“I completely agree: Investors in private companies are somewhere in between” completely diversified and undiversified investors, says Pete Butler (Valtrend), responding to Aswath Damodaran’s comments in the BVWire last week. “Thus, you can't use beta (totally diversified) by itself and you can't use total beta (completely undiversified) by itself,” Butler says. “Both, however, are excellent reference points for a private company's cost of capital.”
That’s why (after informal consultation with Damodaran just over two years ago now), Butler and Gary Schurman (Applied Economics) developed a "private company beta" calculation using modern portfolio theory to account for partial diversification for the "somewhere in between" investor, says Butler, citing question 46i of the FAQs to the Butler Pinkerton Calculator (modified for clarity here):
- We have done more than just qualitatively consider the ramifications of diversification; we have developed an Excel spreadsheet to assist appraisers in making informed, quantitative decisions related to the question of diversification. Please click here to access the spreadsheet now.
- Although somewhat subjective, the assumptions of this spreadsheet have as their ultimate goal to price risk depending on the level of diversification the analyst believes is appropriate for the average investor in the [subject] buyer pool.
In the past, when BV appraisers assigned a company-specific risk premium to their discount rate, “what level of diversification did they have in mind?” Butler asks. “Total beta/private company beta brings the debate front and center, to where it should be—on how to use it—and not whether it has a math or logic problem, which is where, in my opinion, ‘total beta has taken on a life of its own.’"