Estimated reading time: 6 minutes
The article in brief:
- Private asset valuations snapped back in Q2 as the economy began to reopen, and private capital investors took concrete steps to shore up portfolio companies.
- The prospect of new waves of COVID, leading to another economic shutdown and double-dip recession, hangs over the market.
- Private investors had much better information to work with for their second-quarter valuation processes than in Q1. Yet, it remains a struggle to determine how much weight to give COVID-influenced financial metrics from preceding months, how to handicap management forecasts for the second half of the year, and how to interpret volatile price data from public equity and credit markets.
- New deal activity picked up in the private equity and credit markets, thus providing more intel on current private market valuation terms. The data continues to reflect wide ranges and limits based on historical standards.
VRC is comparing notes with private fund clients on how they are handling the unprecedented challenges presented by the novel coronavirus to their operations and their portfolio companies’ bottom lines. Emerging from the discussions is a consensus: market participants need to be flexible to adjust to the new reality. This “new reality” includes wild price swings seemingly divorced from the fundamentals in publicly traded comparables, duration uncertainty of COVID impacts on cashflows, and the proliferation of highly suspect earnings addbacks in deal forecasts. Funds that have stayed true to robust and documented valuation processes find adjustments to these types of realities are easier to make.
Better Information and an Improved Market Tone
VRC has been tracking market movements closely and compiling various data points, highlighting key features of the macro-economy and private capital markets in Q2. The end of the first quarter was chaotic, and the impact of COVID on various sectors and companies was opaque. But the end of Q2 delivered a much clearer picture, revealing market losers and winners.
As the economy slowly reopened in early May, the labor force adopted work-from-home arrangements, and many companies began seeing revenue growth. By July, many saw improved monthly run rate figures, albeit below pre-COVID levels, but on an upward trend. Among the many companies impacted by the shutdowns, from VRC’s sample, most management teams implemented successful cost-cutting measures to at least maintain break-even levels as revenues declined. Companies also shored up their liquidity situation by tapping government funding programs, drawing on credit revolvers, and working with financial sponsors to secure additional equity capital. Many also worked with private lenders to suspend covenants and/or toggle their loans to PIK pay interest when necessary. Overall, COVID-impacted companies performed much better than expected, and hence, the number of defaults was less than expected.
Companies also shored up their liquidity situation by tapping government funding programs, drawing on credit revolvers, and working with financial sponsors to secure additional equity capital.
Valuation in the Time of Coronavirus
VRC’s Michael Park notes how COVID has impacted valuation methodologies (very little) and inputs (quite a bit). Concerning methodology, he said funds still employ a calibrated yield analysis for non-stressed borrowers and an enterprise value/scenario-based approach for credits where there is a going concern issue due to COVID and no signs of improvement.
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, Park said with April and May financials, VRC saw much more company information from the impact of COVID. Because funds were acutely focused on monitoring their existing portfolios, he said 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.
For the third quarter, we expect valuation professionals to focus on borrower liquidity, especially as revolvers are drawn down, and government loan programs are exhausted. We will also continue monitoring rebounding revenues and EBITDA to pre-COVID levels, conversely, for any slowdown or reversal signs.
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.
VRC stresses 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 bond markets to which to 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.
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 had to be 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.
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, valuation firms and their clients are more focused on efficiencies.
Fund managers should both have and follow a well-documented valuation policy that contemplates all contingencies.
EBITDA and ‘COVID Addbacks’
Before COVID-19, the proliferation of EBITDA addbacks may have supplanted covenant light loans as the chief source of anxiety and headaches for private debt professionals. The notion of projecting improved earnings tied to specific operational measures has become the central thesis for many private equity deals. And some addbacks, such as shuttering a warehouse or eliminating a redundant CFO, are justifiable (though companies almost invariably fall short, even on the most legitimate addbacks).
Equity sponsors have been pushing the envelope by claiming they can realize efficiencies that are not guaranteed. Examples of these offensive tactics include business combinations seeking improved cost and revenue synergies, renegotiating better supplier pricing, or squeezing improved returns from their marketing programs. Generally, most deals had some form of addback to GAAP calculated EBITDA, with most covenants allowing adjustments up to 25% of total EBITDA.
Post-COVID, new deals terms are more lender friendly, with lower levels of permitted EBITDA addbacks. However, given the uncertainty on future revenue and earnings, now base EBITDA is called into question. Nobody has yet dared to explicitly claim “a COVID addback” and coin a new term, “EBITDAC,” but most existing and new deal credit stats and covenants are based on forward EBITDA that excludes three months of “COVID trough.” These levels are mostly below pre-COVID peaks. Still, most also do not weigh in the possibility of a spike in cases and possibly a double-dip recession that could hit earnings hard.
One VRC client notes that the difficulty projecting forward earnings can cut both ways. They observe that there is no reason to assume all the nominal COVID “winners” of the last six months (i.e., companies benefiting from the WFH dynamic or the “nesting” phenomenon) can sustain their current pace if the virus is (or isn’t) corralled. Even if it is, he noted, many consumers who were driving growth for these COVID winners will have completed their home office setups or home remodeling projects. Hence, current financial performance can be understated, whereby forward figures should forecast a trend back down to typical results.
Despite opinions on the legitimacy of EBITDA addbacks, forward revenue, and EBITDA levels in the COVID-19 market environment, the rebound in the capital markets is buying into these figures and the global economy’s resiliency.
Continued Updates and Coverage