Middle Market Private Equity M&A Activity – Q1 2020

Click to Download:  Middle Market Private Equity M&A Activity – Q1 2020 Market Valuations Shift

Executive Summary

Valuations Heightened

The simple average Enterprise Value (EV) to EBITDA multiple of 7.4x for Q1 2020 was marginally higher than the previous four quarters. This was the net result of a shift in sentiment considering size and industry factors.

Size Premium

Size became an even greater pricing consideration for the middle market as transaction multiple variances widened for acquisition targets above and below $50 million.

Continued Use of Leverage

Total debt to EBITDA remained at 3.9x from 2019. Senior debt to EBITDA rose steadily to 3.5x, up from 3.2x and 3.0x in 4Q and 3Q 2019, respectively.

Distribution Takes the Top

Transaction multiples for the distribution industry sharply rose above the health care services and technology industries for the first time over the past five years.

Based on our review of GF Data’s latest M&A Report, the reported results for Q1 2020 display a slight increase in transaction multiples, contrary to previous, first-quarter declines.  Although enterprise value (EV) to EBITDA multiples rose to 7.4x, an increase of 0.3x from Q4 2019, material shifts occurred between company size and industries as a result of the COVID-19 pandemic. The total number of reported Q1 2020 transactions remained normal at 62. Most of these transactions took place in the first two months of the quarter before business conditions weakened in early March.

Middle Market Private Equity M&Amp;A Activity - Q1 2020

Average EV/EBITDA transaction multiples increased for the larger companies in the $50 – 250 million enterprise value range and decreased for the smaller companies in the $10 – 50 million range. The increased market uncertainty likely caused a premium to be paid for the larger and perceived safer, companies.

Industry Analysis

We analyzed industry average EV/EBITDA multiples of acquisition targets to gain a more in-depth understanding of how the market perceived industry risk and growth prospects as COVID-19 began to disrupt the marketplace during the first quarter. Approximately 80% of the reported deal volume comprises four industries: manufacturing, business services, health services, and distribution.

Middle Market Private Equity M&Amp;A Activity - Q1 2020

The average EV/EBITDA transaction multiple for health care services experienced a steep decline to 7.4x in Q1 2020, down from 8.4x in 2019. The health care services industry has been negatively impacted in the short-run by the COVID-19 pandemic, as both practices and patients avoided preventative check-ups and elective treatments.  On the contrary, the distribution industry average EV/EBITDA multiple increased markedly to surpass all other recorded industries. The distribution industry was valued extremely high in the first quarter as consumer e-commerce presence and demand for deliver-to-door goods grew considerably. Manufacturing and business services transaction multiples remained approximately the same over the last few years. The technology industry experienced a dip in its average EV/EBITDA valuation multiple to its lowest level since 2016. There was no recorded Q1 2020 transaction data for the retail and media telecom industries.

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Middle Market Private Equity M&Amp;A Activity - Q1 2020

Michael Hanan

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The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

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Illiquid vs. Insolvent – Understanding the Difference

Click to Download:  Illiquid vs. Insolvent: Understanding the Difference

Executive Summary

The Issue:

Companies are facing cash shortfalls as they struggle to reopen from the COVID-19 lockdown.  Companies facing short-term liquidity challenges can seek new cash sources, such as the government’s Payroll Protection Program “PPP” or a bank line-of-credit.  However, certain companies may never achieve the revenue and profitability necessary to remain viable as a going-concern and may ultimately be forced into bankruptcy.  Understanding whether your company faces a liquidity or solvency issue will allow you to most efficiently utilize your available resources.

Illiquid vs. Insolvent

Operating models of illiquid companies may be viable in the long-term, but cash issues could arise in the near-term due to poor cash management or an exogenous shock to the company’s operating performance.  Insolvent companies, on the other hand, have an unsustainable operating model to support operating and debt obligations over the long-term.

What Needs to be Done?

A complete understanding of the company’s financial obligations and operating outlook is necessary to understand whether the company is experiencing a liquidity or solvency issue.  Companies which are publicly traded or have bank debt may require solvency opinions to be performed.  ValueScope’s team of experienced financial analysts and consultants can help you understand what your options are to get through this difficult time.

Our team of professionals provides:

    • Experience- we’ve conducted solvency and liquidity analyses for clients across the country
    • Credibility- Ph.D.’s, CFA’s, CPA’s, ASA’s, CVA’s, and MBA’s
    • Independence- we have the personnel, expertise and research resources to provide the assurance you require for a solvency opinion

The Issue at Hand

As businesses have been unable to fully function because of the COVID-19 pandemic, governments have stepped in to provide stimulus packages to equip them with the resources to survive the short-term.  In the United States, the Payroll Protection Program (“PPP”) was set up to provide small businesses with a direct financial incentive to keep their workers on the payroll [1].  Yet the PPP, or any realistic government program, can only solve a business’s short-term liquidity issues.  When a business’s operating performance struggles for a prolonged period of time, and their short and long-term cash inflows are no longer able to meet their financial obligations, the company could become insolvent.

Understanding a Liquidity Issue

A company’s liquidity is a measure of its ability to meet its near-term financial obligations.  Companies can be profitable with positive cash flow and experience liquidity issues.

As an example, assume ABC Company has the following cash flow statement:

Illiquid Vs. Insolvent - Understanding The Difference

As the cash flow statement indicates, ABC Company has positive monthly net income of $100, and sufficient cash flow to cover their necessary capital expenditures and debt repayment obligations.  As a result, the net monthly cash flow is positive $50.  However, a profitable company can still experience a short-term liquidity issue.

As mentioned above, liquidity issues arise when a company cannot meet their near-term financial obligations.  Imagine that ABC Company has the following balance sheet:

Illiquid Vs. Insolvent - Understanding The Difference

Companies experiencing a liquidity problem often face a disconnect between their current assets and current liabilities.  As the ABC Company balance sheet indicates, the company’s current ratio is below 1.0, meaning current liabilities exceed current assets [2, 3].

Additionally, assume $50 of the salaries payable are due today and $25 of the short-term debt is due tomorrow.  Currently ABC Company’s cash on hand is insufficient to meet these needs.  ABC Company is now unable to meet their debt obligations and could be forced into bankruptcy if they cannot meet their obligations.

Dealing with Liquidity Issues

Fortunately, liquidity issues can be resolved in the short-term through obtaining additional financing, such as a line of credit, and in the long-term through better cash flow management.  Improved cash flow management could include negotiating better terms on a company’s AR and AP, and better managing inventory levels.

The PPP is designed to keep companies from experiencing liquidity issues by providing them with the cash necessary to pay their day-to-day expenses and keep them from experiencing a liquidity issue.  However, the PPP is not indefinite, in which case businesses which struggle to regain their customers could ultimately experience a solvency issue.

Understanding When Illiquid Becomes Insolvent

While there are numerous operational and financial options for companies experiencing illiquidity issues, companies experiencing insolvency have far fewer options.  Insolvency includes illiquidity, but without realistic financing options and immediate operational opportunities for improvement.

As an example, assume that XYZ Company has the following cash flow statement:

Illiquid Vs. Insolvent - Understanding The Difference

Unlike our illiquid company, XYZ Company’s monthly cash flow is not sufficient to cover their debt repayment obligations.  Even if they were to cut their capital expenditures to $0, XYZ Company would not generate sufficient cash flow to service their debt.  In this scenario, any short-term financing or accounts receivable improvement would only provide a temporary solution.

Additionally, imagine the XYZ Company has the following balance sheet:

Illiquid Vs. Insolvent - Understanding The Difference

In addition to having cash flow issues, XYZ Company also has total liabilities which exceed total assets.  Between their short-term and long-term debt, XYZ Company has total debt of $850.  Even if XYZ Company sold all of their assets at book value, they would not be able to cover their debt obligations.

Dealing with Insolvency

Companies facing insolvency do not generate the income and cash flow necessary to support their operational and debt obligations.  These companies must identify opportunities to increase net income and cash flow from operations, either through increasing revenue or decreasing expenses.  If the company is unable to improve their operations, their debt burden will be too great, and the company will eventually be forced into bankruptcy.

ValueScope Can Assist You

Companies facing liquidity and solvency issues face tremendous challenges.  Whether it is dealing with creditors, requiring solvency opinions, or working to improve cash flow management, ValueScope’s team of financial and valuation consultants can assist you and help get you through this difficult time.

[1] Loans made through the PPP will be forgiven if all employees are kept on staff for the next eight weeks and the money is used for payroll, rent, mortgage interest, and utilities. (Source: https://www.sba.gov/funding-programs/loans/coronavirus-relief-options/paycheck-protection-program-ppp)

[2]  Current Ratio = Current Assets / Current Liabilities.  The current ratio is the most basic liquidity test. It signifies a company’s ability to meet its short-term liabilities with its short-term assets. A current ratio greater than or equal to one indicates that current assets should be able to satisfy near-term obligations. A current ratio of less than one may mean the firm has liquidity issues. (Source: Morningstar).

[3] Evaluating a “good” current ratio requires a review of the business model, industry averages, and historical performance.

[4]  Currently the PPP funds must be spent in the first eight weeks for the loan to be forgiven.

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Illiquid Vs. Insolvent - Understanding The Difference

Benjamin Westcott, CFA

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The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

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ValueScope Launches Houston Office With Principal Thomas J. McNulty

Click to Download:  ValueScope Launches Houston Office With Principal Thomas J. McNulty

ValueScope, Inc. is excited to announce that Tom McNulty joined the firm on April 27, 2020 as a Principal and Managing Director who will launch our Houston Office.  Tom’s responsibilities include financial consulting, valuation analysis, transaction and dispute advisory, and expert testimony.  In addition to serving as the Managing Director of the Houston office, Tom will assume the position of Energy Practice Leader.

Tom McNulty has 25 years of experience working across numerous industries as well as the entire energy value chain.  He draws on a rare combination of industry, banking, consulting, and government experience to provide his clients with transaction, financial advisory, litigation, and valuation opinion services.  Tom is a nationally recognized energy industry expert and is a frequent contributor on CNBC, Fox Business, and Bloomberg TV.  In addition to his deep knowledge and experience in the energy industry, Tom is well respected for his expertise in derivatives pricing and valuation.

As an advisor, and in his corporate career, Tom has delivered more than $52 billion in transaction, valuation, restructuring, and litigation projects, much of which is energy related.  He has also advised on, or executed, $13 billion in M&A and principal investment deals, and executed or valued more than $14 billion notional in derivative instruments.  His expert litigation work has included shareholder disputes, business valuation, derivatives and hedging, bankruptcy and restructuring matters, and economic damages assessments. 

Tom holds the prestigious CQF (Certificate of Quantitative Finance) and FRM (Financial Risk Management) designations and received his BA from Yale University and MBA from Northwestern’s Kellogg School with various honors.

Tom can be reached at tmcnulty@valuescopeinc.com and at 832-472-3717.

The COVID-19 Market Decline: Now May Be the Best Time to Gift

Click to Download:  THE COVID-19 MARKET DECLINE:


It has certainly been a rough couple of weeks with the recent fall off in the stock market and the shutdown of many businesses, but there may be a silver lining for people who intend to gift in the near future.  The recent decline in market valuations provides an opportunity to gift at lower values, potentially allowing you to gift assets using your lifetime exemption that would have otherwise resulted in a taxable event before the decline.  Given the additional uncertainty surrounding the Presidential Election and what might happen to the estate and gift tax exemption level, now may be the best time to do some gifting.

The U.S. Stock Market Value Over the Last Five Years

From March 23, 2015 through February 19, 2020, the S&P 500 increased from 2104.42 to 3386.15, a 60.9% return excluding dividends.  Between February 19, 2020 and March 19, 2020, the market decreased by 28.85% to a value of 2409.39.  The market decline over the last month decreased the total return over the five-year period ending February 19, 2020 to just 14.5%.  The chart below shows the S&P 500’s value over the five-year period ending March 19, 2020.

The Covid-19 Market Decline: Now May Be The Best Time To Gift

Looking at the performance of the stock market this year, we see a decline of 25.4% year-to-date through March 19, 2020.  However, the year did not start that way.  From December 31, 2019 to February 19, 2020, the S&P 500 increased from 3230.78 to 3386.15, a gain of 4.81%.  The index then fell to 2409.39 as of March 19, 2020, a decline of 28.85%.  The chart below shows the S&P 500’s value year-to-date through March 19, 2020.

The Covid-19 Market Decline: Now May Be The Best Time To Gift

Enterprise Value to EBITDA (EV/EBITDA) Multiples Over the Last Five Years

From March 23, 2015 through February 20, 2020, the Enterprise Value (EV) to EBITDA multiple for the S&P 500 increased from 10.60x to 14.73x, an increase of 38.96%.  Between February 20, 2020 and March 19, 2020, the EV/EBITDA multiple decreased by 25.19% to a value of 11.02x (only 3.96% above the value five years earlier).  The following chart shows the S&P 500’s EV/EBITDA multiple over the five-year period ending March 19, 2020.

The Covid-19 Market Decline: Now May Be The Best Time To Gift

The EV/EBITDA multiple at the end of last year was 14.06x, which was in the 97th percentile of the EV/EBITDA multiple distribution over the last five years.  The recent value of 11.02x on March 19, 2020 is below the 25th percentile.  The chart below shows the distribution of the S&P 500’s EV/EBITDA multiple over the five years ending March 19, 2020.

The Covid-19 Market Decline: Now May Be The Best Time To Gift

Appendix A (download the paper to view Appendices) contains the major valuation multiples for the S&P 500 and its industry sectors as of December 31, 2019.  Additionally, it shows the rank of the industry sectors based on each valuation multiple.  Appendix B contains the same information as of March 19, 2020. 

Appendix C shows the percentage change in the valuation multiples from December 31, 2019 to March 19, 2020 as well as the rank of the industry sectors based on largest decline in each valuation multiple.  As one would expect, the Energy Sector had the largest decline in all multiples, except for price to earnings (P/E), where the Energy Sector actually had an increase.  The Financials Sector saw the next largest decline in valuation.  The Utilities and Consumer Staples Sectors saw the smallest declines in valuation, which is expected given they are both defensive industries.  That said, both industries still saw significant declines in valuation.


The significant recent declines in valuation multiples provides an opportunity to execute gifting at lower values that could have been done previously.  Given the additional uncertainty surrounding the Presidential Election and what will happen to the estate and gift tax exemption level following the election, it may very well be an opportune time to gift.

[1]  A 10.2% annualized return over the 4.9-year period.

[2]  A 2.7% annualized return over the 5.0-year period.

[3] While the S&P 500 reached a high on February 19, 2020, the EV/EBITDA multiple reached a high on February 20, 2020.

[4]  Earnings before interest, taxes, depreciation, and amortization or EBITDA is a measure of earnings (profitability) of a company and is frequently used as a proxy for operating cash flow.

[5]  The daily EV/EBITDA multiples were obtained from S&P CapitalIQ.  CapitalIQ aggregates the multiples of the index constituents, using a weighting based upon market cap or enterprise value.

For more information, contact:

The Covid-19 Market Decline: Now May Be The Best Time To Gift

Michael Conroy, CFA


Mr. Conroy has more than 20 years of consulting and business valuation experience, concentrating on complex estate and gift valuation matters. He provides business valuation and financial consulting services to companies in a broad range of industries. Working with domestic and international clients, Mr. Conroy has performed thousands of business appraisals involving gift and estate tax, financial reporting, mergers, and acquisitions (valuations for buyers/sellers, fairness, and solvency opinions), litigation support, expert testimony, and other company requirements (including stock options and ESOPs). Mr. Conroy previously worked with the national valuation firm CBIZ Valuation Group, LLC here he was a senior manager. Prior to that, he taught chemistry and physics to high school and college students at Xavier College in Ba, Fiji, for two years as a U.S. Peace Corps volunteer.

The Covid-19 Market Decline: Now May Be The Best Time To Gift

Jason Wainwright, CFA, ABD


Mr. Wainwright is a Senior Manager at ValueScope Inc., Inc. In this position, he has worked on and managed numerous business valuations and projects for firms spanning multiple industries, including energy, defense, consumer products, professional services, and healthcare. Mr. Wainwright is a CFA charterholder, has a BBA in Finance & Economics from Texas Wesleyan University, and a MS in Quantitative Finance from the University of Texas at Arlington. Additionally, Mr. Wainwright completed all of the course work and the written and oral comprehensive examinations toward a Ph.D. in Finance from the University of Texas at Arlington.


The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

If you liked this blog you may enjoy reading some of our other blogs here.

Valuation During a Pandemic

Valuation During a Pandemic: How to Approach Covid-19 When Investing in Common Stocks

In financial markets, infrequent or rare events are referred to as “Black Swan” events.  The term “Black Swan” was popularized by Nassim Nicholas Taleb in his 2007 book, The Black Swan:  The Impact of the Highly Improbable.  Taleb describes Black Swan events as possessing three key attributes:

  1. Extremely rare
  2. Severe impact
  3. Obvious in hindsight

Such events can have fundamental causes such as the 2008 market decline and recession or simply can be the result of herd events where people rush to reset expectations.  Regardless of the cause, the US stock market and securities markets in general have proven to be surprisingly resilient since World War II.

The chart below depicts the S&P 500’s value from September 12, 2008 (the trading day before Lehman Brothers declared bankruptcy) through December 21, 2010.  On September 12, 2008, the index closed at 1251.70.  Over the following six months, the S&P 500 fell 46.0% to 676.53.  The market recovered over the following 21 months, reaching 1254.60 on December 21, 2010.

Valuation During A Pandemic

Similar to the 2008 crash, the coronavirus, or Covid-19, typifies a Black Swan event.  Due to the high incidence of severe cases and lack of sufficient hospital and emergency facilities to handle the pandemic if left unchecked, suppression strategies to slow the spread and peak number of cases requiring hospitalization are being adopted [1].   These suppressions strategies include:

  • Self-quarantine for persons exposed to persons with the virus;
  • Closing schools for periods of time;
  • Limiting the size of group meetings;
  • Restricting or closing many retail businesses;
  • Limiting food service to drive-through or take-out;
  • Limiting travel (banning some international destinations and persons originating from certain places) and screening passengers departing and arriving on planes and ships
  • Banning unnecessary travel outside the US (e.g., to parts of Italy and China).

Obviously, such suppression strategies will have economic consequences that will suppress or depress economic activity in many business sectors but could reward others.  Additionally, the greater the uncertainty as to how long, how severe, and how permanent the damage, the greater will be the valuation consequences.

The following chart provides a comparison of the stock market during the 2008 crash following the Lehman Brothers bankruptcy and the Covid-19 crash that we are currently experiencing.  We have indexed the starting values to 100 to provide a better comparison.  March 17, 2020 was the 19th trading day of the Covid-19 crash.  Since the high of 3386.15 on February 19, 2020, the market has declined 25.3% to close at 2529.19 on March 17th.

Valuation During A Pandemic

As shown in the chart above, the trajectory of the Covid-19 crash is similar to that of the 2008 crash.  By day 19 of the 2008 crash, the market had lost 27.3%, declining from 1251.70 to 909.92.  The key question is:  How will Covid-19 actual impact valuations moving forward?  This paper seeks to provide a framework for answering that question.

Market Valuation:  The Two Key Factors

Fundamentally, all valuations should be based on two factors: 1) expectations of the amount and timing of future cash flows and 2) the perceived “systematic” risks associated with such cash flows.  It follows then that changes in valuations result from changes in these two factors.  John Campbell and Tuomo Vuolteenah describe the sources of market crashes as:

”The value of the market portfolio may fall because investors receive bad news about future cash flows; but it may also fall because investors increase the discount rate or cost of capital that they apply to these cash flows.” [2]

Factor 1:  Expectations Regarding the Amount and Timing of Cash Flows

For most businesses, especially those in hospitality (e.g., restaurants, hotels/motels), entertainment (e.g., sporting events), and travel (e.g., airlines), there will be an extended period where business will be depressed (even without government mandates or restrictions) or entirely shut down.  Some estimates project extremely depressed activity levels in the United States could be as short as mid-May or at least until August 2020.  Additionally, it may be that periodic shutdowns in specific communities, regions of the world, or countries may occur until there is confidence that anti-viral regimens have proven successful in limiting and treating the illness and become more widely available, vaccines are at least safe and partially effective and more widely available, and/or the capacity of the health care facilities and systems to treat the severe cases is manageable.   That may mean that we cannot expect a complete resumption of previous levels of travel and commerce in some business sectors until as late as mid-2021 but we might observe partial recoveries in at least some activities over time.

For the most adversely affected businesses, there will be questions regarding the extent of the losses and the ability to sustain them.  Business which requires travel, larger groups, or social interaction are likely to suffer the greatest losses.  At this point in time, at least until the next set of quarterly earnings, conference calls, and revised guidance, the extent of the losses will be uncertain even within defined periods of time, and the length of time those losses will occur will still remain highly uncertain.  This explains in large part the high volatility (i.e., large fluctuations) in the US stock exchange indices over the past two weeks.


 Resilience relates to the ability of businesses to withstand periods of depressed economic activity.  Resilience is affected by a company’s degree of operating leverage and financial leverage.  Operating leverage is affected by the fixed costs and expenses a business must incur to remain either minimally open (if remaining open but with reduced economic activity) or to prevent a loss of the value of assets or foreclosure (e.g., rents, maintenance, storage costs, minimum salaries of retained personnel).  Financial leverage is a function of the amount of liquid assets (cash and investments, which reduce leverage) a business has and the amount of liabilities, especially interest-bearing debts, a business must honor, and the rate of payments required to avoid a default, foreclosure, or bankruptcy. [3]


Mitigation is related in part to the degree to which government subsidies or supports may be received, creditors may extend credit or defer required payments, and the extent to which the company will be able to raise additional funds, if needed, in order to avoid failure and soften the losses.  Government support is likely only in key business sectors, is uncertain as to amount and types (more likely in the form of loans which will have to be repaid once the economy recovers) and will likely vary by country and business sector.  US airlines, for example recently estimated losses of at least $58 billion and appear to be hopeful that at least some types of favorable loans might be provided for relief, but no specific indication exists as to the extent or type of mitigation.  Many creditors of businesses suffering short-term losses or distress may be willing to defer or reduce required or past-due payment amounts on liabilities in order to prevent any otherwise viable business from being forced into bankruptcy.

Cash Flow Expectations and Valuation

To simplify the problem of valuing a common stock, it might be possible to think in terms of the cash flow from now through the end of the crisis, the price at the end of the crisis,  and the probability that the business survives the crisis.  In this framework, the value of a common stock would be as follows:

Valuation During A Pandemic


P0   =    the current price of the security

psurvive  = probability that the business will survive until the end of the crisis

CF =    the “cash” earnings or net cash flow per share between now and the end of the crisis

P1   =    the price of the security at the end of the crisis

r     =    the required rate of return over the crisis period which is the function of the long-term market risk-free interest rate and risk premium required for the given stock

In an even more simple way to proceed, think of CF as the amount of dividends you expect through the end of the crisis.  For many companies that do not pay dividends, the amount expected is zero. [4]  Given that, the only question is determining psurvive, P1, and r.

The reason why the stock market indices are so volatile (and implied volatilities used to value stock options are so high) is because investors have different and rapidly changing views about the cash flows during the crisis, the probability of survival, the value at the end of the crisis, and the required rate of return for each company that is publicly traded and for the market as a whole.  To the extent that many investors are looking at broad stock market indices and funds (ETFs or mutual funds), it is entirely likely that some common stocks will be inappropriately valued initially when panic selling occurs.

Some companies, like utilities and communications providers, may experience reduced revenues but have sufficient and sustained revenues (unless they have high debt loads) to remain minimally profitable during the interim period.  In that case, we might consider even a positive but reduced level of earnings in the short term with positive cash flow during the crisis and a probability of survival that would equal 100% or close to it.

Some grocery stores and pharmacies might actually be experiencing an increase in demand and sudden surge in revenues, but investors may be substantially overestimating the long-term effects.  Investors may be both overestimating the effects of cash flow increasing and implicitly assuming that the price after the crisis will increase as well when that may not be a reasonable assumption.  In other words, the sudden surge in buyers in grocery stores for certain products over the weekend may simply be temporary and once the one-time fears and sudden increases in demand have been fulfilled, revenues will revert to more traditional replacement level demand or may even decline later, to the extent only necessities are purchased by customers until the economic uncertainties are resolved.  This would mean that the short-term effects will be extremely modest or immaterial from a valuation standpoint.

Even when valuing a REIT (Real Estate Investment Trust), you may have to consider the extent to which certain properties derive a portion of their rents from the revenues of their larger tenants, experience increased vacancies, or have to decrease or defer rent payments from tenants until the economy recovers.  In that case, you might discount the amount of dividends that a REIT will pay or be able to pay from now until, say, June 30, 2020.

The oil and gas exploration and production industries are particularly interesting.  The availability of new methods of extraction and production have increased the estimated reserves available worldwide and lowered the costs.  Additionally, demand is affected by economic activity and, thus, expected to be depressed at least until sometime in 2021.  Finally, Russia and Saudi Arabia were unable to agree on reduced production levels, and Russia reportedly believes it can squeeze out the US producers that are heavily indebted to reduce the growth and amount of US production coming into the world market and depressing prices.  In that case, many US oil and gas producers may be facing substantial losses or declines in revenues, especially due to the extent they must drill, complete, and stimulate wells to continue to sustain production and/or are more heavily indebted.  Thus, for many US oil and gas producers, the probability of survival, will likely be significantly less than 100% and cash flow will certainly be negative for the company unless they own a lot of low-cost producing reserves.  Dividend payments will likely be suspended and the value remaining at June 30, 2021 (P1) may be reduced.

Factor 2: “Systematic” Risk and Uncertainty

Investors will naturally discount future values for the time it takes to realize those returns and for the underlying uncertainty.

“Systematic risk”

Most investors are considering a broad portfolio of investments.  They are not concerned with risks that are unique to a given company if those “company-specific” risks can be offset or can be substantially diluted by holding a diversified mix of common stocks.  Instead, they care more about “systematic” risk and especially “downside” risks that occur when the decline in value coincides with market-wide stock price declines and economic downturns.  For this reason, the discounts investors require do vary over time.  During periods of relatively stable economic activity and growth, the discounts for “systematic” risk tend to be reduced over time.  This is one reason the US stock market indices since 2010 have increased steadily and implied “risk premiums” over this period of time through say early February 2020 have generally declined.  However, in the current market conditions, with the belief that the US and world economy is in or will be in a severe recession in 2020, the “risk premium” has increased and is expected to increase substantially.  This means that the discount on the future value will be greater but even more importantly, sometimes investors apply the increased discount rate to the projected value of the stock and reduce the projected growth rates in the future for the economy and the business.  The simple “Gordon Growth” model is as follows:

Valuation During A Pandemic


P0   =    the current price of the security

CF =    the steady-state level of “cash” earnings or net cash flow per share

g   =    the projected “normal” level of growth in earnings per share

r     =    the required rate of return which is the function of the long-term market risk-free interest rate and risk premium required for the given stock

Given the recent stock market declines, investors appear to be assuming generally that even when the economy recovers and stabilizes, CF may be lower in the future than now on a per share basis, g may be lower than previously expected, and the risk premium is greater due to uncertainty than it has been in the past. 

If, however, the economy stabilizes and recovers by June 2021, then the risk premium may revert back to normal and the stock market indices may entirely recover by June 2021 or at some point thereafter.  This may create a short-term investment opportunity at some point in 2020.  For example, Goldman Sachs on March 16, 2020 issued a general report indicating that it expected US stocks to potentially decline another 16% to a bottom around 2,000 on the S&P 500 Index from 2,386 at the close of trading on Monday, March 16, 2020.  The all-time high was reached on February 16, 2020, at 3,394.  Thus, by March 16, 2020, the S&P 500 Index (a broad US market index for common stocks) had fallen almost 30% from the high one month earlier.  If Goldman Sachs is correct, we could expect as much as a 41% decline from the highs realized earlier on February 16, 2020, in the next few months.

What is interesting, however, is Goldman Sachs is also predicting that the US stock market will recover most of the losses realized in the past month by the end of 2020.  Goldman Sachs projected the S&P 500 Index to be at 3,200 at year end under the scenario presented.  In other words, investors by the end of 2020 will have greater clarity and less uncertainty and assume that the economy and stock prices will entirely recover.  That would mean that share prices for larger US stocks would increase 26.5% from the close on Tuesday, March 17, 2020. 

Most investors are not making this assumption.  If they were assuming this to be true, then the S&P 500 Index would likely have recovered to at least 2,800 already.  It is more likely and assumed by most investors that at least some of the damage suffered in 2020 will be sustained and some companies will not recover from the economic effects by the even end of 2021. 


Risks that are identifiable and understood tend to be managed and discounted in a normal and predictable manner.  Uncertainties that are more general and greater than normal, on the other hand, are not well managed or “priced” by investors.  Investors tend to overstate the “risks” in the face of uncertainty on average and, thus, tend to increase the risk premium in the expected return for investments more than they should and discount the longer-term average expected rate of return on such investments. 

Professor Damodaran, a corporate finance and valuation professor at the Stern School of Business at New York University, maintains an estimate of the equity risk premium. [5]  He estimated that the equity risk premium increased 55 basis points (0.55%) from February 1, 2020 to March 1, 2020, which only captures part of the market reaction to date. [6] In broad terms, that is more than a 10% increase in the equity risk premium in one month.  Also, long-term growth rates have declined in his estimates.  While approximate, this does give a good idea of the effects of uncertainty and suddenly negative news on how investors discount for risk and uncertainty.  By March 17, 2020, the implied equity risk premium increased by perhaps another 70 basis points (0.70%), which means that the equity risk premium increased by about 25% in one month due to uncertainty.     

Assuming the economy stabilizes and risk premiums revert to prior levels, this creates opportunities for investing against market sentiment.  For example, if an investor made a bet on the S&P 500 Index at the end of October 2008 (after the Lehman Brothers collapse but well before the market had bottomed out), and reinvested all dividends through March 17, 2020, the total return would have been 232.38%, or 11.1% per annum.    If an investor bet at the end of February 2009 (when the market was close to the bottom) and held until the end of January 2020 (close to the peak), then the total return would have been 450.5%, or 16.9% on an annualized basis. 

Obviously, it is not possible to “time” the market so perfectly, but the lesson from this example is that investors who hold on and don’t panic often come out with reasonable returns over longer investment horizons and holding periods. 

What the current stock prices in the US tell us is that investors may be over-reacting to short-term events that, assuming no systematic failures of the financial system occur, may provide unusual investment opportunities in the short-term. 

On the other hand, Goldman Sachs may be too optimistic in not accounting for the dilution in share values and debts that may be required to raise capital or borrow to cover losses in the short term in order to keep companies from failing and the risks of some companies failing.  At least some investors are betting on that happening.  Furthermore, if the US and world economy suffers more systematic damage to the institutions and faith in those institutions, a series of more serious consequences may follow, as occurred in the 1930s during the Great Depression.  The effects of the Great Depression were systematic in terms of failing financial institutions and the time required to recover.  Ultimately, a world war occurred, and it required a unique set of circumstances to pull the US economy out of the depression.  We highly doubt that will occur in this instance but cannot say that the risk is zero of at least some systemic damage occurring.  


We cannot predict what will occur and recognize tremendous uncertainty exists at this time as to the ultimate economic effects of the current pandemic.  But reacting and thinking logically helps to avoid panic selling into a downturn or overly enthusiastic buying in a booming market (which may have been the case by February 16, 2020).

[1]  See Walsh, “US, UK coronavirus strategies shifted following UK epidemiologists’ ominous report,” CNN, March 17, 2020.  Using simulation modeling, researchers estimated that “even if all patients were able to be treated, we predict there would still be in the order of 250,000 deaths in [Great Britain] and 1.1-1.2 million in the US.” Perhaps 15% of all persons infected will experience severe symptoms requiring treatment including oxygen and 5% of more will require critical treatment with ventilation, according to WHO.  Mortality estimates have been as high as 1% to 4% generally and are much greater for persons above the age of 60 or with known weaknesses in immune responses or adverse circulatory or respiratory conditions)

[2]  Campbell, J. Y., & Vuolteenaho, T. (2004). Bad Beta, Good Beta. The American Economic Review, 94(5), 1249–1275. Retrieved from http://www.jstor.org/stable/3592822

[3]  Financial distress can impose additional costs and cause even greater losses and, if severe, can inhibit a business from recovering once economic activity recovers.  See Hakala and Keath, “Analysis and Valuation of Distressed Equity Securities,” Valuation Strategies, September/October 1999, pp. 24-34.  Publisher: Warren, Gorham & Lamont.

[4]  Some companies will pay dividends over the interim period and possibly at a decreasing rate or amount as economic conditions deteriorate. 

[5]  Damodaran’s estimated equity risk premiums are updated on a monthly basis at:  http://pages.stern.nyu.edu/~adamodar/. 

[6]  The S&P 500 index decreased by 9.07% from February 3, 2020 to February 28, 2020 and decreased by an additional 18.16% from March 2, 2020 to March 17, 2020.

For more information, contact:

Dr. Scott Hakala has extensive practical knowledge of finance, economics, statistics, and business valuation theory. His expertise includes: corporate finance, restructuring and cost of capital; the valuation of securities and business interests (transactions, mergers, acquisitions, fairness opinions); the valuation of intangible assets (patents, trademarks); analysis of publicly traded securities (insider trading studies, trading analyses, event analyses, materiality, damages in securities litigation); expert testimony and economic loss analyses (commercial litigation); wage and compensation determination (reasonable compensation studies, lost personal income, wrongful termination); transfer pricing; derivative securities (options pricing and valuation); and antitrust and industry structure, strategic pricing, marketing and cost allocation analyses.


The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

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Information Asymmetry in Private Company Transactions

Information Asymmetry in Private Company Transactions

What is Information Asymmetry?

In 1970, George Akerlof, an economist who is currently a professor at the McCourt School of Public Policy at Georgetown University, released what is now a famous paper, “The Market for Lemons: Quality Uncertainty and the Market Mechanism.”[1]  The paper examines the market for used cars, and the impact that information asymmetry has on the pricing of cars.  The results of the paper have wide-ranging implications.  Information asymmetry occurs when one party in a transaction (i.e., the buyer or the seller) possesses greater material information regarding the subject of the transaction (i.e., the asset or security being sold in the transaction). 

When purchasing a used car, the car could either be a “good car” or a “lemon” (i.e., a “bad car”).  At the time of purchase, due to the limited time spent driving the car, an incomplete history of the car’s maintenance, a lack of knowledge regarding the prior owner’s driving habits, and the lack of a thorough mechanical evaluation of the car, the buyer cannot be certain whether the car is a good car or a lemon.  The seller, who we assume in this case is the prior owner, possesses all of this information.  Following the purchase and after spending additional time with the car, the buyer will develop a greater ability to predict whether or not the car is a lemon; however, this is too late, as the buyer has already purchased the car. 

Thus, the market for used cars is an imperfect one, where the buyer possesses less information regarding the quality of the product than the seller does.  Akerlof points out that in a used car market with asymmetric information, buyers are willing to pay less for a car, due to their inability to distinguish between a good car and a lemon, resulting in sellers of good cars exiting the market.  This trend results in buyers overpaying for inferior products. 

This phenomenon is seen in the health insurance market as well.  As insurance companies raise the price of insurance, it begins to attract unhealthy individuals, who are more certain of their need for insurance.  Thus, the average medical condition of insurance applicants deteriorates as the price rises.

Information Asymmetry In Private Company Transactions

Implications for Buying/Selling a Company

When purchasing a company, naturally the seller possesses greater information about the company than the buyer.  This results in long, drawn out due diligence processes.  One often overlooked component of due diligence is a Quality of Earnings (QoE) analysis.  The intent of this analysis is to reveal any abnormalities in the financial reporting process and control for one-time events and accounting policies.  The financial statements can be manipulated, intentionally or not, by the seller which results in unreliable figures, such as overstated profitability.  This can lead to a dramatically exaggerated valuation of the company, resulting in lower returns to the buyer. 

QoE analysis is particularly important when purchasing a private business, as those companies are not required to follow generally accepted accounting principles (GAAP).  Often these companies have non business-related expenditures buried in the financial statements, which can be revealed in a QoE analysis.  The following table illustrates this example and the potential impact.

Information Asymmetry In Private Company Transactions

Each company in the table is identical, but for the owner’s compensation line.  Company A’s owner is compensated via a distribution, which will not appear in the income statement, while Company B’s owner takes a salary.  If a thorough analysis on these income statements is not performed, the value of Company A appears to vastly exceed Company B but, in reality, they are worth the same.  The buyer of Company A would be thoroughly disappointed upon realizing that they need to now factor in compensating a new CEO.

The same can be true in reverse; take a look at the following example.

Information Asymmetry In Private Company Transactions

Again, we have two identical financial statements, with the exception of one-time expenses.  Company A relocated offices and faced $200,000 of additional expenses.  While this could have other impacts on the business, for the purposes of this example we will assume it does not.  If the $200,000 remains in the income statement as an expense, this lowers EBITDA, thus lowering the value.  The seller is being penalized for a non-recurring expense that has no impact on the future of the business.


Information asymmetry can be detrimental to both the buyer and seller.  The buyer is purchasing a product for which the information possessed is insufficient to determine its true value.  The seller can be penalized due to the assumption of a lower quality product (i.e. the buyer assumes that the car might have unforeseen problems).  All of this culminates into an inefficient market, and when dealing with the purchase of a company, can have massive implications. 

[1]  Akerlof, George A., “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” The Quarterly Journal of Economics, vol. 84, no. 3, 1970, pp. 488–500.  JSTOR, www.jstor.org/stable/1879431.

A QoE analysis is imperative when engaging in transactions, and ValueScope provides top of the line service at a fraction of the cost of larger firms.  Our team of PhDs, CFA Charterholders, and CPAs possesses expertise in valuation that is unmatched in the industry.

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

Jason Wainwright is a Senior Manager at ValueScope Inc., Inc. In this position, he has worked on and managed numerous business valuations and projects for firms spanning multiple industries, including energy, defense, consumer products, professional services, and healthcare. Mr. Wainwright is a Chartered Financial Analyst and has a BBA in Finance & Economics from Texas Wesleyan University, and a Ph.D. ABD in Finance from the University of Texas at Arlington.


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Estate and Gift Dynamics in the Era of the Big Exemption and Election Uncertainty

Estate and Gift Dynamics in the Era of the Big Exemption and Election Uncertainty

The Tax Cuts and Jobs Act of 2017 (the “TCJA”) was a complicated piece of tax legislation that mostly decreased taxes for individuals and corporations.  However, the net effect on an individual (or corporation) is dependent upon the unique circumstances of that individual.

With respect to individual taxpayers, marginal rates were lowered somewhat from 39.6% to 37.0% at the top marginal tax rate, and the tax brackets were increased.  However, the 3.8% Medicare surtax that was part of Obamacare remains, and some other changes, like property and state tax limitations, hurt some taxpayers more than rate reductions helped.

C corporations benefited significantly from the TCJA, as corporate tax rates were lowered from 35.0% to 21.0%.  Additionally, the owners of certain pass through entities benefited from a provision that allows 20.0% of the owners’ income to be sheltered from income tax, effectively lowering the 37.0% marginal tax rate to 29.6% [1].

The biggest benefit might have come to high net worth families due to the estate and gift tax exemption (E&G) being increased from $5.49 million in 2017 to $11.18 million in 2018 and $11.40 million in 2019, or $22.8 million for a married couple.  The E&G tax exemption is indexed each year thereafter.  As a result of such a high exemption, the number of estate tax returns subject to estate tax has fallen from approximately 6,500 in 2017 to about 2,000 this year.  This exemption is set to lapse after 2025 back to the 2017 level of $5.49 million.

To put this in perspective, the following chart shows the historical E&G tax exemption and the top E&G tax rate since 1979.

Estate Gift Tax

Due to the unprecedented E&G exemption level, there are a number of planning opportunities available for high wealth families.  Of course, any E&G plan would depend on many factors, including but not limited to:

  • The value of the estate,
  • The structure of the estate and the assets held,
  • The age and expected life of the surviving spouse(s),
  • The investment returns and annual spending requirements, and
  • The attitude toward gifting to 2nd and 3rd generations.

An E&G plan should also incorporate one’s expectation of the outcome of the next Presidential and Congressional elections, as there is little doubt that a Democratic President and Congress would lead to a lowering of the E&G exemption and an increase in the marginal E&G tax rate.  

To add another complication to E&G planning, a win by some in the Democrat field may result in the addition of a “wealth tax.”  For example, Elizabeth Warren has suggested an annual wealth tax of 2% for wealth above $50 million and 3% for wealth above $1 billion.  Bernie Sanders is proposing a tax of up to 8% for wealth above $30 million. 

Some wealthy families and their advisors are analyzing the effects of the increased exemption and will get a substantial portion (up to $22.8 million) out of their estate this year (or slightly more next year as its indexed) before it’s too late.  This could save up to $9.12 million in taxes if the exemption disappears, or $8.69 million if the exemption is lowered to $3.5 million per spouse and the rate is changed to 55% for starters, as Warren proposes.  Taking action now would also save on the wealth tax for some individuals, should that ever happen.

To the extent there are assets to gift, whether they are interests in family limited partnerships (FLPs), LLCs, partnerships or closely held companies; or tangible assets like oil and gas interests, real estate, etc., valuation and justifiable discount opportunities exist to lower values and effectively freeze more of the estate through gifting.  Alternatively, there are some, albeit rarer, situations where a higher value may benefit the collective family by increasing the basis of the gift and thereby lowering the future capital gains paid upon sale.

The bottom line for ultra-high net worth individuals is that the estate tax exemption and rates will likely be unfavorable in the future.  The table below shows the tax savings in nominal dollars by gifting the maximum amount this year versus future years given various changes in the exemption and rate.

Estate And Gift Dynamics In The Era Of The Big Exemption And Election Uncertainty

While no one can predict the future of elections and taxes, there is a large risk to wealthy families that the E&G tax exemption will decrease.  It’s reasonable to assume that asymmetry is not on the side of the wealthy taxpayer.

[1] S Corps, LLCs, and partnerships.[/column_5]

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.


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A Review of the Risk Premium Method for Regulated Electric Utility ROEs

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A Review of the Risk Premium Method for Regulated Electric Utility ROEs

Energy ROE

In utility financial economics, the cost of capital, or rate of return, is the cost of an electric utility’s invested funds, both debt and equity. The cost of equity capital is the rate of return that common shareholders require on their investment, commensurate with the risks they assume and the expected returns from other similar investments (opportunity cost). In the regulatory process, the principles established in the US Supreme Court Bluefield1 and Hope2 decisions guide most state regulatory commissions in establishing returns. In particular, the Bluefield decision noted:

A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties; but it has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures.

From both the investor and company point of view, it is important that there be enough revenue not only for covering operating expenses, but also to pay a return on bondholders and stockholders providing the capital for the utility to invest. These funds are required to service debt and pay dividends on equity (common and preferred stock and retained earnings).

From both the investor and company point of view, it is important that there be enough revenue not only for covering operating expenses, but also for the capital costs of a regulated utility.

By that standard, the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit rating and to continue to attract capital.3 A long-term comparison of the rates of return on different sources of capital is shown in the Capital Market Line Figure 1, with data calculated by Morningstar. As shown, the data plots the realized rates of return from different investments versus their risk, as measured by the standard deviation of their returns. The resulting line demonstrates the relationship and positive correlation between risk and rates of return; investors require higher rates of return for an investment with more risk.

The return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit rating and to continue to attract capital.

Energy Roe


The Risk Premium Methodology, or analysis, is based on a comparison of allowed rates of return on equity from decided rate cases, as compared to various sources of debt capital and their corresponding costs. Like the Capital Asset Pricing Model, the risk premium methodology is an example of a build-up approach used to estimate a utility’s ROE. The cost of equity for a regulated utility (or any company) is composed of the following components:

The real rate of return
+ Inflationary return
+ Industry risk/return
+ Company-specific risk/return
+Other risks

Return on equity (ROE)

The examples in Figure 2 compare authorized ROEs of electric companies to long-term utility debt rates, between 2000 and 2018. As shown, the authorized rates of return on equity from various commissions are summarized into a quarterly authorized ROE on the vertical axis and are compared against the cost of utility debt (represented by Moody’s Utility BAA yield (“Triple B”) on the horizontal axis of the graph. In the lower right corner of the graph, the regression calculation is shown as a reference for all of the figures in this article. The first item of interest is that with a slope of approximately 35 percent, a utility’s allowed rate of return moves up and down at a slower pace as compared to changes in interest rates/debt costs.

Energy Roe

Although the data above illustrates the correlation between authorized equity rates of return and the cost of debt, it ignores “regulatory lag.” Regulatory lag reflects the fact that a utility will file a rate case at a certain point in time but will not receive a final decision, with an allowed rate of return, for a period of time, approximately one year. Therefore, it is more appropriate to compare the authorized ROEs from commission decisions with interest rates as of one year prior.


In Figure 3, the timing has been shifted to compare authorized rates of return with debt costs from one year prior.

Energy Roe

Regulatory lag reflects the fact that a utility will file a rate case at a certain point in time but will not receive a final decision, with an allowed rate of return, for a period of time, approximately one year.

Making this change to the “regulatory lag” timing assumed improves the coefficient of variability, or R-squared, of the analysis. In a “perfect world,” the R-squared from the analysis would be 1.0, indicating that 100 percent of the changes in authorized ROEs are due to changes in interest rates, but many other financial and economic risk factors exist. Considering the build-up approach mentioned earlier, a risk premium approach based on authorized rates of equity returns and utility debt costs would address the following return components:

A Review Of The Risk Premium Method For Regulated Electric Utility Roes


Another debt index to consider is the cost of long-term US Treasury Bonds with a maturity of 30 years.4

Figure 4 is similar to the one based on Moody’s utility bonds, but it is “higher,” meaning it has a y-intercept that is 1.2 percent higher to account for the risk differential between risk-free Treasury bonds and a Triple- B utility bond index. The following are the build-up components for this analysis:

A Review Of The Risk Premium Method For Regulated Electric Utility Roes

Energy Roe

Although Figure 5 could be used to simply look up an implied ROE for a certain level of interest rates, some additional precision, and better correlation, can be gained by calculating the implied “premium” (the amount the authorized ROE exceeds the cost of debt) for each quarter and comparing that to debt costs 12 months prior. While the downward slope may look odd at first, recall that this is the equity premium, which is added to the cost of debt, to determine an implied return on equity. The downward slope reflects that as interest rates increase, the corresponding authorized returns on equity also increase, but at a lower rate.

A Review Of The Risk Premium Method For Regulated Electric Utility Roes

A similar relationship is seen in the comparison of authorized rates of returns and utility bond yields in Figure 6:

A Review Of The Risk Premium Method For Regulated Electric Utility Roes


Combining the two methodologies above with current interest rates, these models suggest an equity rate of return in the range of 9.7 percent to 9.9 percent. As previously discussed, the risk premium approach is one of the methodologies considered to determine a fair return on equity for regulated utilities. However, it is important to note that this methodology has relative strengths and weaknesses, like all simplified financial models taught in academia. The risk premium analysis does a reasonable job of capturing real interest rates, inflation, and industry risk factors. However, to determine a credible conclusion for a fair ROE, more analysis is required.

A Review Of The Risk Premium Method For Regulated Electric Utility Roes

As illustrated in Figure 7, most of the data points lie within an approximate 125- basis point (1.25 percent) range around the trend-line indication. For public utility companies, these risks would be expected to reflect company-specific risk factors from their geographical concentration, state and federal regulation, and potential mergers and acquisitions, among other risk factors. For a utility that is not public nor owned by a public holding company, additional risk factors not reflected earlier would also need to be considered. The common stock of smaller private utilities is considered to be a riskier investment than a public utility’s stock, commanding higher returns from investors. Some of the key factors affecting this are a small utility’s lack of liquidity, less access to competitive debt financing, and geographical concentration, as well as company-specific factors such as aging infrastructure or litigation risk.


In summary, the risk premium methods discussed earlier provide a reasonable starting point for a utility’s ROE, but other risk factors and other financial models must be considered in concluding a fair return on equity for a utility. The analyses shown earlier provide another insight into what investors expect and what commissions authorize for allowed returns. Like all financial approaches to estimating an appropriate rate of return, however, this data and analyses are best considered in addition to other financial models.

1. Bluefield Waterworks & Improvement Company v. Public Service Commission of West Virginia, 262 U.S. 679, 692, 693 (1923).

2. Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591, 603 (1944).

3. Ibid.

4. Although 10-year Treasuries are sometimes referenced, given the long-lived nature of utility assets, the longer-term bonds better match a utility’s underlying assets.

For more information, contact:

Brad R. Currey, CEIV, CFA

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Middle Market Private Equity M&A Activity – Q3 2018

Middle Market Private Equity M&A Activity – Q3 2018

Executive Summary

Average Valuations are Slightly Down

The aggregate EV/EBITDA multiple of 7.3x for Q3 2018 is in line with the multiples observed over the last few quarters, but valuations have tapered off compared to the 7.5-8.0x seen in the latter half of 2017.

Leaning Towards Conservatism

It appears that private equity firms are preferring to use less debt in their acquisition efforts.  Despite plenty of capital available in the leveraged finance market, total debt/EBITDA has decreased, and the percentage of deals using less than the maximum amount of leverage allowed is rising.

Headwinds for Sectors Trying to Stay “In Favor”

Technology and health care were once again leaders in terms of highest average valuations, but their multiples in 2018 are lower compared to last year.

Also of note is the media & telecom sector.  This industry had an average EV/EBITDA multiple of 8.2x in 2017 (second highest among all sectors) but sharply fell to just 5.0x in 2018 (lowest among all sectors).

Based on our review of GF Data’s latest M&A Report, Q3 2018 was a mixed bag of indicators for the private equity transaction arena.  63 transactions were reported by more than 200 private equity firms in the quarter.  This is an increase over the 47 transactions reported last quarter and the 53 transactions reported in Q3 a year ago.  However, total transactions are slightly down from the 71 and 67 that were reported in Q4 2017 and Q1 2018, respectively.  Just 177 transactions have been reported for 2018 thus far, so we will need to see a slightly faster pace if we are to keep up with 249 transactions reported last year. Middle Market Private Equity.

We also note that multiples, in terms of total enterprise value (EV) to EBITDA, were slightly down.  While two sectors reported higher multiples in Q3 than in Q2, most sectors declined.  In aggregate, EV/EBITDA multiples averaged 7.3x for Q3 2018.  This is down from 7.4x last quarter, 7.5x in the same quarter last year, and a high of 8.0x observed in Q4 2017.  Not surprisingly, targets with larger enterprise values were acquired at higher multiples.  In Q3, companies with enterprise values in the ranges of both $50-100M and $100-250M were acquired at 8.6x EBITDA, whereas companies in the $10-25M range were acquired at 5.8x EBITDA and $25-50M companies were acquired at 7.1x EBITDA.

Middle Market Private Equity

Industry Analysis

To get a better understanding of the mixed M&A trends, we took a deeper dive into the report and analyzed the various industry classifications of the acquisition targets. 

Middle Market Private Equity


Manufacturing valuations have largely hovered in the low-to-mid 6x range since 2014, although they have trended upwards in the past two years.  Recent EV/EBITDA multiples observed include 6.8x in 2017 and 6.9x in 2018.  This is in comparison to an average of just 6.3x from 2014 to 2016.  However, there has been an apparent drop in recent deal volume.  Only 56 transactions have been reported in 2018 thus far, compared to an average of over 100 from 2014 to 2017.  Time will tell if Q4 activity will pick up and get manufacturing M&A volume back to historical levels. 

Mergers And Acquisitions

Business Services

While the average EV/EBITDA multiple of 7.0x for 2018 dipped slightly compared to the 7.3x in 2016 and 7.4x in 2017, EV/EBITDA multiples for the business services sector are still higher than their 2014 to 2017 average of 6.8x.  As another positive, volume is up for this sector in 2018 with 48 transactions already reported through just three quarters compared to only 44 and 41 in each of the previous two years.

Mergers And Acquisitions

Health Care Services

Both M&A multiples and volume are down for the health care sector.  EV/EBITDA multiples have averaged just 7.5x so far in 2018.  This is lower than the 7.8x, 7.6x, and 8.1x multiples observed in the last three years.  Volume is also down, with just 19 reported transactions in 2018 thus far compared to an average of 24 over the past three years.  However, if Q4 can keep the same pace as the first three quarters, 2018 could finish in line with average volume. 

Middle Market Private Equity M&Amp;A Activity - Q3 2018


As of now, 2018 appears to be a lackluster year for M&A activity within the distribution industry.  The average EV/EBITDA multiple of 7.0x so far in 2018 is moderately lower than the 7.5x and 7.7x seen in 2016 and 2017, respectively.  Volume is also down thus far, with just 13 transactions reported in 2018 compared to twice as many (26) reported last year.  We still have one more quarter of data to digest, but with multiples and volume both appearing lower, we won’t be holding our breath for any magic in the distribution sector in 2018.

Middle Market Private Equity M&Amp;A Activity - Q3 2018


Retail showed signs of recovering with EV/EBITDA multiples of 7.0x and 7.6x in 2016 and 2017, respectively.  However, multiples have dropped to just 6.7x thus far in 2018.  On a positive note though, this is still higher than the EV/EBITDA multiples of 6.0x in 2015 and 5.5x in 2016.  Retail will be a key industry to watch regarding growth for the overall economy. 

Middle Market Private Equity M&Amp;A Activity - Q3 2018

Media & Telecom

At first glance, the media & telecom sector had a significant drop in its average EV/EBITDA multiple.  However, a closer look reveals that the average multiple of 8.2x for 2017 was largely inflated compared to the sector’s average EV/EBITDA multiple of 6.5x for 2015 and 2016.  This perhaps could have been influenced by numerous large mergers in the industry including Disney and Fox, AT&T and Time Warner, and others.

Middle Market Private Equity M&Amp;A Activity - Q3 2018


From 2014 to 2016, technology EV/EBITDA multiples averaged a respectable 7.7x.  Multiples then rocketed to an average of 10.2x in 2017.  It appears that this was not an anomaly as 2018 multiples have averaged 9.8x through Q3.  As “fin-tech”, cyber security, and data analytics continue to grow in popularity, we expect technology multiples to finish 2018 on a strong note and remain elevated into 2019.

Middle Market Private Equity M&Amp;A Activity - Q3 2018

Information in this article is based on the GF Data November MA Report dated November 19, 2018.  GF Data provides private equity sponsored merger and acquisition information for middle market companies with enterprise values between $10M – $250M.

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Maximizing Value Throughout the Business Life Cycle

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Maximizing Value Throughout the Business Life Cycle

Most business owners think about valuing their business and how to get the best deal when it’s time to sell.   While some owners consider their company’s value from inception, too frequently owners give no consideration to value creation until much later, often when it’s too late to affect value.  In fact, value is created from the design of the business plan all the way through the close of the final business sale.

This paper explores value creation and how valuation-centric analysis throughout the business life cycle not only maximizes value but compounds the effects of accelerating value. 

The graph below depicts the business life cycle and when cash flows are typically achieved. 

Business Life Cycle

Value is ultimately derived from the timing, amount, and risk of a business’s cash flows.  If an owner is able to shift the above graph, the rate of value creation is enhanced, improving and compounding the owners’ wealth both during and after the business is ultimately sold.

Cash Flow


I have seen untold business plans; some well thought out, some with massive holes, but few with good financial planning and modeling.  At the launch phase, valuations necessarily incorporate detailed projections of unit sales, pricing, cost, and infrastructure components.  This analysis helps answer many questions fundamental to a successful launch.  It also helps the owners understand the level of capital required, its likely sources, costs and possible dilution, and the timing and number of tranches that may be necessary.  A competent valuation will help attract capital, and at the lowest cost, in addition to “cleaning up” the plan and focusing Management on the most value-maximizing strategies.

Mistakes at this stage are costly, as restarting or re-engineering leaves investors and lenders with little confidence and ability to fund further.  The track record of the owner is negatively affected and often difficult to recover from.

Additionally, getting the capital structure right is critical at the start; there are no second chances here.  Options, warrants, preferred equity, and debt with privileges and features all have values and associated costs.  There is no way to understand the economic ramifications of these decisions without sophisticated modeling as component parts of the financial forecasts and expected ultimate sale.


Execution is critical during the growth phase as this is when a business model is perfected affecting many future years of financial performance.  The value drivers of the business start to come to light and modeling the effects of those drivers helps optimize strategies and the allocation of finite resources.  Scenario and sensitivity analysis aids in understanding the cash flow and value impact of dollar or percentage changes in investment and performance.  Anything short of detailed and creative modeling is guess work.  While intuition has its place, financial modeling offers a more consistent framework on which to build and understand value.

Strategic and growth planning is a dynamic process.  Marketing econometrics that lead to better and optimal strategies at this stage often have the highest return.  Additional capital raises may be required or desired.  Management planning, incentives and compensation analysis are often helpful during this phase.  Understanding the market price of these decisions is important to maximizing value.

Growth can be achieved many ways, but there are only two basic paths:  organic and acquisitive.  Both need to be examined as the “build versus buy” decision is almost always in play.  While investing and building operations is always a viable option, so is acquiring other companies that could accelerate growth or play a strategic role.  Valuation analysis is multifaceted here.  Value creation needs to be assessed based on the tradeoffs of the build versus buy decision.  By growing organically, an owner might take less risk, and better control growth and operations.  By acquiring, an owner hastens the growth of the company, creating business synergies and often bolstering investor returns.  The acquisition method, though, is somewhat riskier as each acquisition must have a strategic fit and be acquired at the right price.  Sometimes a single poor-acquisition can leave a young firm struggling not only to grow, but to survive.


This phase is often characterized by the entrance of new competitors, and while sales may be increasing, margins are sometimes squeezed.  As investments decline, cash flow may improve, and the owners may enjoy enhanced distributions.

The goals of valuation analysis in this phase are to tweak the business model, help in the planning process, and provide ongoing visibility via better decision-making tools.  This can be accomplished through updated valuations (typically yearly), capital structure optimization, and business optimization that often involves detailed data analysis of operations, pricing elasticity studies, or other metrics that can improve cash flow.

Additionally, financial planning and analysis (FP&A) tools and support are very useful in helping Management budget, plan, and make informed daily decisions.  The visibility gained by using this “dashboard” model has been quite instrumental in lowering risk and managing cash flow for many companies.


This life cycle phase may be the most relaxing but the least rewarding.  Too many competitors, too little growth, and declining profits often accompany this phase.  Cash flow is often flat as major investments are in the rear-view mirror.  Not a bad place to be unless you’re the type who needs to reinvent yourself, which sometimes happens.  Even so, valuation modeling can help extend the life cycle through better planning.

There may be transactions during this period with managers, outsiders (maybe taking a few chips off the table) or family, such as with children working in the business.  Valuations are needed for all these circumstances, and the IRS is keenly aware of “gifts” to children based on undervalued stock.

The maturity phase is also a good time for succession planning; predominately to understand the alternatives and the wealth ramifications of different strategies.  These strategies include leveraged recapitalizations, private equity investments, management buy-outs, and ESOPs.  No matter which strategy is selected, an analysis of exit-timing is instrumental to generating the greatest sale price for the business.


Few owners want to think about the exit because it triggers negative thoughts, not the least of which is one’s own mortality.  That said, leaving a legacy to its stakeholders is usually important.  But self-interest also dictates that owners receive the maximum benefits for their decades of hard work.  Performing analysis of value and understanding strategic value to acquirors may be the most important valuation undertaking over the life cycle.  Often, it’s the last chance to get it right.

Understanding strategic value is best accomplished through detailed valuation and synergy analysis, presentation decks, and effective financial and legal representation throughout the sale process.  Adjunct analysis can be informative as it includes an understanding of the after- tax wealth differences between various deal structures.  Hopefully, some of the measures during the earlier phases have been completed making the exit more effective and rewarding.  The sooner owners understand the drivers of value and how to promote those assets most efficiently, the greater the value seen at exit.

Hopefully, this paper has highlighted that valuation is far more than appraisal.  It’s about value creation and its many forms.  Utilizing these tools over the business life cycle can accelerate and improve the business, while creating additional wealth to its owners and stakeholders.

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.


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