Portfolio managers and the financial reporting teams of investment companies such as private equity or venture capital are considering the impact of the recent pandemic and economic conditions on their March 2020 (and beyond) valuations in accordance with ASC 820, Fair Value Measurements. The public markets experienced a meaningful downturn in stock prices starting around the declaration of the COVID-19 pandemic on March 11.
Public markets, which are accustomed to high levels of access to liquidity, exhibited a significant reaction to the sudden loss of liquidity due to COVID-19, and stock prices suffered. Additionally, specific performance or economic measures, such as lost revenue, the effect of supply chain disruptions and other factors have become available at a slower pace and have affected the market.
It is important to remember the definition of fair value according to ASC 820: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Not only is an orderly transaction required, but also that a market participant would take into account current market conditions and all relevant known and knowable information as of the measurement date. By definition, an orderly transaction is not a distressed sale or forced liquidation, and assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities. In short, a “fire sale” does not represent fair value.
Look to existing valuation policies and procedures
Companies should remember their valuation policies and procedures that are already in place and the underlying requirement of ASC 820 to maximize the use of relevant observable inputs and minimize the use of unobservable inputs. ASC 820-10-35-35 indicates that valuation techniques should be applied consistently while acknowledging that changes may be warranted if the change results in a measurement that is equally or more representative of fair value in the circumstances.
Methodologies to determine fair value have not changed; however, management may need to review which valuation methodologies are most appropriate in the current environment.1 For example, a discounted cash flow method may have benefits compared to other valuation approaches, because this model focuses on the intrinsic value and fundamentals of companies. This discounted cash flow model also has the benefit of being more flexible compared to other valuation models to capture the assumptions that are relevant in the current economic environment. Specifically, a discounted cash flow model can address both the current shock to demand and supply triggered by social distancing and stay-at-home orders, as well as contemplation of recovery and post-recovery assumptions. However, there may be challenges related to the availability of quality data to assess these assumptions, especially in consideration of the March 2020 measurement date. Certain inputs and assumptions used in applying the methodologies may need to be revised or should be given additional consideration. Examples of such inputs and assumptions related to projections for the investee include (but are not limited to):
- Expected revenue in 2020 resulting from the impact of social distancing and stay-at-home orders
- Expected shape (“V,” “U,” “L” or “W”) of the recovery, expected duration of suppressed performance, and effects of these assumptions on revenue, earnings and cash flow
- Expense structure considering the impact of the coronavirus (the degree of variability in the cost structure versus high fixed costs)
- Net working capital needs, which may increase if customers stretch payment terms
- Future capital expenditures or discretionary items considering changes in projected revenue
- Consideration of different valuation multiples that could be more applicable
- Consideration of Level 3 inputs if previously were using Level 1 and Level 2 inputs that may not be available or appropriate
Holding an investment at cost or a prior period valuation because one has no plans to sell an investment is not in alignment with fair value and the assumptions of a market participant. ASC 820 is clear in its consideration and application of an exit value, so fair value inherently assumes that there will be a transaction.2
Those firms that prefer a market model should increasingly perform a calibration analysis. Calibration is a technique used where an observed transaction price is used to back into certain identified but unobservable input assumptions. These assumptions are then updated and rolled-forward for subsequent measurement dates. In this example, one would expect to observe directional consistencies between cited comparable market multiples and the fund’s implied multiple.
Similarly, companies should consider that the Securities and Exchange Commission has recently (April 21, 2020) published, for public comment, a new rule that would establish a framework for fund valuation practices. The rule is designed to clarify how fund boards can satisfy their valuation obligations in light of market developments, including an increase in the variety of asset classes held by funds and an increase in both the volume and type of data used in valuation determinations.3
Considerations for expected growth and financial performance
Valuation of an investment typically comes down to expected growth and financial performance of the investee, and the inherent risk in achieving the prospective financial information, or PFI, as well as the level of interest in the company and its industry by market participants. The following factors should be considered:
- The subject industry. The financial and economic impact of the coronavirus and related measures taken to flatten the curve are not affecting all industries the same. It is important to factor in the liquidity of a company’s customers, as well as its suppliers, and how they could be affected by the current market environment. The current market is one where customer or supplier concentration can certainly have a significant impact on the company’s financial performance.
- The size of the company and its access to liquidity. These can be significant contributors to how well the portfolio company can weather the storm. Typically, the larger the company, or the better access to liquidity, the more resilient it will be. Consideration should be given to the size and credit quality of the company’s customers, suppliers and lenders.
- The enforceability of contracts that a company has with customers, as well as with its suppliers, is increasingly important.
- The financial condition of a company is a key consideration, such as its leverage level and its ability to draw on credit lines for liquidity.
- The need to significantly scale down forecasts or change forecast assumptions. Consideration should be given in estimating the impact to revenue, expenses and the working capital cycle caused by the disruption to businesses because of social distancing and stay-at-home orders. The market has anticipated an expected increase in discount rates and decrease in valuation multiples, in advance of better data (some of which has recently become available in April) to assess longer-term trends becomes more evident. However, the adjustments should be considered to reflect the impact that could be reasonably estimated as of the measurement date.
- The degree of runway the company has will be based on the liquidity, leverage and the variability in its cost structure. A company will be in a better position if it can minimize cash burn. In addition, a company will be better off if it recently refinanced its debt compared to a company that will need to refinance in the current environment. The cooperation of the senior creditors is also important. A company will benefit if the senior lender is willing to temporarily halt amortization or allow some cash interest to convert to payment-in-kind. An institutional creditor has more flexibility to make these amendments compared to a financial institution that is more susceptible to stricter regulatory requirements.
- The documentation around the value preservation plan in addition to value creation strategies.
- The strength, competency and track record of the management team (or sponsor) in how it managed to turn around a business during a downturn or under volatile conditions.
Relevant economic factors
The following are recent relevant economic factors to consider. RSM provides regular economic commentary for the middle market. To monitor the latest in the economy visit The Real Economy Blog.
- The Federal Reserve gained a lot of knowledge the last recession, which resulted in the Fed’s taking swift and significant action—including lowering interest rates by 1.5% within two weeks and implementing significant quantitative easing with increased bond purchases.
- The Coronavirus Aid, Relief and Economic Security (CARES) Act, signed into law on March 27, 2020, provides options for small and midsize businesses facing liquidity challenges from the COVID-19 crisis. Visit The Real Economy Blog for more insight into the three relief options available.
- While the decline in economic conditions has been quite swift, and there is general consensus that the recovery will be much more stretched out, the shape (“V,” “U,” “L” or “W”) is still uncertain and may vary by industry and may even vary by companies in an industry.
Conclusion
Valuations of equity and debt investments during 2020 will be challenging. The public markets have experienced volatility and reduced liquidity that cannot be ignored, but the private equity and debt markets have additional factors to consider. In the current environment, a methodology based on guideline public company multiples may not capture all of the relevant factors, so different methodologies or assumptions may be necessary to develop a fair value estimate that is reliable based on current market conditions.
