Private Equity Option Value Undervalued by PE and VC

 

Private equity option value is the property of some businesses to rapidly increase in value given the fulfilment of non-systemic, discrete trigger event(s). The simplest manifestation of this phenomenon is in a company with a cash cow business and a venture business. The cash cow business can be expected to produce stable cash flows; the venture business, on the other hand, will be a minor cash drain given the persistence of the status quo, but will dramatically appreciates in value given the correct circumstances. This company, containing both the cash cow and venture components, derives its option value from the latter component, and the market is fairly decent in attributing a premium to it over a similar business without the venture component.

The true power of private equity option value becomes apparent when the two components, the cash cow and venture pieces, are facets of a single business. A mine that produces rare earth metals – a class of minerals necessary for practically all things electronic that separate today from 1950 – contains a diverse portfolio of low-volatility products and can thus have its cash flows be modelled fairly accurately. Given, however, that China controls by some accounts close to 90% of the world’s recoverable rare earth minerals and is placing trade restrictions that limit the export of the material from its mines in Mongolia and surrounding regions, the price of rare earth metals outside China could be expected to sky-rocket. Thus, the business will continue to produce stable cash flows if the status quo prevails, but will, if China chooses to restrict export of its rare earth metals, substantially appreciate in value. The “venture” and “cash cow” components of the business cannot be separated – they are one and the same. Let’s call these businesses integrated option value businesses (as opposed to discrete option value businesses).

Options are limited in how arcane they can be given the limitations of the hedging mechanisms operating behind them. Traditional options, specifically vanilla (American) calls, are derivatives that give the buyer the right, but not the obligation, to buy an underlying asset at a pre-determined price by a pre-determined time. To make a risk-adjusted profit off the sale of an option, a trader uses sophisticated (read: expensive) hedging strategies. There is an element of economies of scale to this process – a trader could very well construct an option based on the migratory patterns of elephants in relation to the 14th CDO tranche, but he must find enough buyers to support the hedging of the product. Given this limitation on the availability of options, private equity option value can be the only way to fully exploit a foreseen trend, for example, a jump in a class of industrial raw material.

Integrated option value businesses are simultaneously too large for venture capital funds and undervalued by private equity funds. Venture capital firms create portfolios of firms whose profit-loss functions very closely resemble a call option – as many as 50%-70% of a VC’s portfolio is expected to fail. As a result, the firms operate on a model that requires a strong degree of diversification. Many integrated option value businesses, as a result of their stable cash flow properties, are too large for most VC funds. At the same time, non-VC private equity funds, which are large enough to swallow these businesses, are constructed for a lower level of risk where even a single portfolio company’s failure can be seen as a disaster. These PE funds are not willing to pay a premium for integrated option value because of the risk entailed in it. As a result, these integrated option value businesses are valued at the level of a firm without the potential upside, creating a significant opportunity for a buyout fund willing to take quasi-VC risks.

A valley, created largely by sloppy regulation, exists between non-VC PE and the other divisions of private equity that allows such inefficiencies to propagate. The risk structure of a VC firm, as described above, is one legitimate factor in the divergence between VC and other forms of PE, such as buyout, growth capital and mezzanine financing (venture capital is a subset of private equity). Yet the division has been encouraged by current and pending regulation, the proposed which goes as far as requiring all PE firms, except those involved solely in VC, to register with the SEC, failing the whole way to delineate the boundary between the two. As a result, there are very few firms today capable of exploiting the delta between the high-risk high-return environment of VC and the low-risk, low-return (but highly levered and thus higher-risk and higher-return) landscape of non-VC PE. The integrated option value business falls into this gap.

Today, the significantly underappreciated option value in integrated option value businesses is creating tremendous opportunities for private equity groups. The rare earth minerals deal above was consummated by Pegasus Capital in its acquisition Molycorp Materials; it stands to make a killing on the deal. By exploiting the inefficiencies of this market structure, a buyout firm willing to take on a degree of VC risk would be buying free options, making levered returns without borrowing a single dollar.