Article: Valuation isn't about value - it's about the deal!

We are investors in Frontier Markets. We acquire companies and deploy capital from our investors to create growth and value. But we can’t do this when the prices which owners are asking for are so far from what we consider to be “sensible”.

In this perspective we look at the role which valuation and price-setting plays, and we offer three guidelines for overcoming the impasse which we see too often in company transactions.

When we invest in companies we use valuation for one single purpose to establish a financial basis on which we can make a deal.

But we’ve seen too many times how valuation takes on a life of its own and becomes an issue which distracts from the end objective - making a deal. This is frustrating and disappointing.

In all our deals we’re trying to balance three competing interests.

The first is the seller. The seller’s trying to get the highest price for his company and he’ll talk up the factors which in his view raise the value of his company.

The second is our investors. Our investors will only support our deals if we present a valuation which is reasonable and defendable. Or as Buffet puts it, “a sensible purchase price”.

The third interest is the company after the acquisition. If we agree to an unreasonably high price, the company will end up with less capital to support growth and contribute to the wider economy.

When we balance these interests we create the basis for a solid deal, a solid investment and a solid return.

But when one of these interests is out of balance, we don’t go forwards. And in our experience the seller’s inflated expectations of the value of their company has been the sole factor which has collapsed deals.

So how can we unblock this? We offer three simple guidelines.

Guideline #1: Don’t start the journey unless you’re sure you want to finish it.

This is important. Too many times a seller starts the transaction process only to pull away after the first offer has been made. Sellers must be absolutely sure they realize what they are starting. Selling a company involves a very substantial change in their lives and livelihood. Transactions take lots of time and effort and involve a level of complexity unlike any other corporate transaction. So sellers must have a very open discussion with themselves, their families and stakeholders before starting, because changing minds half way for no specific reason reflects poorly on all concerned.

Guideline #2: Valuation is just the start, not the end. So don’t get hung up on it.

There are many ways to figure out how much a company is worth. Because we’re in the investment business we like valuation methods which emphasize how a business is performing. How does it generate free cash? How does it earn a return on the assets it uses? How is it financed - how much debt is it carrying, how much money have the owners left in the business as equity?

We tend to ignore assets which do not contribute to the operations, nor add immediate value - like a large parcel of unused land which will need many millions of dollars for development, or a disused production line in need of rehabilitation.

Most importantly we look for unequivocal facts. We like hard data validated by audit. We then look forwards and take a view of how the company could grow if we invest in growth and tighten up performance. This gives us a landscape a few years in the past and a few years into the future. We’re careful not to be unreasonable in our expectations. Growth is hard to find, many costs can be stubborn, and Frontier Markets have a bureaucratic machinery which can slow things down.

We then build up our view of the company’s value using standardized approaches to produce a picture of a company’s value. Most importantly we try to find a sensible value which makes the deal worth it for the owner, for our investors, and for the company after the acquisition.

Then we stop the valuation work, as we have a range in mind which we want to discuss. The lower end of the range is typically where we start the discussions, expecting this to be a starting point.

But the upper end of the range represents a serious, logical position based on facts and internationally-accepted methods of valuing companies. The upper end of the range is our view of the maximum amount which satisfies all parties: seller, investors and the acquisition target. We set this range with extreme care and diligence and with many years’ experience. And we let this upper limit guide our behaviour - we will not go above it.

And typically this is where the disconnects start.

In our experience sellers have all the information at hand, but don’t translate this information into a “sensible price”. Sellers will develop a value based on informal numbers or thinking. We often hear “two times last year’s revenue”, or “15 times profit”, or even “net asset value” in such discussions.

The most frustrating point comes when a seller quotes ‘breakup value’ as a minimum. This metric can be easily manipulated. If it is going to be used in any discussion about valuation, it should not be the sole basis for valuation. It should also be recalculated with sensible and careful assumptions.

This creates an asymmetric discussion which is usually fatal for a deal.

Put simply, the seller lays out a price, we lay out a price. In Frontier Markets these values are usually a very, very long distance apart. We argue our relative positions and we offer a wide range of different mechanisms to genuinely try to close the gap - while maintaining a sensible price.

But now the danger is that the seller’s position has become a fortified castle he can’t leave. The more the discussions advance, the stronger the castle walls become. We’ll simply leave the field now as there’s no point going further. And then the deal dies. Which brings us to Guideline #3.

Guideline #3: Just make the deal

Although selling a company is more complex than it seems at first, it can be an incredible way to generate wealth. In some cases successful sellers reinvest their gains into new businesses with higher growth and prospects. In some cases sellers use their proceeds for charitable works. In others cases sellers pass the proceeds to their family members, creating opportunities for them individually which would not have been possible before the sale.

However the proceeds of the sale are put to work, there’s a very simple logic at play: if there were no deal, then these opportunities would not exist. Period.

So we hold the view that it’s always better to make a deal than not. We are fair as individuals and a company. It’s not in our interest to short-change a seller, and we believe it’s always better that all parties - sellers, investors and the acquired company - walk away from a deal having been treated fairly and with respect.

When we propose deals we do so with these values at heart. What we ask is that sellers understand this - and that their financiers support the education of the sellers - so we can can all get to Guideline #4.

Building value for all our futures.

I co-wrote this post with Alaa Oumansour, my Partner in Cassini Partners. Cassini Partners was an investment company operating in Emerging Markets. Originally published February 2019.