Unique market shock poses significant challenges in valuation

Unlike 2008, 'you have a situation where revenues have gone to virtually zero overnight'.

Southland Royalty may not be a household name, but its unexpected downfall represents a cautionary tale for investors. The oil and gas outfit filed for bankruptcy in late January, just three months after its private equity owner EnCap reported that it valued its investment at $773.7 million, nearly equal to its total investment in the company since 2015. The demise of Southland came weeks before the coronavirus pandemic and oil shock hit the markets.

See all of Private Debt Investor’s coverage of covid-19 and its impact here

While Southland may be an extreme example of the challenges private managers face in marking their illiquid portfolios (and may be anomalous to the typical trajectory toward bankruptcy), when the latest crisis and its economic repercussions and uncertainties are thrown into the mix, the valuation process for managers will undoubtedly be that much more difficult for the first quarter, which just ended.

“We are experiencing a shock that most of us who are alive have not experienced before,” said David Larsen, a managing director in Duff & Phelps’ alternative advisory asset practice. Unlike the financial crisis, which saw significant fire-sale pricing, the unknowns associated with the pandemic are much greater. “We’re taking steps that adversely impact the economy for the good of humanity.”

Jack Ciesielski, portfolio manager of RG Associates and the former publisher of The Analyst’s Accounting Observer, noted that when markets are largely frozen as they are now, assigning a fair value, or the price that would be received in an orderly transaction using assumptions at the measurement date, would be challenging at best. Consequently, managers will be forced to mark-to-model, meaning that they must estimate what fair value would be in an orderly market without a distressed price. “There will be pressure on accountants to sign off on valuations that are going to contain a lot of estimates when there aren’t any active markets with willing buyers or sellers,” Ciesielski said.

The magnitude and speed of the declines in the global debt and equity markets pose a number of challenges for many fund managers that are tasked with valuing their funds’ illiquid holdings, Cindy Ma, global head of portfolio valuation & fund advisory at Houlihan Lokey, wrote in a client note in March.

“Many performing loans may become distressed, especially for highly leveraged companies, due to declines in future cashflows and corresponding declines in value resulting from the impact of covid-19,” Ma said in an interview. However, she added that “we have learned from 2008 and 2009 that it is critical to distinguish market illiquidity from financial distress”.

Larsen of Duff & Phelps noted that the current market turmoil affects fair value in two fundamental ways: market participants translate increased uncertainty into additional risk, and the risk associated with payment of interest and principal increases when the credit quality of a borrower decreases. “When faced with these risks, market participants require additional rates of return, which increases the yield on a private debt investment and decreases the value of the investment.”

He noted that expected returns for investments with varying credit quality have increased significantly, as shown by increases in observable credit spreads, and that borrowers significantly affected by the crisis may have substantially decreased their ability to repay loans, potentially leading to default.

Indeed, at the end of the quarter, the leveraged loan market had traded down to 70 cents on the dollar from par at the beginning of the year, according to David Rosenberg, chief economist and strategist of Rosenberg Research. At the end of 2018, investment funds were the next highest holders of leveraged loans behind banks, whose exposure to those loans and collateralised loan obligations was 50 percent, according to Fitch Ratings.

By the end of the latest quarter ending 31 March, nearly $1 trillion of high-yield bonds were trading in distressed territory, with spreads on 300 high-yield bonds nearly doubling from the beginning of March to 1,900 basis points over Treasuries, Rosenberg wrote in a client note. Moreover, the ratio of net debt/EBITDA in the small-cap space had spiked to 5.12 times at the end of February, up from 4.70 a year ago and 3.09 nearly a decade ago.

“Everyone is asking the same question: how do we get through the next 30 to 90 days?” Randy Schwimmer, head of originations and capital markets at Churchill Asset Management, told Private Debt Investor late last month. Portfolio companies don’t know what to expect, and their sponsors and owners are being forced in real time to come up with contingency plans on how to pay their bills and manage their employees. Thus, he said that “there’s no glib answer” to how sponsors are thinking about valuations in the current climate. He also mentioned that Churchill requires sponsors to invest at least 50 percent cash equity in new buyout deals, in contrast to the 40 percent typically seen in the broadly syndicated market.

‘Material uncertainty and risk’

For managers that invest alongside their limited partners, the impact of the crisis on their investments will weigh more heavily on their balance sheets and internal rates of return, said Dafina Dunmore, director, non-bank financial institutions, at Fitch Ratings. For managers such as KKR and Blackstone Group, which publicly report their results quarterly, the effect of the crisis for good or ill will be reflected as unrealised losses or gains in their earnings releases.

Indeed, Blackstone in early March warned investors in a regulatory filing that the novel coronavirus “presents material uncertainty and risk with respect to our funds’ performance and financial results”. And that was well before extreme measures to stem the spread of the virus had been taken in the US, which brought the economy to a virtual standstill. In the filing, Blackstone said that the rapid development and fluidity of the situation makes any prediction about the ultimate impact of the coronavirus impossible.

Both the broad economic ramifications and their effect on portfolio companies will pose significant challenges to how managers and their CFOs account for them. “We’ve never seen a situation where there’s such a short-term impact that may either rebound significantly in the short term or may have potential long-lasting effects,” said Daniel Roche, national business valuation service line leader at accounting firm Marcum. Beth Weiner, head of Marcum’s alternative asset management practice, expects that even those private managers that don’t normally mark their books every quarter will have to do so now. Although audits are not even finished for the quarter, “there will probably be drastic changes, not for the methodology but for the inputs”, Weiner said.

“A lot of companies are still working through their portfolios, and don’t have a good handle on where things will shake out,” Fitch’s Dunmore said. Private credit funds have grown significantly, and she expects the valuation impact will be deeper on more recent vintages.

“We’re definitely going to see write-downs, but it’s hard to estimate the magnitude,” said Meghan Neenan, managing director and head of North American non-bank financial Institutions at Fitch Ratings. The impact will vary significantly by sector, with energy, airlines, hospitality and brick and mortar retailers seeing some big marks. But consumer staples and life sciences companies should hold up reasonably well.

In the current quarter, which will experience the full force of the virus’s impact and a likely pickup in forced sellers, some managers could see realisations fall to effectively zero, Neenan said. But marking to model gives managers the ability to be more forward looking, she added, noting that private managers have the flexibility to hold onto their investments through market dislocations. She pointed to the 2008 financial crisis, when Blackstone was forced to write down its investment in Hilton Hotels to 50 cents on the dollar. In 2013, Hilton became the biggest hotel offering in history. Still, she noted that “everything is different from 2008”. This time, “you have a situation where revenues have gone to virtually zero overnight”.

Although results can affect any efforts by public managers to raise capital from investors, that may be less of an issue, given the $2 trillion of dry powder held by private managers. Indeed, the crisis eventually will provide opportunities both for managers and their limited partners to pick up good companies at a significant discount. The question, Neenan said, is “how quickly do you avoid catching a falling knife”?