The end of the first quarter was chaotic, and the impact of covid-19 on various sectors and companies was opaque. But the end of Q2 delivered a much clearer picture, revealing the significance of covid’s impact on inputs for private fund valuations.
Where funds have made changes is in the input assumptions they employ – mainly how they handle historical earnings data and earnings forecasts. That exercise evolved between Q1 and Q2. During Q1, fundamental financial analysis on portfolio companies was next to impossible because most of the available data was pre-covid and virtually meaningless. Instead, VRC made reasonable assumptions on prospective company performance and focused more on liquidity positions and business continuity and broad market and comparable company movements as a proxy for impact on earnings and valuations.
For Q2 valuations, VRC saw much more company information from the impact of covid. Because funds were acutely focused on monitoring their existing portfolios, valuation teams had better, more detailed information than for any three months in recent memory. Most managers had detailed information on revenue impact from covid, details on management cost cuts, liquidity discussions and forecasts, and the first cuts at 2020 and 2021 forecasts with covid impacts.
Many VRC clients relay stories of contentious conversations with boards and auditors over the last six months. One client recalled going back to the textbook GAAP definition of “fair value” – the price at which willing market participants would transact given reasonable information – but found it wanting in a market where there was little activity. His organization ended up taking what he described as a loan-loss approach to valuing the entire portfolio (after bucketing the holdings by the degree of covid impact) rather than taking a more granular, credit-by-credit approach.
Another client recounted pushback from the fund’s auditors when the valuation team declined to mechanically apply a single March 31 price from a loan database because doing so seemed arbitrary when prices had been all over the map: 99 on February 28, 60 on March 30, and 89 on April 15. This client ended up using those prices for guidance, but valuing the individual credit on a fundamental basis, notwithstanding protestations from the accountants.
Still, other clients struggled, especially at the end of Q1, when indicative broker quotes were hard to come by for many names. In some cases, only one trading desk was left quoting a price when four or five had been willing to do so – or when they were forced to reconcile valuations between their more liquid funds and their less liquid vehicles.
It should be stressed that all the dislocations experienced in late Q1 emphasized the notion that private credit markets are not truly liquid like the public equity markets, or even the high-yield bond markets on which they rely upon entirely. Fund managers should both have and follow a well-documented valuation policy that contemplates all contingencies. The policy should explicitly map out what to do when pricing for public comparables becomes unreliable (or irrelevant due to forced selling or inactive trading) or if broker-dealer quotes dry up. Contingency plans could mean conducting a fundamental yield or EV analysis or handing a position off for a third-party valuation. In markets similar to Q1 2020, the best approach, as promulgated by VRC, is still to conduct a bottom-up valuation analysis on a credit-by-credit basis to best capture all current variables and their impact on valuation.
VRC also noted altered process timing due to covid. Many clients pushed up the timing of the valuation process two to three weeks before quarter-end to allow extra time to analyze portfolio companies and prepare valuations. Given the volatility of markets, valuations often were recut two or three times before locking down quarter-end valuations. Process timing demands were complicated even further by the increase in more investor-friendly funds, such as interval or mutual fund structures, which allow more frequent-than-quarterly investor liquidity windows, such as monthly or even daily. In these instances, the valuation process almost seemed continuous from Q1 and into Q3.
While investor demands and the type of fund generally determine the frequency of “official” NAV strikes, and thus valuations, some firms produce much more frequent informal valuations – typically more black-box-driven – for private funds for internal purposes. Additional work and time required to complete analyses, coupled with more frequent valuations required under more investor-friendly fund structures, the valuation process timing is becoming tighter and more repetitive. Consequently, after the covid impact on the valuation process in Q1, valuation firms and their clients are focused on improving process efficiencies, while still maintaining high quality support. Efficiencies in terms of leaner reports and better use of technology are at the forefront of the movement.
There were many lesson learning from the impact on the valuation process due to COVID, but to be sure, valuation firms, as they have done in the past, will adapt in the short term as well as the long term when process changes are needed.
John Czapla is chairman of the board of VRC, an independent, global valuation firm