Private Equity ‘Control’ Valuation Approach Illustrated by Elon Musk’s Twitter Bid
By Rick Nathan, Senior Managing Director
As the stock market tumbles in a bear market, many observers seek to understand why most private equity (PE) valuations are not falling in lockstep. The divergence is best explained as the difference between the long-term strategic value of owning an entire company and the short-term value of passive participation as a purely financial stockholder. This divergence — sometimes referred to as a ‘control premium’ in the public market context — is clearly illustrated in the current take-over bid by Elon Musk for control of Twitter.
Public markets are highly volatile, particularly in the current environment. Stock traders are passive financial investors, seeking to participate in a small slice of a company’s day-to-day, quarter-to-quarter, financial performance. Investors consider the company’s revenues and earnings today, the guidance for the next quarter, and the risk of an upside or downside surprise during that period. They compare those financial prospects against the competing opportunities in other companies’ shares, and other financial assets such as bonds, all the while considering the broader macroeconomic impacts and current sentiment on inflation, Government spending, pandemic, war and peace. Algorithmic trading heightens this volatility by amplifying these changing sentiments every minute. Generally, these public investors pay little attention to where they think share prices may reside 5 years in the future.
In contrast, PE investors acquire entire companies with a long-term perspective, taking active control to build the business over a 5-year period¹. They determine their initial purchase price based on the value of owning the whole company: current cash flows are a key input, but the strategic value of controlling the business is also very important. They factor in their strategies for value creation through stronger financial performance over time, taking a current snapshot of all of these components to negotiate a purchase price for the entire company². These PE investors also understand that their longer-term exit value will be paid by a similarly minded purchaser, so there is little need to take the day-to-day public market sentiment into their calculations along the way.
Elon Musk is demonstrating the same approach in his current bid for Twitter. He is seeking to acquire strategic control and offering $54.20/share as his view of the long-term value of owning the entire company and taking it private. Stock traders have bid up the Twitter price from the $38/share range before the bid announcement to reflect their assessment of whether or not the transaction will be completed (and at the indicated price) without considering the day-to-day sentiment affecting all other stocks. As the broader stock market falls, the Twitter stock remains stable because everyone perceives that these broader market impacts will not change Elon’s view of the longer-term value. The Twitter share price declines only as traders perceive a growing risk of completion (or price adjustment), so the day-to-day price finds a balance between the long-term value if the bid is completed, and the normal trading dynamics impacting all other stocks, where the price would be expected to land if the bid is withdrawn.
Notably, Elon has not indicated any intention to reduce his Twitter bid price as a result of broader stock market declines. These day-to-day fluctuations are irrelevant to his longer-term plans and his longer-term assessment of value. His inquiry into the number of fake Twitter accounts (bots) is much different: if it turns out that a much greater portion of Twitter traffic is artificial than has been previously disclosed³, then the business is much smaller than previously believed. Its longer-term value would be lower because it would first need to grow significantly just to reach the size and scale currently understood, a task that would take longer and be more difficult to achieve. This type of fundamental impairment of value has a direct impact on the company’s strategic value today. If Elon’s fears of greater artificial traffic turn out to be true, he would be justified in reducing his bid price (or withdrawing his bid) to compensate.
By analogy, PE investors may be understood as always valuing their portfolio companies with a strategic control premium intact. They care about the long-term prospects of the business, and will adjust their valuations when they see fundamental impairment or strategic growth in the business value that changes their long-term outlook. Day-to-day stock market volatility is not generally relevant in these calculations if it is perceived as short-term ‘noise’. However, an economic recession that requires a reset to a strategic plan can definitely change PE values. The key is whether or not the owner perceives a fundamental change that affects their longer-term strategic value. Elon will still offer $54.20 if he gets comfortable with the strength of the Twitter business, regardless of whether the stock market has declined since his initial bid date, but he would be justified in making a change if Twitter turns out to be a smaller business.
¹ PE investors generally plan to hold a business for 4 to 6 years, although their ultimate holding periods can be highly variable.
² The valuation analysis is identical if the PE investor acquires control at a lower threshold (>51%), or if a venture/growth investor forms part of a small group of like-minded investors who together control the business.
³ Twitter reports that ‘less than 5%’ of accounts are bots in its SEC filings. Elon Musk has been pressing the company for evidence of these figures.