Estimated reading time: 2 minutes
The article in brief:
- Business Development Company market participants are focused keenly on valuation in the wake of the novel coronavirus and the impact on their underlying portfolio investments.
- Valuation methodologies haven’t changed, but diligence, pressure, and the valuation process’ pace have gone up.
- Absent market dislocations from a second wave or the presidential election, market players are bullish on the outlook for private lending going forward.
VRC Portfolio Valuation Practice Group Lead John Czapla was in the hot seat during an “Ask Me Anything” panel at the BDC Roundtable 2020 in early September, as valuation concerns appear top of mind for market participants dealing with the impact of the novel coronavirus on their businesses. Asked in a snap poll what’s keeping them up at night during the COVID-19 crisis, the audience cited “valuation” as their top concern (60%), eclipsing even more near-term worries about liquidity (51%), asset coverage (21%), meeting distributions (18%), business continuity and SEC reporting (both 16%).
Czapla told the audience that, apart from conducting more market and company due diligence, the pandemic hasn’t materially changed the valuation methodologies the VRC team uses to conduct third-party valuation opinions on private loans and equity. It has, however, raised the stakes and increased scrutiny for fund’s internal valuation teams. That pressure trickles down to the portfolio valuation group: “We see earlier starts and accelerated timelines so managers can have more time internally to review and prepare valuations.” He said managers are looking closely at the pandemic’s revenue impact on portfolio companies and how they are managing costs and their liquidity, working with equity sponsors and banks, and whether they breached covenants and, if so, how are they working with bank lenders.
Czapla said another area of intense focus for BDC valuation teams is the appropriate earnings base to use, both on a trailing and forward-looking basis. “For a while,” he said, “people were throwing around terms like EBITDAC—EBITDA-adding back COVID-induced impacts on revenues and earnings. That never really took off. But amendments were being done, and covenant resets, and the question was, ‘What EBITDA are we going to use?’” Czapla said many market participants settled on a version of earnings that reflects some but not all of the earnings impact of the pandemic seen over the last 12 months to account for the possibility of a strong second wave of the virus. As long as the liquidity situation is robust, some lenders have been more accommodating by allowing for covenant testing holidays through the end of the year; doing so takes the EBITA question out of the equation.
Czapla also added that with the rise in new deal activity, the EBITDA underwriting base sometimes also considers the next 12 month EBITDA, which excludes the trough (April and May) from the calculation, or some form of estimated EBITDA for 2020.
Among other topics discussed by Czapla and his fellow experienced BDC professionals from the accounting, tax, and legal fields:
- Though not out of the woods, especially in the event of a second wave, the BDC industry—with support of constructively engaged equity sponsors and liquidity from the federal government—did a remarkable job weathering the pandemic so far. One panelist said a client with 200 positions in their BDC quipped, “If you had told me that by June we would only have two nonpayments [of interest], I’d have told you my chances were better of winning the lottery.”
- Funds are sanguine about the new SEC guidance on fund valuation, which explicitly allows boards to punt valuation to the advisor and encourages third-party opinions, but lays out criteria for oversight. Nearly half the audience who responded to the snap poll said it would result in no change in how they deal with their boards, though Czapla warned the increased interactions between boards and advisors on the valuation topic could cause friction.
- Most BDCs are prepared for the gradual phase-out of LIBOR as a short-term lending benchmark and have provisions in their loan documents for alternatives. Czapla noted that there are several contenders to replace LIBOR. Still, no consensus has emerged. Many of the candidates don’t reflect credit risk or are overnight benchmarks that lack a term structure, impacting the ability to hedge interest rate risk. As with the LIBOR market, many expect that a forward market will eventually develop.
- Large BDCs continue to enjoy a competitive advantage in a market where first-lien and unitranche loans are dominant. Many sponsors prefer to deal with a single lender; the trend toward working with a single lender was already established but is amplified by underwriting deal practicalities during a pandemic.
While the prospects of a second wave and an imminent presidential election continue hanging over the market, Czapla told the audience he is bullish on the outlook for private lending absent a deviation from the current market trajectory, a sentiment echoed by other panelists. “Funds are moving from defense, meaning portfolio monitoring, to offense—actually going out and doing deals as we see more M&A activity, especially in the tech and healthcare space,” Czapla said. In addition to traditional M&A activity, there are discussions of a potential wave of dividend recapitalization financings if the White House changes hands. Some sponsors may be in a hurry to take money off the table before possible change in the tax regime and carried interest rules for the private fund industry.