment, sentiment and group behaviour is real and relevant, and often they drive share prices.

Profits may be achieved over varying holding periods, from owning a share for years to intra day trading. Hence the difference between the so called “traders” and “value investors”. The main difference being that value investors hold on to shares for longer periods of time, while also basing their investment decisions on in-depth research and valuation techniques.

Value realisation

Asset managers, as a rule, do not get involved in the day to day running of portfolio companies. Very little, if any, effective shareholder activism exists in South Africa, perhaps with the exclusion of a few large institutional shareholders, which in reality are more focused on governance and compliance rather than the creation of shareholder value.

Rarely are board appointments dictated by asset management firms, or executive management replaced if prolonged underperformance occurs.

Indeed, the aim of the typical asset manager is not to achieve profit through the nurturing of the portfolio company to a bigger, better, and more streamlined entity. The asset manager is focused on timing its entry purchase and exit sale to achieve maximum reward.

Table 1 (opposite page)is a table that illustrates the typical contradictory reactions between asset managers and private equity fund managers, on a non-exhaustive set of circumstances: See table 1.

 

Table 1

Circumstance Asset manager reaction Private equity fund manager reaction 
Sustained under performance Liquidate its shareholding Revisit strategy 
Sub-optimal balance sheet Liquidate its shareholding Restructuring 
Poor or non-implementation of strategy Liquidate its shareholding Replace CEO 
Sustained margin pressure Liquidate its shareholding Revisit strategy 
Fraud/sudden resignations Liquidate its shareholding Replace management / reorganize 
Unexpected downturn in markets or cyclicality Liquidate its shareholding Adjust business plan / extend
holding period 

The Barbaric Way

Investment techniques

All that has been mentioned in terms of investment techniques are well known in the public domain. What is less well known is how private equity practitioners identify and benchmark potential transactions. The general consensus is that private equity firms will not approach highly indebted companies, although this has proven not always to be the case in the past.

So how do private equity firms identify attractive companies? The following questions are still relevant:

  • What is the company’s gearing capacity?
  • Does it have sustainable cash flow and can the cash flow be improved through the active intervention of the private equity investor?
  • What are the growth opportunities and the scope to improve the quality of earnings?
  • What is the quality of management?
  • What are the potential exit opportunities?

A number of other methods are also used by private equity practitioners. The following is a technique frequently employed by Absa Capital Private Equity in benchmarking potential acquisitions. The aim of the technique is to ascertain whether the acquisition price being offered is reasonable. The technique is best explained by using the following example:

Company A, a services company, is identified as an attractive opportunity, but the PE ratio offered seems excessive (in this case 21). To benchmark the purchase price offered, the company is compared to two other recent acquisitions: company B, in the manufacturing industry, and company C, in the retail industry.

The technique relies on the one year forward EBITDA, average projected EBITDA growth, capital expenditure and working capital projections. The aim is to calculate a ratio similar to the commonly used PEG ratio
(Price Earnings divided by forward growth): See Table 2 below.

Table 2

Company A Company B Company C 
EBITDA 100 200 300 
Capital expenditure (15) (33) (71) 
Working capital (46) (5) 
“Free” cash flow (FCF) 91 121 224 
Purchase price (PP) 933 917 2,667 
PP/EBITDA 9.3 4.6 8.9 
Cash flow multiple (CFM = PP/FCF) 10.3 7.6 11.9 
EBITDA growth (G) 16% 10% 16% 
CFM/G ratio 64.1 75.8 74.4 

 

As can be seen from the example above, company A achieved a CFM/G ratio lower than companies B and C, although the EBITDA multiple of company A (9.3) is much higher than that of company B (4.6) and slightly higher than that of company C (8.9). The PE ratio of the company in question is substantially higher than both companies B (9.5) and C (13.9).

The lower CFM/G ratio suggests a stronger buy signal for company A, while less so for companies B and C.

The main reasons for the different CFM/G ratios are easily explained, as they are driven by the different lines of businesses these companies are in:

  • Capital expenditure requirements.
  • Working capital cycles.
  • Projected EBITDA growth.

Naturally, the method does not take into account a number of factors, such as management efficiency, company life cycles, regulatory environments, etc. However, the aim of the CFM/G ratio is to benchmark a purchase price offering in the first instance, and to provide a consistent purchasing discipline and methodology in the second.

The CFM/G method does clearly illustrate that high PE and EBITDA multiples, as investment tools on their own, are more often than not misleading. To purchase a company on a “low” PE, or to resist a purchase on a “high” PE may in fact lead to incorrect investment decisions.

Value realisation

In stark contrast to public side asset managers, the typical private equity firm takes a longer term view on its portfolio companies. The private equity manager is actively involved in the running of its portfolio companies, interacts with management and the board on at least a monthly basis, strongly influences the appointment of the board and management, and is not afraid to dismiss board or management individuals for underperformance. The aim is to drive value creation through strategic input from all parties, and to hire outside specialists to assist in the process, often actively identifying growth and exit opportunities.

The three main reasons for the different CFM/G ratios, as as referred to above, are very relevant in a private equity environment, while less so in a public listed environment. All three items focus on one thing: cash flow. In a geared environment, none is as sacred as free cash available to repay debt.

The Conclusion

The methodologies and techniques used by public-side investment managers do not differ materially from those used by private-side investors. However, an asset manager is more focused on share price and dividend growth, as driven by company growth, and the timely purchase and sale of its equity to realise a profit.

The private equity manager is also driven by company growth, but it achieves its profit through financial leverage, increasing the efficiency and effectiveness of management and encouraging strategic and change thinking through partnering with management and the board of directors whilst also actively identifying growth and exit opportunities.

The fundamental difference is the interpretation and different applications of valuation techniques. This is proven by the sustained out performance of the private equity industry.

In the end, both the public and private managers are motivated by the maximisation of returns for investors, but the roads travelled take different turns and may have very different outcomes.

Wouter Viljoen BCom PDA, CA(SA) is  a deal executive at Absa Capital Private Equity.