Leveraged Lending

Understanding Enterprise Value

Methods of Assessing Enterprise Value

Conventional appraisal theory provides three approaches for valuing closely held businesses – asset, income, and market. Asset approach methods look to an enterprise’s underlying assets in terms of its net going-concern or liquidation value. Income approach methods look at an enterprise’s ongoing cash flows or earnings and apply appropriate capitalization or discounting techniques. Market approaches methods derive value multiples from comparable company data or sales transactions. Although value estimates should reconcile results from the use of all three approaches, the most common and reliable method is the income approach.

Generally, two methods comprise the income approach. The “capitalized cash flow” method determines the value of a company as the present value of all the future cash flows that the business can generate in perpetuity. An appropriate cash flow is determined and then divided by a risk-adjusted capitalization rate, most commonly the weighted average cost of capital. This method is most appropriate when cash flows are predictable and stable. The “discounted cash flow” method is a multiple-period valuation model that converts a future series of cash flows into current value by discounting those cash flows at a rate of return (discount rate) that reflects the risk inherent therein and matches the cash flow. This method is most appropriate when future cash flows are cyclical or variable between periods. All methods are supported by numerous assumptions. Supporting documentation should therefore fully explain the appraiser’s reasoning and conclusions.

Whatever the methodology, the assumptions underlying enterprise valuations should be clearly documented, well supported, and understood by appropriate decision-makers and risk oversight units. Examiners should ensure that the valuation approach is appropriate for the company’s industry and condition.

Relying on Enterprise Value in Adverse Conditions

Lenders often rely upon enterprise value and other intangible values when underwriting leveraged loans to evaluate the feasibility of a loan request, to determine the debt reduction potential of planned asset sales, to assess a borrower’s ability to access the capital markets, and to provide a secondary source of repayment. Also, during the life of the facility, lenders view enterprise value as a useful benchmark for assessing the sponsor’s economic incentive to provide outside capital support.

When conditions for the borrower are adverse, determining whether to use enterprise value as a potential source of repayment is more complicated because the assumptions used for key variables such as cash flow, earnings, and sale multiples must reflect the adverse conditions. These variables can have a high degree of uncertainty — sales and cash flow projections may not be achieved; comparable sales may not be available; and changes can occur in a firm’s competitive position, industry outlook, or the economic environment.

Because of these uncertainties, changes in the value of a firm’s assets must be tested under a range of stress scenarios, including business conditions more adverse than the base case scenario. Stress testing of enterprise values and their underlying assumptions should be conducted both at origination of the loan and periodically thereafter, incorporating the actual performance of the borrower and any adjustments to projections. The bank should in all cases perform its own discounted cash flow analysis to validate the enterprise value implied by proxy measures such as multiples of cash flow, earnings, or sales.

Because enterprise value is commonly derived from the cash flows of a business, it is closely correlated with the primary source of repayment. This interdependent relationship between primary and secondary repayment sources increases the risk in leveraged financing, especially when credit weaknesses develop. Events or changes in business conditions that negatively affect a company’s cash flow will also negatively affect the value of the business, simultaneously eroding both the lender’s primary and secondary sources of repayment. Consequently, lenders that place undue reliance upon enterprise value as a secondary source of repayment, or that use unrealistic assumptions to determine enterprise value, are likely to approve unsound loans at origination or experience higher losses upon default.

Valuations derived with even the most rigorous valuation procedures are imprecise and may not be realized when needed by an institution. Therefore, institutions relying on enterprise value, or other illiquid and hard-to-value collateral, must have lending policies that provide for appropriate loan-to-value ratios, discount rates, and collateral margins.

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