The coronavirus pandemic has been a significant challenge for businesses and economies since it emerged at the beginning of 2020. Over the past few months, financial markets have witnessed dynamic surges in volatility, as well as reduced liquidity impacting all asset classes in some shape or form.
The combination of volatility and reduced liquidity has posed a valuation challenge for both asset managers and service providers as they look to close dealing net asset values (NAVs) at this time. Without doubt, the fair value of financial assets and liabilities is among the most critical tasks in getting an Investment Vehicles NAV finalised and published, as well as supporting risk management, regulatory reporting and financial reporting systems.
In the aftermath of the financial crisis in 2009, significant pieces of regulation were put in place, including AIFMD and UCITS 5, that required entities to put in place robust policies and procedures over the measurement of fair value. The intention behind the valuation provisions of these legislative measures was to compel Investment Advisors to have policies and procedures in place that were transparent to investors, covered all of the assets classes and types that they traded and provided investment managers with a valuation roadmap to navigate turbulent times with more confidence and control.
In these challenging market conditions, the risk associated with the valuation of financial assets and liabilities will need to be carefully managed and overseen. In lieu of these, we have identified some of the key challenges that we believe managers and their boards of directors will face over the coming months.
Managers should review their current portfolio composition with the specific objective of performing a gap analysis to ensure that there are measures in place to deal with all of the asset types and situations that a fund might find itself now exposed to. For example, a fund that has historically traded listed equities only, might now find itself inadvertently holding unlisted derivatives of a Portfolio Company earned through a rights issue; or holding an unlisted security caused by economic or other conditions that have impacted the portfolio company.
With a gap analysis completed, managers, together with their valuation functions and committees should then determine:
Any changes to an entity’s valuation policy or processes should be approved by the appropriate valuation committee or governance structure in place within an asset manager. Consideration should also be given as to whether any such change constitutes a material event of which would need to be disclosed to investors in accordance with AIFMD.
Based on the experience that we have learned from the last financial crisis, we have sought to highlight some of the key valuation challenges we anticipate firms will face over the coming months.
1. Stale prices
Should market liquidity decline across different asset classes, one of the consequences will be that we will begin to witness an increase in the amount of stale prices observed across portfolios.
The challenge for asset managers and their service providers will then be, how to assess fair value in the absence of a recent traded price.
Adopting a two-step approach to valuation makes sense here, first gathering together a qualitative analysis of facts and circumstances associated with the stale price such as:
If at the end of a qualitative assessment a market participant determines that there just isn’t enough available market information, consideration should then be given to applying an alternative pricing method to fair value these positions. A robust valuation policy should have a clear pathway for the valuation function to quickly identify what the most appropriate alternative pricing methods is to ensure they are applied consistently to value stale positions (e.g. a modelled market approach could be applied, taking into account recalibrated multiples/yields between the latest market transaction date and the valuation date).
2. Single broker quotes
Certain securities, including fixed income positions such as Corporate and Convertible Bonds; Term Loans and Asset Backed Securities may be valued through a process that involves obtaining multiple counterparty quotes; aggregating these and determining a reasonable range as to what market participants might buy or sell these positions for. Typically this aggregation process is back-tested throughout the year, by the valuation team, who compare actual traded prices against indicative quotes received from particular counterparties in order to assess the appropriateness of using a particular counterparty as a valuation source.
In a market where trading volumes have reduced, the availability of multiple counterparty quotes may be challenged and caution needs also to be exercised in looking to identify stale prices emanating from brokers that are being utilised as part of a firm’s pricing run. These should be discounted as appropriate.
In the case where an investment manager needs to assess a single broker quote, consideration needs to be applied by the valuation teams to understand whether the single broker quote received represents an arm-length transactions or indeed whether the trade was at a distressed/fire sale value. If the former, evidence should be obtained to support the reasonability of using the single quote, if the later then further consideration should be applied. Thought should be given to applying supplemental valuation models to assess the veracity of the single broker quote being used, performance of back-testing of the quote against observable market transactions.
Best practice to manage against the risk of using single broker quotes is to have in place, exception reporting that highlights when single broker-quotes are used in the valuation close process, together with a well-constructed thought process and valuation approach to deal with such challenges if and when they arise.
3. Private equity
For private equity positions, the first step would be to identify if the underlying entity will continue to operate on a going concern basis, or not. If the former is assessed to be the case, then the preferable valuation method is to use the market approach; otherwise the valuation should be performed on a liquidation basis.
Market approach models that are commonly used to price private equity instruments will need to be recalibrated between the latest arm-length transaction date and the valuation date to address the guideline public companies’ multiples dynamics currently observed on the markets. Guideline public transactions data might be limited under the current market conditions.
One important note is to avoid double counting of the downside effects when pricing private equity positions. For example, the current recalibrated market multiples (e.g. Price/Sales, or P/S) should be applied to non-adjusted basis (e.g. actual sales data) in guideline public companies’ analysis.
Another important note is to use the market observable data and market approach to the maximum extent and not to completely switch to discounted cash flow (DCF) analysis, as DCF models could be of less reliance due to fewer market observable inputs used and tend to smooth out the real picture and volatility of the priced instruments. A good rule of thumb is to assess the overall dynamics of DCF models’ results versus the dynamics on the related markets, and to supplement DCF analysis with the market approach models, if the valuation teams opt to use DCF analysis.
4. Private debt
To estimate fair value of private debt instruments, the valuation teams first need to assess if the underlying borrowers will continue to service the debt in the near future (taking into account all the current stimulus actions and debt servicing vacations, etc.), or if they would most likely default on the debt obligations despite provided stimulus within the next few months.
If the valuation teams could reasonably conclude that no default is going to happen in the near-term future considering the stimulus support provided to the borrowers, then the yield analysis could be used to price these private debt instruments. The yields will need to be recalibrated between the latest arm-length transaction date and the reporting date to address the increased spreads currently observed on the markets, as well as risk-free rates dynamics.
Recalibration of spreads between the latest arm-length market transaction and the valuation date should consider two main components:
As the liquidity on the debt markets evaporates, it could be more difficult for borrowers with the near-term debt repayments to roll forward their debt under the current market conditions, which could cause defaults on these near-term debt obligations.
If the valuation team could reasonably assess that the borrower is highly likely to go into default in the short run, then it is recommended to use the waterfall analysis to assess the expected recovery on the defaulting instrument, the timelines of expected recovery and the appropriate discount rates to price the defaulting instruments.
To summarise the observations above, there are many opportunities for market participants to revisit their valuation and risk-management procedures and controls to successfully navigate these turbulent times.
You may find it useful to review our latest insights and thinking to support you in leading through volatility; don’t hesitate to reach out if you have any questions.
This article was written by Tatiana Nikolenko, Senior Manager, EY Financial Services.