The Global Family Office Report found private equity (PE) represented 22 percent of family office assets on average, more than any other asset class except listed equities. Family office investors are often courted by companies as patient investors willing to commit capital for longer periods.
The liquidity premium generated by PE is particularly attractive to family offices; their ability to commit capital with greater control can lead to significantly higher returns over time. For many family offices, direct investment in PE can also allow them to time investments to their own time horizon, creating tax or estate planning benefits.
However, PE investments can be complex and hard-to-value. They typically contain options and market conditions such as return multiples or thresholds, specific internal rate of return and price performance targets that alter cash flows over the life of the investments. The complexity lies in corporate transactions, external financings, capital raises and the implementation of incentive compensation plans or awards.
Family matters: Three valuation considerations
Family offices making PE investments need to be aware of a number of valuation issues related to investments in more complex structures:
1. Valuation Method and Financial Model Selection
Making direct company investments requires selecting the proper valuation approaches and using an accurate financial model. Applicable approaches for going-concern companies include:
Income approach: requires robust financial projections, usually prepared by the subject company’s management, which may or may not be available to family office investors.
Market approach: relies on guideline publicly-traded companies or guideline change-of-control transactions, and the key is finding sufficiently comparable companies from operational, financial and size standpoints – often difficult for niche businesses.
Once the proper methods to value the subject company as a whole are decided, family office investors may also need to consider a financial model that captures the unique feature(s) specific to the security’s structure.
2. Fair Value
The FASB Accounting Standards Codification Topic 820 (ASC 820) provides guidelines for determining the fair value of portfolio investments on a periodic basis, usually quarterly, so family office investors may know what their investment is worth.
3. Incentive Compensation
Restricted stock awards are granted in a variety of forms as incentive compensation to management and other investors or interested parties. Profit interests are equity incentives similar to stock options but issued by limited liability corporations, and made available to executives, management, key employees and service providers. Many privately-owned firms are required by Internal Revenue Code Section 409A to value incentive options to support option grants for tax purposes.
Patience is a family virtue
Data suggests family offices are participating directly in PE deals more often. Although many family offices have the patient capital and time horizon for PE, they may not have the staff to address more complex valuation issues when making direct investments in illiquid companies. An independent valuation provider can be an important partner to support the investment decision or provide critical information for tax or estate planning purposes.