In the fast-paced world of M&A dealmaking, the issue of valuation can be a huge challenge. The price that one buyer is willing to pay could be tens or even hundreds of millions of dollars different than what someone else is ready to offer. In this report, dealmakers share their experiences and opinions about this crucial phase of the M&A process.
Methodology
In Q3 2017, Mergermarket interviewed 25 dealmakers in North America to learn their views on the challenges of M&A valuation. The respondents were senior executives at investment banks (40%), private equity firms (40%), and corporations (20%) that most often do deals in the middle market (below US$500m in value).
Introduction
In M&A negotiations, the issue of valuation is typically the most important of all. And the central question facing acquirers is not necessarily, “How much is this asset worth?” Instead, the question
they must answer is: “How much are we willing to pay for this?”
The reasons for this distinction are understandable. After all, an accurate valuation can be extremely difficult to calculate. This is especially true for outlier targets – take the recent example of ride-sharing giant Uber. Japanese tech conglomerate SoftBank has expressed its interest in buying as much as 22% of the company, for up to US$10bn.1 The catch is that SoftBank’s offer would value the company 30% lower than its last valuation, of around US$70bn. Uber attained this valuation by impressing investors with non-stop growth – despite also sustaining billions of dollars in net losses.2
In fact, Uber has many of the qualities that make valuation challenging: high market share in a growing niche, combined with net losses; a short amount of time in the market, with impressive growth; cutting-edge technology; and a history of management issues. Of course, these are not the only hurdles that dealmakers face when valuing companies, either.
In order to learn about the most vexing issues M&A practitioners face when determining a valuation, Mergermarket, in partnership with Firmex, conducted a survey of senior executives at North American investment banks, private equity firms, and corporations. The executives shared their views on the challenges they face, the most common blunders they see made – and a few of the horror stories they have gone through in assessing company valuations.
In addition, Mergermarket sat down for an extended interview with Scott Hebbeler, managing director at Lincoln International, to learn about his experiences valuing M&A targets. Scott provides a wealth of insight
into the difficulties inherent to the task of valuation.
Part 1: Precision and bias in M&A valuation
Coming up with a suitable valuation in an M&A deal can involve a significant amount of artistry, in addition to the typical spreadsheet math. If a company is particularly small or in a novel sector, there may not be many comparable deals to rely on. Young start-ups, especially in the tech sector, may have negligible earnings or few customers to speak of.
As a result, few dealmakers believe that valuation can be deemed a science. In our survey, when asked to describe how precise the M&A valuation process is on a scale of 1 to 5, where 5 is “highly precise” and 1 is “highly imprecise,” the average response was 3.28. This demonstrates that respondents believe the procedure is more science than art – but not by much.
Several respondents noted that new tools and better due diligence have improved the valuation process substantially in recent years. “Had you asked this question seven to eight years back, I would have chosen ‘2’ but now things have changed significantly,” said a senior M&A director at a cloud computing company. “Data analytics and machine learning coupled with AI are changing the way information is retrieved and analyzed. Highly precise and accurate data can be sourced, which helps us arrive at a proper valuation in an M&A deal.”
Another survey participant pointed out that the situation varies from sector to sector. “We deal with brands which are mostly B2C-oriented, and we adopt a very careful approach of determining the valuation of the company in an M&A deal,” said a senior vice president for corporate development at a consumer goods company with over US$10bn in revenue. “But a lot of intricacies are involved when you deal with a consumer-oriented brand, as market reactions are spontaneous and all this has to be taken into consideration
during the valuation.”
Strategic vs. financial
When Microsoft announced its acquisition of social network LinkedIn in June 2016, many observers went agape at the US$25.5bn purchase price, which represented an incredible 94.7x EBITDA multiple. However, it is impossible to evaluate the deal on a strictly financial basis, given that it was strategic. Microsoft could have far better levers to take advantage of LinkedIn’s assets than buyers which lack the software giant’s infrastructure and reach.
Indeed, 72% of our survey respondents said it was either “much more difficult” (12%) or “somewhat more difficult” (60%) to arrive at a valuation in a strategic deal than in a strictly financial deal. One managing director at a private equity firm in operation for more than 35 years noted: “The seller may not have a strong financial record but sometimes the market or product mix is enough for him to negotiate. The brand value or non-financial factors are difficult to quantify.”
Nonetheless, 48% of our respondents said they believed a seller typically has more leverage when it comes to valuation in a strategic deal as opposed to a strictly financial transaction. No one said sellers do not have more leverage, and the remaining 52% said it depends entirely on the specifics of a given deal. “When a seller is aware of the impact their assets can have on a company, they tend to quote higher sums,” said a managing director at an investment bank focused on the financial services sector.
The power of bias
Another crucial factor that can affect a target’s valuation is mental biases. The field of behavioral economics has demonstrated that people are far from rational when making economic decisions – including those in mergers and acquisitions.3
An array of irrational human habits can have an effect on valuation, and two-thirds or more of our respondents believe that at least three common biases play a role in valuation judgments: the bandwagon effect (68%), anchoring (72%), and ignoring the intangibles of a target in favor of financials (72%). Four in ten survey participants said that ignoring the intangibles in a deal – which will be the focus of Part 2 of this newsletter – is the most dangerous bias in valuation decisions.
Article by Merger Market
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