3. Valuation of Optimally Managed Target (Control Premium)

Next, it makes sense to try and identify potential management inefficiencies in the target company and to value the target under the assumption that these inefficiencies can be cured so that the firm will be managed optimally:

  • Optimized investment policy (i.e., divest unprofitable projects and divisions and leverage profitable ones)
  • Optimized financing policy (i.e., exploit available borrowing capacities to optimize the tax structure of the firm)
  • Optimized payout policy (return unused cash tax efficiently to shareholders).

 

The difference between the valuation under optimal management (Step 2) and the valuation in the status quo (Step 1) constitutes the so-called control premium.

The control premium is the value added a buyer could achieve by managing the target company more efficiently but keeping it as an independent entity. Often, the purpose of private equity investors is to harness that control premium.

 

Example:

Consider a firm that is currently valued at 5'000. After a careful analysis of the business, a private equity company concludes that the value of the firm could be enhanced to 8'000 under a new management, for example because the existing assets are managed inefficiently. Consequently, the control premium is 3'000.

This is how much the private equity stands to gain if it acquirers the firm at 5'000 (and is right about the optimization potential).