There has been much debate about unsystematic risk, and to what extent it should impact the valuation outcome. There are lots of different opinions, explanations, court rulings, etc., covering its appropriate range, how much should be considered unavoidable, how much might already be covered in other measures such as projected cash flows, how to assess it, how to measure it, and how to defend our determination of it. Each specific topic could be the subject of a separate thesis, and I will not attempt to tackle every debate in one article. So, let’s step back and think about unsystematic risk from a slightly different, simpler, perspective.
In any company, there are only two general categories of risk that impact value through the calculation of cost of capital: systematic and unsystematic. If systematic risks are, by definition, outside of the control of the business owner, because they are driven by the broad public market, then unsystematic risks must, by definition, be within the control of the business owner, because they are not driven by broad public market factors. Some risks, such as the basic equity market risk, are only systematic in nature, while others, such as customer concentration, for example, are only unsystematic in nature.
Some risks, however, such as those relating to industry, size, and even liquidity, might have both systematic and unsystematic characteristics. By recognizing such mixed risks, we can more accurately assess their impact on our clients’ values, and can do more to help clients mitigate them.
For example, the high rate of technology obsolescence in the cell phone industry (industry risk) might appear to be purely systematic. However, a cell phone component designer/manufacturer might be able to mitigate some of that risk by developing a robust product innovation program, and working with the original equipment manufacturer to ensure that its components remain relevant. With such a program in place, the industry risk could be treated, at least partly, as unsystematic (controllable), rather than systematic.
As another example, the small company size risk premium is generally assigned as a systematic factor. However, within any given size bracket, any particular company could be structured, and could operate, at a higher quality level (lower risk) than its standard size bracket would dictate. It would likely not be able to function several levels above its size, so it could not entirely eliminate its size risk premium, but some degree of the risk is certainly within its control to mitigate.
In order to understand the magnitude of the unsystematic risk components in private companies, consider the research of Robert T. Slee, author of the textbook Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interest (2nd edition: John Wiley & Sons, NJ, 2011) in which he presents a depiction (Exhibit 2) of the relative costs of capital for private companies versus public companies.
In the above graph, the public company line depicts the cost of capital as the company moves from an all debt capital structure (3 percent) to an all equity structure (8 percent). The private company line, on the other hand, depicts the relative costs of different sources of capital by themselves, as follows:
5% = banks
8% = ABL
21% = mezzanine
30% = private equity
37.5% = venture capital
42.5% = factoring
As Exhibit 2 indicates, the cost of capital for a private company can be four to five times the cost of capital of a public company. To demonstrate the impact of such a difference on a company’s value, suppose a company is generating $3 million of cash flow per year, has no debt, and is expected to grow at 3 percent per year for the indefinite future. At a cost of capital (discount rate) of only 8 percent, that company would have a terminal value of approximately $60 million. However, at a cost of capital of 40 percent, the same company would have a terminal value of only approximately $8 million; a whopping difference of $52 million.
A quick look at the public market bears out the above disparity. The S&P 500, which represents about 75 percent of the U.S. public equity market, is currently valued at an overall multiple of approximately 19 to 20 times the collective earnings of its members. However, in the private sector, many lower middle market businesses are being sold for multiples of only three to five times earnings, demonstrating the huge difference in values of public versus private companies.
Why the huge value disparity? Roughly a third of the difference relates to a combination of the systematic portion of the risk premiums for liquidity and size that are borne by private companies. The other two-thirds, however, relate to unsystematic risks that are within the control of the business owners and, therefore, within our purview, as their advisors to help mitigate.
In his textbook, Robert Slee explains that “an investment in a private company is typically riskier than an investment in a public company” because the private company’s company-specific risk is perceived to be much higher than that of a public company. Why? Public companies are required to be more transparent, typically have better developed organizations, more fully developed strategies, and better systems, to name but a few factors. In short, they are perceived to be better managed and are, therefore, less risky and worth more than their private company counterparts.
How can a private company begin to close the gap? Slee points to characteristics such as, “Does the company have the look and feel of public companies in its market segment. [Is there] credentialed management depth? [Is there] an active board of directors? Has strategic planning been developed to implement both short- and longterm goals? [Could] all public reporting requirements, especially in the financial area, be met with timeliness? Does the subject company perform financially above the average in its market segment?” These are just a few of the many characteristics in which public companies are typically superior to private companies.
The opportunity for valuators, therefore, is to identify, understand, prioritize, and address the risks in our clients’ businesses that would create the most value by their mitigation, and to develop value road maps for our clients to methodically build value in their businesses by reducing the risks that are depressing value.
The Morningstar build-up model presented in Exhibit 3 will help to clarify the components of the opportunity for us and our clients. Although the percentages used in the table are slightly different than the percentages reported in the Pepperdine Private Capital Market Line above, the differences, which reflect the most recent data available, do not materially affect the overall analysis.
Based on the 2013 Morningstar Valuation Yearbook, the risk-free rate and equity risk premium, combined, total 9.1 percent. Adding a liquidity premium for companies that are pre-IPO, about 3.2 points (35 percent premium), results in the cost of equity of a large private company that is public-ready, or about 12.3 percent. Lastly, adding a size premium of 8.9 percent for the Morningstar size bracket of 10y results in the cost of equity for a small private company that is public-ready, totaling 21.2 percent. Any incremental cost of equity above the 21.2 percent must relate to unsystematic risks.
If we view the range of potential unsystematic risk premiums as the difference between the 21.2 percent and the 40.5 percent reported as the cost of venture capital in the most recent Pepperdine study, we can then develop a method of assessing any given company’s position within that range, since that is the range that is theoretically controllable by business owners if they change the behavior of their companies. As an aside, one could even assert that the actual range of costs of capital is even higher than the Pepperdine study indicates because the study only reflects actual reported transactions. The 40 percent of companies that attempt, and fail, to transact would, undoubtedly, have even higher costs of capital, but those companies have not yet been empirically surveyed.
You may notice my inclusion of the size premium above as the Morningstar 10th decile 10y premium of 8.9 percent, rather than the 10y premium of 11.65 percent, the latter of which covers companies up to about $96 million of value. The reason stems from my belief that a company that would otherwise fit the 10z category, if structured and operating with the quality of a company that fits category 10y, could warrant the lower 10y risk premium.
In effect, a certain portion of the size premium should be considered as unsystematic (controllable), and a certain portion should be considered as systematic (unavoidable). In fact, I believe that using the overall 10th decile premium of 6.03 as the systematic portion might even be appropriate, which would increase the overall controllable cost of capital to more than 22 percent, versus the 19.3 percent above.
To continue the previous example, if our subject company with $3 million of cash flow could approach the risk profile of a small private company that is public-ready, and reduce its cost of capital from 40 percent down to even 24 percent, its value would increase from the $8 million range to almost $15 million, or an increase of approximately 80 percent.
Not all companies, of course, will be starting from a cost of equity as high as 40 percent. However, I believe that most private companies in the lower middle market could increase their values by 70 percent, or more, over a three-to-five year period, by moving closer to the way a public-ready company is structured and operates.
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