The merits of a maligned methodology

Valuing portfolio companies based on a discounted cash flow approach is controversial when applied to private equity. We discover why valuation experts still consider it the most appropriate method for infrastructure.

In the private equity world, where fund managers seek to comply with various “fair value” financial accounting guidelines which normally lead them down the path of mark-to-market asset valuations, there is a somewhat sceptical view of valuing assets on a discounted cash flow (DCF) basis.

According to many a private equity professional (perhaps half-serious and half-joking), DCF valuations work like this: decide what number you want to reach and then, working backwards, DCF will get you to that number. In other words, any valuation can be justified using DCF. This helps to explain why, at best, DCF will be offered alongside fair value-based valuations in private equity fund reporting – very rarely in isolation. Many funds will simply overlook it altogether.  


Hence, it’s perhaps not the easiest case to make that infrastructure assets should be valued on a DCF basis – as they usually are in the case of portfolio companies managed by unlisted infrastructure funds. Especially not, you might argue, in a post-financial crisis period where many investors in infrastructure have been left bruised as a result of having been exposed to over-leveraged assets that have ended up struggling to refinance and which may have to be sold at a big loss. Why trust the valuation method that was applied to these assets?

Independent valuation experts acknowledge the issues, particularly in relation to so-called “infrastructure-lite” assets, which have some infrastructure characteristics but which are also exposed to things like GDP and demand risk. Into this category you might place the likes of car parks, ferry operators and motorway service stations.

But there is still a strong belief that DCF methodology should be applied to infrastructure assets, even those at the more opportunistic end of the risk-return spectrum.

“The reason why there is concern around DCF in private equity is that longer-term cash flows are less certain than infrastructure cash flows,” says Thomas Romberg, a director of energy, utilities, mining and infrastructure valuations at financial services firm PwC.

He adds: “For regulated UK water and electricity/gas network valuations, for example, as long as the businesses perform and are financed within the parameters set by the regulator, their enterprise values shouldn’t drop below their Regulatory Asset Values (RAV). For ‘infrastructure-lite’ assets, which may be operating in a less stable regulatory framework or are exposed to GDP growth rates, there’s more of a risk but you can still forecast the cash flows a long way out. It’s not like private equity where you’re looking to exit in three to five years.”

Mathias Schumacher, managing director at financial advisory firm Duff & Phelps, acknowledges the “suggestion you can arrive at any valution you want [using DCF] and one can observe an enormous spectrum of outcomes”. But, apart from siding with Romberg’s point about the relative certainty of infrastructure income streams, he makes the additional point that because many infrastructure assets are “very unique” it “makes it difficult to identify publicly traded companies that have similar economic characteristics, which limits the use of a market approach”.

There’s no doubt that, generally speaking, the business models for infrastructure assets are more predictable than companies typically backed by private equity or venture capital firms. Schumacher points to the predictability of toll bridges or hydropower plants compared with, say, a high-tech company. He also points to an interesting theme that runs counter to this, however. Namely, the impact of regulatory reviews:

“For regulated infrastructure assets, the risk resides with the regulator and what return they allow the company to earn when the next review is due,” says Schumacher. “As these are often politically sensitive decisions, they are hard to predict.”         

Perhaps this element of unpredictability explains why, despite their generally stable cash flow characteristics, investors are often keen to see a range of values for infrastructure assets rather than just one definitive valuation. “Some clients request a value range and they understand that the range has been developed according to various sensitivities,” says Schumacher.

More information the better

Maybe it also reflects that limited partner investors simply want as much information as they can get these days – a requirement that has its roots in a global crisis which shook many peoples’ assumptions when it came to risk/return profiles. For independent valuation professionals, the trend is their friend.

“More and more infrastructure funds are seeking periodic valuation advice from independent valuers because, since the credit crunch, pressure from investors and auditors have increased, demanding regular and robust valuations of the funds’ investments,” says Romberg. “I would say around two-thirds of major infrastructure funds are getting independent valuations, and it’s a growing number.”

Investors in infrastructure may be growing more demanding, but given the stable, long-term characteristics of the assets, they do not appear to be demanding a re-think on the applicability of the discounted cash flow-based valuation methodology. As many observers have concluded in the wake of the controversy over some infrastructure funds charging private equity-style fees: “Infrastructure is not private equity”.