Many valuation calculations made before the crisis have now been rendered meaningless. Sellers seeking to auction off their businesses with too many adjustments are leaving private equity firms and strategic investors weary.

Yet buyers are keener to base themselves on the hard ground of pre-COVID valuations before applying a “salami slicing” approach, according to advisors.

This is leading to a fierce debate over discounts. They say that bargaining methods in current processes are akin to those seen in a Turkish bazaar. Buyers are scouring for potential risks, becoming more aggressive in their line of questioning and demanding “proof” that businesses will see only a limited impact from the crisis.

Imaginative  accounting

Concrete examples of financial spin include Schenk, a German industrial player, that attracted scorn for the use of “EBITDAC”, in which earnings were adjusted for the impact of COVID-19.

“EBITDAC is stupid,” one banker said, pointing to examples he had seen of the novel financial metric cropping up in sale processes.

“It's almost like me saying I didn't grow in the last three months, but I am going to grow by double the normal amount in the next few months.

An executive at a large private equity admitted his firm is shying away from processes that are making unreasonable adjustments: “Like anytime, there's a bit of judgment and being reasonable,” he said, calling for both bidders and vendors to be mindful in their numbers.

An advisor specialising in consumer M&A cited questionable attempts by sellers “obviously hiding” their companies’ true financial standings.

For example, a consumer products group recently surfaced in the market and boasted of improving margins thanks to its expanding online presence during the period, he said.

A closer examination of the books showed the business was “obfuscating” its costs, he said. With half its staff furloughed and advertising on traditional channels cut, savings were reallocated to heavily subsidise the online product offer. This will inevitably lead any buyer to question the company’s underlying position and post-coronavirus prospects as government supports wanes.

Disruption,  discounts

Some advisors say that using the LTM end-December earnings figure is a good starting point in coming up with a valuation - but then the work begins.

Dealmakers should attempt to quantify the expected impact of coronavirus over the following years and discount their valuation expectations accordingly, said Nick Wood of AlixPartners.

He suggests raising questions about whether the business model has been disrupted, its track record, the recoverability of business performance and the future demand.

Most business plans will be heavily sensitised downward to reflect a more cautious view on short term performance to reflect the increasing risk of a recession, with any apparent bounce back adjusted as a one-off.

Volatility in public markets, which act as a benchmark for prices, haven’t helped. Vendors and bidders should also look at a sector’s cycle averages rather than current multiples in isolation.

Dealmakers would equally be wise to apply similar calculations based on the estimations of next 12 months’ earnings and multiples, said KPMG’s valuation director Matthew Warren, adding that the reliance on past performance will not necessarily give a strong indication of future run-rate in the current environment.

Sector fortunes

• Industrials: Manufacturers that supply government bodies have been resilient. 
• Consumer: Sector advisors may apply a cut of 10%-25% from expected 2020 revenue numbers.
• Leisure: The absence of any leisure M&A deals is a major challenge in nailing down valuations.
• Healthcare: Buyers are pushing their pre-COVID 2020 projections into 2021, encouraged by renewed debt market activity.

Discounted cash  flow

Of course, it will also be essential to “triangulate” EBITDA multiple valuations with more sophisticated valuation tools such as discounted cash flow (DCF), Warren noted.

A DCF approach allows market players to understand cash flow volatility, as opposed to EBITDA based comparables, which require analysts to use a maintainable earnings figure, which is difficult assess in the current environment, he said.

EBITDA multiples could also be misleading in the current environment when capital markets have been so volatile and, particularly when profitability has been temporarily reduced by the coronavirus pandemic.

Discounted cash flow valuations overcome this problem because near-term earnings can be reduced without radically altering the overall valuation of a business.

But as with other metrics, the challenge of DCF is the difficulty of forecasting future cash flow in the current environment.

“Right now the future is higher risk and more uncertain than ever has been,” Wood cautioned.

And even if a vendor and buyer can arrive at a theoretical valuation for a target, there is a question of strategic rationale, the competitive nature of a buyer’s bid and deliverability of a deal play, said Wood, adding that in the current environment, buyers are cautious and debt is hard to come by.

With the significant fall in M&A transactions over 2Q20, the subject of valuing companies in this environment is a purely “an academic question for the sake of an academic argument,” an industrials advisor at mid-large cap bank bluntly claimed.

“No one is doing anything at the moment,” the banker added.

Originally published by Min Ho, Claude Risner and Joao Grando in London on mergermarket.com