Here’s How To Use the Valuation Bridge

by Michael Roth

The valuation bridge is a valuable tool that both GPs and LPs can use to determine how and where “value creation” is coming from. In order to maximize the value of this analysis, it is important to understand what the valuation bridge tells you but also what it doesn’t tell you.

The valuation bridge identifies whether the total value of the fund has grown as the result of revenue growth, margin improvement, multiple expansion, or paying down debt.

Revenue growth and margin improvement, together, are the drivers of EBITDA growth.

  • Revenue Growth – Revenue growth is the proportion of equity growth that can be attributed solely to revenue from the time of investment to the most recent/exit date. A positive number means the company has been able to execute on its growth strategy.
  • Margin Improvement – Margin Improvement is the proportion of equity growth that can be attributed to the change in EBITDA margins from the time of investment to the most recent/exit date. A positive number means the company has been able to improve its operational efficiency and earn more of its revenue as EBITDA.

Multiple expansion is the proportion of equity growth that can be attributed to the change in the Enterprise Value / EBITDA multiple from the time of investment to the most recent/exit date. A positive number means the Firm was able to “buy low and sell high”. What an investor needs to determine is whether this is due to:

    • Growth and/or operational improvements that make the company more attractive than its peers or
    • Stock picking that is primarily due to market timing.

Fundamentally improving the company is the preferred source of multiple expansion. This is because it is more repeatable than timing the markets.

Debt Paydown is the proportion of equity growth that can be attributed to the change in net debt (total debt minus cash). A positive number means a company has reduced their net debt, which may be due to paying down debt or an increase in cash.

Other is frequently referred to as the “combination effect”. It aggregates the combined effects of EBITDA Growth (Revenue growth and margin improvement) and Multiple Expansion.

The valuation bridge does not tell you whether the portfolio companies outperformed the markets.

The valuation bridge does a good job dissecting the sources of equity growth. What is does not tell you is whether a company’s operational changes were better or worse than the public markets. This is important because viewing the operational changes in isolation does not tell you whether a manager added value or whether the portfolio companies benefitted from overall market trends.

This is why we developed the Market Bridge. Over the course of a fund’s life, a private equity manager earns a management fee of 1.5% – 2.0% during the investment period (first three to five years) and 1.0% – 1.5% during the remainder of the fund’s life. This is well above the average fee paid on an index mutual fund. Our Market Bridge allows user to determine whether GPs are actually earning their premium fees by adding value in excess of public market peers or just benefitting from financial engineering and/or market timing.

Closing Thoughts

The valuation bridge provides a powerful summary of the sources of value creation. However, the valuation bridge, viewed in isolation, does not identify whether a manager is truly adding value. If a GP invested in J. Crew, the valuation bridge will tell me how they created value and the Market Bridge will tell me if they added value in excess of their retail sector peers over the course of the investment.