(Estimated reading time: 10 minutes 26 seconds)
The article in brief:
- Participants at the VRC and RSM Annual Accounting and Valuation Forum for Credit Funds seeking to adopt the AICPA’s accounting and valuation guidelines for private funds are challenged with implementing the concepts of calibration for debt valuation, handling discounts and premiums, and assessing the quality of third-party price quotes used in valuation.
- Debt valuation can be approached with methodologies including comparable yield, synthetic credit ratings, and enterprise value/asset collateral coverage; market participants should consider time horizon/prepayment, unit of account, and traded debt levels as they seek to follow the guidelines.
- The current state and near-term outlook for private capital markets remain robust deal volumes and still historically tight lending terms) void for riskier capital (e.g., lower-rated debt and second planning, but with some early warning signs, it is beginning to show its age.
A few months after the final release of the AICPA’s accounting and valuation guidelines for private funds, many market participants are embracing the best practices guidance and adjusting their policies and procedures accordingly, said panelists at the 5th Annual VRC and RSM Accounting and Valuation Forum for Credit Funds.
The central discussion with our panel of esteemed professionals from both the buy- and sell-side as well as VRC and RSM, focused on the guidelines. Participants said the biggest challenges for credit funds seeking to adopt the guidelines include implementing the concept of calibration, handling discounts and premiums, and assessing the quality of third-party price quotes used in valuation.
A second presentation by John Czapla looked at the state of—and outlook for—a private debt market that is showing some cracks but is still flush with capital and, thus, appears well-positioned to handle any more serious fissures that may occur.
The AICPA Guidelines Revisited: The Final Cut
While the AICPA guidelines were only finalized and released in August, panelists noted that a draft was in circulation for more than a year ahead of its final release. As such, attending professionals from private debt side agreed that, while the guide’s best practices are geared more directly to PE and VC funds, the time spent in the last year focusing on the more specific private debt investor guidance and case studies has them better prepared to leverage and navigate the guide.
However, the best practices are not without their challenges and intricacies leaving attendees and panelists with a hearty basis for continued thoughtful and progressive discussion.
The Dynamics of Calibration for Debt Valuation
VRC’s Paul Balynsky kicked off the discussion with a review of one of the more challenging concepts in the guidelines: calibration for debt valuation. Calibration entails setting up valuation models to reflect the economics at deal close and establishing the position’s relationship to benchmark market data, which can be applied to help determine future changes. Valuation recalibrations are necessary when refinancings, recapitalizations, or mergers occur.
Balynsky walked through calibration examples for both equity and debt.
For equity, he described using the following steps:
- Determine the initial deal multiple, excluding fees;
- Compare to multiples for a group of comparable companies; and
- Determine a “performance rank” for the portfolio company relative to peers to establish an initial benchmark discount or premium and then adjust that benchmark discount or premium—along with the portfolio company multiple—over time based on changes to the multiples for the comp group and/or the portfolio company’s performance rank.
Debt calibration, Balynsky said, can be approached with different methodologies:
- Comparable Yield. The credit profile and yield at investment is compared to corresponding companies or credit composites, with adjustments based on relative company performance. Positive attributes of this approach include its use of more direct data. A drawback is that changes due to relative fundamental performance may require a good deal of judgment.
- Synthetic Credit Ratings. This methodology calibrates credit stats to an initial and a matching rating benchmark. Subsequent valuations involve re-rating the security and moving the spread up or down depending on the change in company rating and benchmark yields (market performance) over time. This approach intuitively captures both issuer- and market-level changes but suffers because rating benchmarks are mostly comprised of large-cap companies with liquid debt securities that sometimes trade differently than private debt. (A panelist from the buy-side echoed this critique, noting the relationship between liquid, broadly syndicated paper, and private debt nearly broke down completely in late 2018 when spreads on the former widened considerably, even as private debt valuations hardly changed at all.
- Enterprise value (EV)/Asset Collateral Coverage. This is not covered directly in the guidance, but may be suited for distressed credits (EV coverage for cash-based lending and restructuring; asset collateral coverage for liquidation scenarios).
The time spent in the last year focusing on the more specific private debt investor guidance and case studies has better prepared professionals to leverage and navigate the guide.
Another panelist discussed several interrelated concepts that market participants should consider as they seek to follow the guidelines:
- Time Horizon/Prepayment. If a loan includes a prepayment penalty that expires in three years and the investor expects to hold the position beyond expiry, it might not make sense to mark it up to the penalty amount, whereas, if prepayment is imminent, it probably does
- Unit of Account. For example, when a lender receives warrants with their investment, the Guide suggests they should value the two securities separately.
- Traded Debt. An investor who owns junior debt securities but becomes aware of a trade in the senior debt should factor this new information into their valuation.
Next, Balynsky addressed the topic of considering the value of debt as it related to determining the value of equity. In such situations, when debt is part of an EV waterfall, the guidelines suggest that the value of equity falls within a range: the lower equity bound is established when debt is valued at its payoff amount (par or call price if imminent and certain); and the upper equity bound is established when debt is fair valued, and the Sponsor has a favorable coupon relative to market levels (below par fair value). He noted that, except in unusual circumstances, VRC typically values debt at its payoff amount.
Recalibration Case Studies
Walking through the process of recalibrating debt when market- and/or company-specific factors move, Balynsky gave the example of a unitranche term loan, initially yielding LIBOR +5.50, roughly in line with that of its market peers. The issuer’s leverage level is also similar to its peers. Rolling forward, it was assumed that spreads for the peer group widened by 50 basis points and that the issuer’s underperformance took its leverage from 5x EBITDA to 6x. The combination of broader peer group spreads, and the issuer’s higher leverage could result in a 100 basis points spread widening to LIBOR +6.50.
Another panelist ran through a distressed debt valuation case study pulled directly from the guidelines. It uses math-based models to describe different scenarios for the distressed issuer, one a restructuring, the other a liquidation, with both potential outcomes reflected in the valuation. At the outset of the investment, the two scenarios are given equal weighting. Over time, however, as the company’s prospects diminish, the guidelines suggest weighting the downside case (liquidation) more heavily, which translates to a sharp drop in valuation.
Transaction Cost Ambiguity
Panelists also shared insights on how to reflect transaction costs in equity and debt valuations, and there was an acknowledgment of considerable uncertainty, with conventional accounting treatments giving conflicting information on how to handle transaction costs at origination and in subsequent valuations.
For equity, fees are typically booked as an unrealized Day 1 loss that gets amortized over the life of the investment. Debt, on the other hand, often is purchased at an original issue discount (OID). The guidelines state that OIDs deemed origination or transaction fees should be excluded, whereas those deemed yield enhancers should be retained in the fair-value calculation. One buy-side panelist noted that their firm looks at how actively involved they were in structuring a deal to determine how much of the OID should be deemed fees in determining fair value.
The guidelines encourage the use of the third-party price quotes for valuation, but there was broad consensus that not all broker/dealer price quotes are created equal. The guidelines state that a quote should be “contemporaneous and actionable.” An obvious red flag is whether the dealer providing the quote is not active in trading the type of assets they are quoting on. But even when they are, a panelist warned there are additional factors to consider before accepting a quote, including whether it’s “coming from an associate or the head of the desk.”
Additional nuances include evaluating the variability of quotes—and that’s not always as straightforward or intuitive as it might seem. One panelist warned against using quotes that are “all over the map.” Another, however, gets concerned when quotes are too close together, especially when one set of prices comes from a trading desk and the other from a third-party pricing vendor: “That tells me we may just be talking to the same dealer!”
The State and Outlook for the Middle-Market Macroeconomy
Jason Kuruvilla, partner at RSM US, presented an outlook for the U.S. economy and some key metrics that participants in the middle-market are watching closely, which could point to potential stress points going forward.
For the overall U.S. economy, Kuruvilla said there is growing uncertainty. As a base case, he forecasted a modest downturn in GDP growth in 2020, down to 1.4 percent, versus 1.8 percent overall this year, as household consumption slows, capital expenditures drop, and the positive impacts of the 2017 tax cuts are eclipsed by trade frictions with China and, more generally, slowing economies around the world. Indeed, while the overall economy may avoid slipping into recession, Kuruvilla noted that many sectors of the economy—including manufacturing and agriculture—arguably are already in recession.
In the middle-market, Kuruvilla noted that the RSM U.S. Middle-Market Business Index, which the firm created jointly with the U.S. Chamber of Commerce, was down three points in the third quarter, which he attributed to slowing global growth, the U.S. manufacturing slowdown, and the drag from tariffs. On the positive side, middle-market borrowers still have ready access to credit without a lot of pressure for covenants or other restrictions. Still, Kuruvilla noted that there are some worrisome signs of slowing in middle-market capital expenditures.
The wild card for the economy—and for the middle-market companies that represent a major portion of it–is the trade conflict with China. In a worst-case scenario, Kuruvilla said a failure to resolve the dispute could knock as much as 1.5 percent off U.S. growth in the coming year.
Indeed, while the overall economy may avoid slipping into recession, many sectors of the economy—including manufacturing and agriculture—arguably are already in recession.
The Outlook for Private Debt
Following Kuruvilla’s rundown of the macro conditions middle-market companies are facing, VRC’s Czapla took a more granular look at the middle market’s vital signs—including fundraising, deal volume, deal multiples & yield trends, and credit statistic levels. A picture emerged of a market that remains robust with historically high private equity (PE) deal flow volumes, high PE multiples, record credit origination volumes, and historically tight credit spreads and deal terms. However, some statistics, such as lower new deal PE volumes, a recent risk aversion, and trade-off of lower-rated and junior credits, and a rise in default rates and distressed ratios may be foreboding that the end could be near.
In the private equity markets, Czapla showed record deal multiple levels and still historically deal volumes, but they have been trending down. Behind the numbers, he explained that the two-thirds of newer deal volumes are comprised of lower multiple, smaller-sized, add-on acquisitions as opposed to high multiple, larger new company acquisitions.
Market participants note a clear aversion of GPs continuing to pay lofty seller multiples in light of a trend towards higher borrowing rates as well as a more cautious stance on the outlook for the general macroeconomic economy, as Kuravilla pointed out in the previous segment. The smaller add-on acquisition continues to provide lending opportunities to the private credit market, but are there enough companies to “add-on” to maintain volumes to whittle down all the private debt dry powder?
Another indication that the middle-market may not be quite as vigorous as it used to be is the discernable movement by investors higher in the capital structure and towards safer credits. Czapla noted that since summer, spreads between B and BB loans are up about 50 basis points, and spreads between CCC and B are up nearly 700 basis points. There also has been a noticeable increase in the current and prospective default rate, and ratings downgrades are picking up.
Are there enough companies to “add-on” to maintain volumes to whittle down all the private debt dry powder?
In the junior capital markets, banks have become much less active in the high-yield bond and second lien loan new issuance markets on the back of lower investor demand for this paper. Czapla noted, “There’s clearly a risk aversion with investors now, especially on the CLO side.” CLO managers fear the risk of B to CCC rated security downgrades that could fill up their CCC covenant buckets, which would lead to a default event in the CLO. A default would shutoff fees to CLO managers and distributions to CLO equity holders until covenant levels were back in compliance. This trend is one of the factors that contributed to the financial crisis of 2008/2009 as credit downgrades caused a widespread selloff in the CLO markets to get back into compliance.
Given recent trends, market participants have been labeling the credit markets as “bifurcated.” “Good deals,” the higher-rated, safer credits are still receiving attractive terms; whereas, the “bad deals,” the lower-rated, riskier credits are receiving much less favorable terms.
Other key data and observations Czapla shared:
- Fundraising for middle-market private equity has softened slightly, but at its current $118 billion run rate for 2019 is still near all-time highs.
- With slowing deal volume, robust capital raising, and capital calls at the lowest level in a decade, the overhang of capital will continue driving pricing and terms.
- The flight to quality observed in inter credit rating spreads has not yet manifested itself in intra-issuer subordination spreads in the middle-market, where the average spread between first and second lien paper from the same issuer has held steady at around 400 basis points.
- Investors may be succeeding at pushing back on two features of the private credit market that have given them heartburn in recent years; the volume and percentage of “covenant-lite” deals appear on track to go down in 2019 and percentage of deals that include EBITDA adjustments dropped sharply in the third quarter. (Any reduction in EBITDA addbacks should be welcome since, as Czapla pointed out, a recent S&P study found that exactly zero of recent vintage deals that included EBITDA addbacks have hit their projections).
While Czapla says there are clear signs of stress in the private credit markets, he suggested that with all the excess capital waiting on the sidelines, they may be better positioned to handle a potential downturn than in years past. In fact, there has been a clear paradigm shift as private market players have been stepping in and filling the void for riskier capital (e.g., lower-rated debt and second lien loans), notably on the larger end of the middle-market that were typically serviced by the banks. Only time will tell if middle-market macroeconomic trends and market forces will alter the course of the current record expansion.
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