Private Capital Markets: Valuation, Capitalization and Transfer of Private Business Interests (Second Edition) by Robert T. Slee (John Wiley & Sons, 2011)

Performing fair market valuations keeps thousands of appraisers busy in the United States.  Most professional appraisers rarely venture outside of this one standard of value.  Now imagine that fair market value accounted for less than 10 percent of the appraisal needs of the private capital markets. The private appraisal market would be enormous!  This is just one message from Robert T. Slee’s book, Private Capital Markets.

Slee’s book is a private finance textbook, not another valuation text.  This is the first book to develop a unified structure for the analysis of the private capital markets.  Why do we need that? 

Slee’s premise is that the public and private capital markets differ in most every meaningful way. Business professors have consistently taught finance as if 1.) private companies do not exist or 2.) the financial motives and needs of private company owners are the same as those of managers of large public companies.  Neither is true.

This book creates and explains middle market finance theory, which is the integrated capital markets theory unique to middle market private companies, especially those with annual sales of about $5 million to $350 million. This holistic theory explains how business valuation, capital formation and transfer are so interrelated that a person cannot understand one of the three without comprehending how they all fit together. 

Slee’s book also introduces a new field called middle market finance.  This is the study of how managers of middle market private companies make investment and financing decisions. The book provides information and new tools to help those managers make better decisions and create competitive advantages.

Slee introduces the new framework of value worlds to explain valuation, capital and transfer. Value worlds dramatically extend the appraisal concept of standard of value.  The book thoroughly illustrates how the purpose of an appraisal selects a value world. Most appraisers, owners and other advisors do not understand that value is relative to the purpose of an appraisal.  Since there are dozens of appraisal purposes, there are dozens of value worlds.  The valuation rules are different in each world. 

Various authorities create and enforce the rules in the value worlds.  For example, in the fair market value world, the IRS, tax courts, Employee Retirement Income Security Act of 1974 (ERISA) laws, appraisal societies and various other authorities instruct appraisers how to value business interests within each authority’s sphere of influence. Most value worlds, such as the owner and investment value worlds, have only one or two authorities. Slee’s value world construct places the appraiser in the role of an interpreter of these authorities’ rules.

The book surveys the entire capital and transfers spectrums of the private capital markets.  It describes all institutional types of capital in terms of their access, sample terms and effective all-in costs. Slee explains all transfer methods making up the private business transfer spectrum.  The book uses a fictitious company (PrivateCo) with typical, lower, middle market characteristics to illustrate how company values are derived in the various value worlds.

The Second Edition of this book introduces and illustrates the Private Cost of Capital Model. The author and John Paglia of Pepperdine University created this model to empower users of private capital market data, such as from Pepperdine capital market surveys, to derive private company discount rates from empirical data.  This model is in stark contrast to models such as the Build-Up Method and Adjusted Capital Asset Pricing Model that rely on cost of capital data from the public markets.

Other main points from the book include the following.

• The idea that public data typically should not be used to derive private discount rates.  Public and private capital markets are not substitutes. This argues against decades of academic doctrine.  The book’s very first page lists 12 specific factors that differentiate public companies from private companies. The book explains in detail how the two capital markets differ fundamentally in structure and behavior.

• Every private company has dozens of correct values at the same time, because each value world produces a unique value.  The book demonstrates that PrivateCo has legitimate values that range from $2.4 million to more than $18 million on the same date and based on the same income statements and balance sheet.

• Transfer methods select value worlds, which determine value. This means that once a business owner chooses the method (ESOP, recapitalization, estate planning, etc.) of transferring his business, he is also choosing a method to transfer value.  The owner usually has no idea he or she is doing this.

For the first time in history, the private   capital markets have been thoroughly surveyed. Starting in April 2009, Pepperdine University conducted semi-annual Pepperdine Private Capital Market surveys.  The Pepperdine Private Capital Market Line depicts an empirical cost of capital line for the middle market. 

• Capital markets are significantly segmented. This means that small, lower-middle market, middle-middle market, upper-middle market and large companies have unique costs of capital and differentiated behaviors of players in the segments.

The Second Edition of Private Capital Markets is fully revised. It has two additional chapters, including the Private Cost of Capital Model, empirical cost of capital data from the private capital markets and several new value worlds.  The reader can get an excellent overview of the material in this large volume by reading only 110 pages in the order that the preface recommends.

In my opinion, Slee provides ample support for his key arguments about the middle markets. This is the most useful information that exists on the private capital markets.

The book focuses on private companies with annual sales of $5 million or more and asserts that “small-company market theory does not yet exist in the literature.” This means that neither Slee’s middle market finance theory nor public market capital theory directly addresses the market for about 95 percent of all U.S. companies. Owners and advisors of those small companies will find the book’s triangulation model (valuation, capital and transfer), empirical data from the private capital markets and much of the book’s other content valuable.

A section on buy-sell agreements provides advice that conflicts with an important assertion elsewhere in the book. Page 168 states, “In the absence of [provisions defining a process for determining the buy-sell price], negotiation between the parties is generally the best way to set a price. Current owners understand the risk of the investment and future prospects of their company better than anyone [reviewer’s emphasis].” However, pages 211-212 say, “…the owner generally values the business far beyond what it is worth to anyone else….”  The difference between the owner’s and the general market’s perception of a company’s value is so huge that “it is amazing that deals ever happen.”

This means that the recommended “negotiation between the parties” would likely lead to the buyer overpaying by so much that it would constitute a terrible investment decision.  Assume, for example, that two equal owners agree that the value of the company’s total equity is $2 million for purposes of the buy/sell transaction. They also assume no one else would pay more than $1 million for the company’s equity.  The buying owner would pay twice what anyone else would for half of the company’s equity. Not a good financial investment!  Using one or more professional appraisers knowledgeable about the private capital markets makes far more sense to me.

I noticed the book says the following on page 15, “Unless otherwise stated, public companies are defined herein as those entities that trade on a public exchange and have a float of more than $500 million.”  This means the reader could argue that this supports the use of data from smaller companies that are technically “public companies” to appraise private companies.  Based on the book’s descriptions of the private markets and empirical data that now exists from the private capital markets, I believe most readers will agree that the empirical private markets data is generally far more relevant.

For the serious business appraiser, this is a valuable and surprisingly readable book. It is a practical road map to help private business owners and their advisors work in different value worlds to solve difficult financial problems and create competitive advantages.

Philip M. Hamilton, CBA, is the principal of Five Waterfalls Consulting, LLC.  The Austin, Texas company provides business appraisals and valuation-related consulting services.