Every estimate of value requires a rigorous application of judgment and a thorough understanding of applicable facts and circumstances. Among the more common valuation scenarios faced by valuers of alternative assets is for non-traded debt, which refers to a privately held debt security. Practical solutions for dealing with this valuation nuance that occurs in the ongoing application of fair value principles and in the determination of fair value estimates is provided below.
All available approaches to value non-traded debt – typically coverage analysis, shadow rating, yield analysis, covenant review, liquidation analysis and minimum enterprise value analysis – should be utilized.
A yield analysis is a form of the income method whereby the valuer determines the fair value of a debt security based on yield spread movements. This must take into consideration changes in market yields as well as company-specific risk factors, as typically measured through shadow rating changes. A minimum enterprise value analysis is a form of the market approach whereby market multiples are utilized to determine a hypothetical sale price of the company in question as a whole. In addition, depending on the level of the security in question in the capital structure, a waterfall analysis will need to be applied to appropriately determine the fair value of the security in question, along with all other pari passu securities.
a) Non-performing loans
Given the comparative nature of the procedures required to determine the appropriate yield to be applied to the subject cash flows associated with the security in question, the framework of the implied yield as the issue date of the security as a calibration point is useful only for performing loans. For nonperforming loans, the risk of non-payment is not appropriately captured using comparative risk and market data. Hence alternative valuation methodologies will need to be employed, which could include other application of the income approach or a liquidation analysis.
b) Differing value indications by yield analysis and other approaches to value, namely minimum enterprise value analysis
Depending on the terms agreed to between the underlying borrower and the investor, as well as the movement of markets and credit risk associated with the borrower, a yield analysis may not indicate that par is a fair approximation of fair value. Hence, with the introduction of an income approach to the valuation of debt securities, values of such securities have begun to fluctuate as historically the approach to value was ‘par until proven otherwise’, that is, until other than temporary impairment was established.
The valuer will have to exercise considerable judgment in determining the appropriate fair value of a security in a situation where an issuance has very favorable terms (such as a low spread over Libor) while the market spread has widened but the underlying company is performing according to or even ahead of plan. In such a scenario, the yield analysis will suggest a value below par, while a market-based approach (say a minimum enterprise value analysis) will suggest that the investment is fully covered, hence suggesting a par valuation. There is currently no agreement amongst practitioners as to how to potentially weight the results of the different approaches.
Case study: Non-traded debt
Situation: Private Company A issues $100 worth of senior debt on December 2007 at a 15 percent interest rate. During 2008 the company issues an additional $50 of subordinated debt at an 18 percent interest rate. On December 2008 yields for debt tranches similar to the original senior debt have increased to 20 percent and yields for subordinate tranches similar to the subordinated debt have increased to 23 percent. A minimum enterprise value analysis suggests that Company A is worth at least $125.
Key question: What is the value of the two tranches of debt?
a) Both senior and subordinated debt tranches are valued below par given that yields on similar debt tranches have increased?
b) The subordinated debt tranche is below par given that yields have increased and the minimum enterprise value is not sufficient to cover the debt and the senior debt tranche is at par given that the minimum enterprise value covers the senior debt?
c) Both senior and subordinated debt tranches are above par because similar debt has a greater yield?
Answer: Both senior and subordinated debt would be valued below par given that yields have increased. To estimate the fair value of debt one needs to consider numerous factors such as yield analysis, minimum enterprise value, coverage ratios and actual company performance versus budgeted. Given the limited amount of information we have in this example, it appears that the value of the subordinated debt would have decreased more that the value of the senior debt given the minimum enterprise value analysis. However, a more comprehensive analysis would have to be conducted to determine the magnitude of the discount to par for both tranches.
Note to readers:
All valuation assessments require the assessment of rigorous judgment and require a thorough analysis of individual facts and circumstances. The example above is by necessity simplified and therefore differences in opinion could result in the methodologies used and the overall resulting fair valuation. Fundamentally, the ultimate fair value estimate must be synchronized with the assessment of what a market participant would pay in an orderly transaction at the measurement date. This chapter highlights some valuation nuances and provides suggested conclusions based on an interpretation of the limited facts provided.
This is one of 11 valuation nuances explained in The Definitive Guide to Private Equity Valuation: An in-depth A-Z guide to valuing investments fairly, a new book from PEI Media. Primarily written by valuation experts Duff & Phelps LLC, this guide provides investors and fund managers with valuable tools and practical guides to fairly value nuances and scenarios, as well as case studies and best practices. Sample contents and more information on the book are available at www.peimedia.com/pevaluation.