Introduction:

Management’s primary responsibility is to create Equity Value [DC1] at a pace that exceeds their investor’s return threshold for an investment of a similar risk characteristic. Despite universal agreement, private companies have no method of measuring performance relative to the company’s Equity Value creation responsibility. And public companies use the stock price as this barometer, which clouds performance as stock prices are heavily influenced by factors outside the management’s control.^[1]

Yet Private Equity investors track the value of each of the investments in their portfolio. Moreover, they report the value to their clients, usually on a quarterly basis. How are Private Equity investors able to track value creation while CEOs do not?

This bothered me—a lot. For many years. If you don’t keep score, how do you know whether you are exceeding value creation expectations? If creating Equity Value is the goal, the ability to measure Equity Value creation is paramount.

I was deeply unsatisfied with the norms to get around this. Enormous efforts would be put into establishing a budget, often involving negotiations to allow management to lower, and then beat, expectations. Rewards and repudiations depended on who made and missed their budgets. This struck me as an enormous waste of time, as the outcomes were focused on actuals versus budget instead of how much value was created or destroyed.

Accounting methodology does not focus on measuring value creation. Net income, cash flow, and net assets are tabulated, but nowhere does the methodology attempt to address whether value creation goals are being met.

Economic Value Added (EVA) was created as a method for addressing this issue. Though EVA is a meaningful step in the right direction, it has not been adopted by the Private Equity industry. In my opinion, EVA is not an appropriate approach for good reasons.^[2]

My solution flowed naturally from how the Private Equity industry values its portfolio companies. I adapted this approach to how management, as responsible stewards of its investors’ capital, track and report its value creation performance.

My Private Equity sponsors loved it. They saw the calculation of value creation each quarter, which aligned with how they measured the performance of their investment. The discussions validated that management was focused on the right levers of value creation. If we excelled, the quantitative discipline of the methodology would be the evidence. If we fell short, it would quickly reveal itself in the numbers. Our interests were aligned. We talked in each other’s language.

We didn’t waste time negotiating budgets. We didn’t rely on management storytelling as the basis for evaluating management’s value creation performance. We relied on the financial calculations of value creation.

The methodology proved to be versatile. It applied to periods that included acquisitions, new equity investments and distributions, increases or decreases in debt, and major capital outlays.

Some of my Private Equity investors tried to get other portfolio companies to embrace the methodology. Some of my management team took the methodology with them to new ventures. To my knowledge and disappointment, none have resulted in sustainable traction.

I view Equity Value Creation methodology as my greatest accomplishment. It might die as a result of me hanging up my CEO spikes. I hope someone who reads this book takes an interest.

Value Creation Calculation Dilemma

Management’s responsibility is to create Equity Value at a pace (Equity IRR) that exceeds the investor’s return threshold for an investment of a similar risk characteristic (equity hurdle rate). Assuming the equity hurdle rate was 15 percent, the investor’s level of satisfaction at various outcomes is illustrated in the table below.

The methodology is rooted in this simple concept. How does the Equity Value at the end of the period compare with the Equity Value at the beginning of the period, and how much time has elapsed? Based on the calculation, how satisfied would the investor be in the Equity Value creation outcome?

For example, if an investor invests $1 in a company, and later the investment is worth $1.30, how satisfied would the investor be? The answer depends on the duration of the investment. If only one quarter passed, the annualized IRR would have been close to 100 percent, and the investor would be extremely satisfied. If, on the other hand, more than four years have elapsed, the IRR would be well below the investor’s 12 to 18 percent expectation, and as such, the investor would be dissatisfied.

At one level the measurement of Equity Value Created seems basic. If you know how much and when equity was invested, as well as how much the equity is now worth, the calculation is straightforward. For example, see the table below:

The calculation depends on knowing the Equity Value at the beginning and end of the measurement period. The $100 is explicitly knowable at the launch of the company, and the $169 value would be explicitly known if the company was sold at the end of year two.^[3] How, though, could this approach be applied on an ongoing basis during the investment cycle?

Approach to Measuring Equity Value Creation

The methodology outlined herein was designed to not rely on either (a) an exit or (b) the stock price. In contrast, the methodology measures the ongoing performance of a management team in its responsibility to grow Equity Value at a pace in excess of the equity hurdle rate. As such, it is applicable in all the following circumstances:

1. As a quarterly measurement of actual performance.
2. As a useful calculation for both private or public companies. If a company is public, the methodology does not rely on stock prices to isolate measurement from the external effects of the stock price, such as (a) macroeconomic environment, (b) perceived gaps in the Market Value relative to intrinsic value, or (c) random ebbs and flows in the stock price.
3. As a reliable measurement in determining value creation by a major division of a company.
4. As a way to measure forward-looking value creation implied by a forecast or budget.
5. Most importantly, as a methodology to assess management’s performance and align incentives between management and investors.

The methodology outlines a practical annual and quarterly measurement that determines value creation performance and can drive value creation behavior.

Discussion of EBITDA Multiple

Central to this methodology is the use of EBITDA multiple as an approximate, albeit imperfect, indicator of the value of the business entity. Importantly, the use of an EBITDA multiple does not require putting undue weight on the absolute linkage between intrinsic value and the value as tabulated by multiplying EBITDA by an EBITDA multiple. In fact, the exact EBITDA multiple used in the calculation won’t be material to the IRR calculation. For example, if a range of eight to twelve times EBITDA is viewed as an appropriate range for an industry sector, using ten times EBITDA will yield similar results as if eight or twelve were used.^[4]

Instead, it relies on using a static EBITDA multiple to answer the following two questions:

• Past performance: “On a like-for-like EBITDA multiple, how much Equity Value was created during the period, and what was the implied IRR?”
• Projected performance: “On a like-for-like EBITDA multiple, how much Equity Value will be created if the budget is achieved during the forecast period, and what will be the implied IRR?”

Equity Value Created Calculation

The equation for calculating how much Equity Value is created in a given period is straightforward.

1. Measure change in EBITDA
2. Multiply by the EBITDA multiple, which yields change in Enterprise Value
3. Add cash generated, which yields change in Equity Value Created

In table 1, we compare multiple scenarios that use an EBITDA multiple of ten with each having an identical change in EBITDA during the period. The amount of cash generated associated with the change in EBITDA determines the amount of Equity Value that was created or, if negative, destroyed.

To tabulate cash generated, subtract change in Net Indebtedness from change in equity invested.

Net Indebtedness is Gross Indebtedness less cash balance. If the company added to the debt during the period, Gross Indebtedness would rise, whereas if it paid down debt, Gross Indebtedness would lower. Net Indebtedness subtracts the cash balance from the Gross Indebtedness both at the beginning and end of the period, thereby reflecting the portion of the Enterprise Value that belongs to equity holders.

However, Net Indebtedness is also affected by change in equity investment, either as a result of new investments or distributions or cash dividends. The inclusion of change in equity in the calculation of cash generated ensures changes to cash balance caused by increases or decreases in equity investments do not affect Equity Value Created.^[5]

Table 2 illustrates multiple examples that yield the same cash flow as scenario 2 above.

Multiple of Invested Capital (MOIC) is an important measurement of value creation performance. The calculation is simple, with the numerator being the Equity Value at the end of the period (EEnding Equity Value) and the denominator being the equity value at the beginning of the period (beginning equity value).

Let’s start with the denominator. Table 3 uses the variants of scenario 2 to show a range of beginning equity value.

To calculate the numerator—the Ending Equity Value—simply add Equity Value Created from table 1 to Beginning Equity Value in table 3. MOIC can then be calculated by dividing the Ending Equity Value by the Beginning Equity Value, as shown in table 4.

The last step is to factor in the duration of time in which the value creation took place. The Equity IRR is estimated, and the level of investor satisfaction is assessed. Using 2d as the example, investor’s assessment might range from dissatisfied to extremely satisfied depending on the time it took to create the value, as illustrated in table 5.

Investor Alignment

Imagine a company that uses Equity IRR as its fundamental measurement tool. The following conversations would become commonplace:

Investor:   How is your business unit performing?

CEO:          Very well. Our Equity IRR was 38 percent over the past two quarters and 32 percent over the past year.

Investor:   That’s excellent! What are you forecasting to achieve over the next two quarters?

CEO:          Well, it’s at risk of dropping a bit, but it will be respectable. Twenty-five percent is the low end, and 30 percent is still within reach.

Investor:   I’ll be very pleased anywhere in the 25–30 percent.

The savvy investor would focus on the excellent IRR historical performance and strong forecast. Performance against budget becomes far less relevant. No longer would budget preparation and approval be a contentious negotiation process. The absolute measurement of value creation would replace actual versus budget as the assessment of management’s performance.

Summary

Management’s responsibility is to create Equity Value at a pace that exceeds the investor’s return threshold for an investment of a similar risk profile. As such, Equity Value creation and IRR must be measured. Moreover, incentive systems should be directly tied to the pace of equity value creation.

The Equity IRR value creation methodology provides the ability to measure Equity Value Equity Value Created and Equity IRR. Better decision-making follows. Over time, the competency and culture of an organization center on delivering Equity IRRs at a rate that will satisfy investors.

^[1]  When stock price increases, CEOs don’t hesitate to highlight this as an achievement of the management team. However, when stock prices are in decline, CEOs remind their investors of the unreliability of the stock price due to stock market factors that are outside the control of the CEO.

^[2] Economic Value Added (EVA) has three shortcomings. First, it doesn’t directly incorporate cash flow into the calculation. Instead, it uses depreciation as a proxy and change in net asset value. The all important role of cash flow is obfuscated.

Second, EBITDA—which is a primary valuation metric used by investors in many industries, including telecom—is not used in EVA. Though EBITDA is not a GAAP-defined term, it is used because it is the best approximation of cash flows generated from operations.

Third, EVA relies on the accounting definition of value—the balance sheet. Material gaps often exist between the stockholder’s equity as tabulated on the balance sheet and the perceived value of the business. I put weight on the perceived value, as this value is very real to the investors who are buying and selling ownership positions in companies. Investors report perceived value to their investors in a process sanctioned by the SEC. They “mark to market” when communicating value to their investors instead of citing stockholders’ equity.

^[3] If the company was public and the public price was seen as a sufficiently accurate view of intrinsic value, the calculation would also be straightforward. In fact, if the $100 of value grew to $169 of value over two years, the appreciation of stock price would yield the same 30 percent IRR result.

^[4] Over time, the market is used to refine EBITDA multiples through a combination of public stock valuations and private M&A transactions. The important attribute is to apply like-for-like multiples across the periods of the measurement.

^[5] If an acquisition is paid for in full or in part by issuing stock to the seller, the implied value of the equity grant should be treated as a new equity investment in this calculation.