Hazard warning: valuations in the midst of volatility
CFOs attempting to run scenarios and valuations for their portfolios are faced with an avalanche of uncertainty and potentially dangerous outcomes.
What can be done to regain a sense of stability and calm in an unstable and chaotic environment?
Not only have the new working conditions caused delays and interruptions in work being delivered, financial reports rely on information coming from portfolio companies, which are also dealing with disruption and major adjustments in ways of working.
While investors undoubtedly want as much information as possible; from their perspective, trying to ascertain overall holdings and exposures is a key priority, in many cases it’s not wholly sensible to provide certain figures or statements.
According to Ryan McNelley, a managing director at Duff & Phelps and head of the European portfolio valuation team, “CFOs are trying to buy themselves some time to make sure the answers they give are well thought out.” And rightly so, looking at the ups and downs witnessed in the public markets over the last few days and how that could impact private assets does very little to provide any sense of clarity.
Melanie Pittas, partner at Haysmacintyre LLP, is seeing some clients delaying audit sign-offs in order to wait and see what the impacts may be, so that they can make appropriate disclosures in their accounts. “For others, we’re suggesting that sign off be delayed because there has been so much change in the last few weeks and significant uncertainty about the future – we need to perform a detailed assessment of the likely impact of COVID-19 on operations and going concern. Typically, we work to timetables agreed with our clients at the planning stage, but we’re seeing that clients understand the need for us to pause and take stock. Indeed, on listed accounts, the regulators have set a moratorium on signing for two weeks”
Focus on the details
McNelley believes the most important thing right now is to work on a detailed, individual portfolio company level, rather than trying to apply broad brush strokes. “Today, the economic disruption is temporary, and while everyone has their theory on how long it will be until recovery, few think this will be permanent.”
With that, some business will be more affected than others, which is why it’s crucial to look at each company and each impact separately.
Be careful with benchmarks
Says McNelley, “Portfolio companies will be using the next six to eight weeks to come up with 2020 reforecasts and CFOs may have to do valuations without that.”
Right now, it’s too early to tell what the new forecasts will look like. “When you go to value an asset, normally you could apply an EBITDA multiple by looking at comparables in the public domain. So should you apply new multiples to original forecasts, or do you apply them on a subjective haircut without management’s reforecast? How do you come up with that number knowing that management might be coming up with another?”
This appears to be the most hazardous area in terms of determining valuations, and adds more justification to delaying valuations at this point.
While LPs clearly need as much information and clarity as possible at this point, CFOs must try to respond sensibly. “LPs aren’t fools, they’re very aware of what’s going on and they’re not expecting everything to be great,” says McNelley. “To claim that everything is fine would damage your credibility.”
Instead, McNelley advises communicating to investors what you are doing to preserve value and what steps are being taken to control the situation.
For Pittas, a detailed and tailored going concern assessment is crucial at this stage. “We’re asking clients to model out best and worst case scenarios, and then assessing reasonableness of management assumptions. What’s the absolute worst case in terms of impact, and how does that flow through to the fund and the manager itself, their bottom line and ability to sustain their business.”
Know what you know
A key focus should be on sticking to accounting requirements; US GAAP and IRRS. “The accounting standards are rigid. The Fair Value accounting standards state that fair value is the price you would receive if you were to the asset today – taking into account current market conditions. And you certainly should not hold investments at cost,” says McNelley.
Furthermore, as is the case across the world, there is a huge amount of information being published, some of it accurate, some of it less so. “The same thing is happening in the valuation world right now. CFOs might hear someone saying that because the public markets are down 30%, so are all of your assets; that you’re forced to mark your whole portfolio down. But actually, the IPEV guidelines are far more nuanced than that. Be reassured that there’s more out there,” advises McNelley.
Take comfort in guidelines
Indeed, while it might be tempting to apply more creative measures in attempting to value companies or in benchmarking exercises, McNelley believes that valuation guidelines - namely IPEV - do provide practical guidance for such situations. “In the current context, IPEV is a great source on how to deal with the current situation.”
IPEV released a statement and updated guidance. It reads: “The alternative asset industry is larger and more sophisticated than in previous crises. Limited Partners (LPs) need to know the fair value of their limited partnership interests to make asset allocations, to allow beneficiaries to make investment decisions, to exercise their fiduciary duty and for their own financial reporting requirements. Therefore, LPs have a critical need at 31 March 2020 for their fund managers (GPs) to report underlying investments at fair value on a timely, consistent and rigorously determined basis.”
None of what’s happening right now is pretty. But no investor is expecting it to be either. Stick to what you do know, use the guidelines, and most of all keep communicating on a regular basis.