Estimated reading time: 4 minutes
The article in brief:
- Private equity and private credit markets have weathered the pandemic remarkably well and show strong signs of recovery headed into 2021.
- There are still lingering question marks in the valuation realm ranging from liquidity concerns as stimulus programs lapse to how data from a most unusual period should be taken as a baseline for valuations.
- While the markets have returned to a sense of normalcy, it’s a new normal, and participants need to be careful of potential remaining pitfalls.
We’ve got this.
According to a recent panel discussion with two members of VRC’s portfolio valuation group and an industry colleague from RSM US, a provider of audit, tax, and consulting services, that seems to be the growing consensus in private equity and credit markets to the middle market. In the session, moderated by VRC Chairman John Czapla, VRC Managing Director Paul Balynsky reflected on the first three quarters of 2020, when borrowers and lenders were scrambling to assess the impact of the coronavirus and resultant economic slowdown on their business and the value of loan assets, respectively. Looking ahead to the balance of the year and the first quarter of 2021, Balynsky said that other than the most impacted companies, most valuations have nearly recovered to their pre-pandemic levels, and valuation ranges have narrowed. Companies have become better at projecting future revenues, and valuation professionals have grown more confident in those projections.
There are, however, several areas of remaining uncertainty hanging over the market heading into year-end, including:
- The near-term impact of a potential resurgence in the COVID virus on the liquidity of private borrowers in specific sectors (even as vaccine development and therapeutic improvements bode well for the long term);
- Practical questions arising from the pandemic, including how companies should account for government loans extended under the Paycheck Protection Program;
- How to continue to leverage public market inputs for private security valuation, even as public markets sometimes seem to defy economic fundaments and;
- How to value capital structures and cost-of-capital for private companies that have experienced large writedowns in equity values.
Following are highlights of the panel discussion. Access to a replay of the discussion is available here.
A COVID Rebound and Liquidity Concerns
Even as the preponderance of companies have weathered the pandemic surprisingly well, there is a lingering concern that some companies may run out of liquidity. Balynsky’s fellow panelist, RSM Principal Lindsay Hill, observed that if the virus continues to surge and leads to partial economic shutdowns, audit and valuation professionals should be preparing for an increase in the number of stressed and distressed companies. This is especially important to note as federal assistance programs implemented earlier in the year are expiring and may not immediately be replaced. Hill stated it has been several years since the private markets experienced a severe default wave. She advised market participants to consider whether default scenario analysis is appropriate for certain names. Balynsky chimed in that for companies that may be most impact by a second wave of shutdowns, downside valuation scenarios should be considered.
All three panelists agreed that there is some degree of variability in how companies are reflecting Payroll Protection Program loans in their financial statements. Hill noted that some entities initially considered whether they could include PPP proceeds in earnings, an idea that was appropriately pushed back on by auditors and valuation professionals.
But even on the liability side, there has been back and forth on how to classify PPP loans and where they belong in a company’s capital structure—if anywhere. Balynsky said VRC has been consulting closely with companies to ascertain whether they think the criteria for loan forgiveness will be met. While most companies should be able to check the boxes and have their loans forgiven entirely, he noted that the criteria are tougher in certain industries. In such cases, he said, it may well make sense to treat PPP loans as liabilities, though junior to most other debt forms. However, in most cases, most are considering full forgiveness of the loans, and thus the debt is not captured in the capital structure and the equity waterfall analysis.
Public Secondary Market Comparables and the Primacy of Primary Markets
While private credit investors cannot ignore price indications from high-yield debt and broadly syndicated loan markets, Balynsky said that public credit markets are not truly liquid like public equity markets and tend to dislocate from fundamentals. Prices for public credit instruments have remained volatile in the wake of the pandemic, bouncing from highs driven by general market euphoria to technically-driven lows from forced selling by funds being hit by investor redemptions. Fortunately, Balynsky noted, that the best source of data for private markets, new deal flow, has begun to pick up in the second half of the year.
Valuation Challenges Beyond Shaky Management Earnings Forecasts
While the earnings forecasts provided by companies at the beginning of the pandemic were understandably suspect, especially at the end of the first quarter, the panelists agreed that companies have shown a noticeable improvement in their accuracy and, in many cases, surprised on the upside.
But Balynsky flagged three other areas associated with cost-of-capital calculations where valuation professionals are still finding it challenging:
- Selection of guideline company capital structures; with many companies experiencing sharp equity writedowns due to COVID, it may be appropriate to employ a smoothing mechanism that looks back as far as three to five years to impute a more normalized equity to debt ratio.
- Similarly, while risk-free interest rates have been in secular decline for at least a decade, today’s near-zero rates are likely the result of nervous monetary policymakers keeping them artificially low. As such, smoothing out the risk-free rate, again using a three- to five-year window may be prudent.
- Finally, Balynsky said it makes sense to use a historical dataset—or better yet, two of them—to develop a smoothed baseline equity risk premium and then apply the unique facts and circumstances of the particular company in question.
The private equity and credit markets held up remarkably well in the face of a global pandemic and are adjusting to the “new normal.” But just as it’s not quite time to take the masks off, market participants should go into 2021 with heightened vigilance as the impacts of the pandemic may not have yet entirely played out.