Valuation in Times of Uncertainty

Addressing Valuation Impacts as a Result of the Coronavirus Crisis

VRC leaders — PJ Patel, Justin Johnson, John Czapla, and Larry Van Kirk — recently discussed the valuation impacts they’re seeing as a result of the coronavirus crisis in the areas of public companies and potential goodwill impairment testing, private equity activity, and the private credit markets.

Watch for more information as we provide education and information to help clients and partners find certainty in making business decisions related to valuations, financial opinions, and other value-related advisory services during uncertain times.

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[Transcription]

[Jennifer Dries, Marketing Director:] Hello. I’m Jennifer Dries, Marketing Director with VRC. We thank you for tuning in with VRC Leadership, PJ Patel, Justin Johnson, John Czapla, and Larry Van Kirk as they address the valuation impacts as a result of the coronavirus crisis. During this time of uncertainty, VRC and its global organization partner, VRG will be sharing many updates like this to provide educational information to help clients and partners find certainty at a time that is quite uncertain. PJ, I’ll pass the floor to you.

[PJ Patel, Co-CEO:] Thanks, Jen.

VRC has a unique viewpoint in this market. We work on 600 deals a year and value 5,000 securities annually, and with that, we’re going to share some of our thoughts on what we’re seeing in the environment today.

Gentlemen, let’s start with a general question, just in terms of how we look at valuation in this sort of environment. We’ve been through different health crises in the past as well as the financial crisis in 2008. What are you seeing in terms of valuations and some of the inputs and metrics and such that impact the valuations and impact the stock market?

[Larry Van Kirk, Senior Managing Director:] You know, one of the big things we’re seeing in similarities to 2008 is obviously the stock price impact where one of the valuation techniques that we often are asked to reconcile to, or at least employ, is looking at the stock price and where it is. And obviously, sometimes companies, even though their underlying fundamentals are the same, they get lumped into a group or a certain sector that requires their stock price to be depressed. Where if you look at it from other metrics, including income or cash flows, the valuation result would be significantly different.

So we’ve had a lot of conversations with our clients in a similar fashion where the stock price seems to be kind of in disconnect with really the underlying fundamentals of the business.

[PJ:] That sounds good Larry. Justin?

[Justin Johnson, Co-CEO:] I think as you look at health crises, I really don’t think those are good comparables to this. Nothing in the past that we’ve seen—SARS, H1N1, or anything like that—has impacted the markets like this has. I mean even if you go back to the Spanish Flu, which was the most severe of any global pandemic in modern history, it did not have this type of impact on the markets.

So this really is new territory in terms of a health crisis impacting valuations in the markets. I do think looking to the 2008 financial crisis is more of a comparable, unfortunately. But I’m hoping that it won’t be that serious or severe and certainly not that prolonged.

One thing we need to keep in mind is that this is a health crisis that caused an economic crisis and a market crisis. And to a certain extent, it’s the shutdown that’s really impacting things. The shutdown is largely self-imposed. So that’s very different than the prior, you know, 2008 financial crisis and the Great Recession. I think it’s therefore difficult to predict with a great deal of precision how we might come out of this. I think it’s all going to depend on how long the shutdown is. And then, you know, when we come out of it, it could come quickly. It could be a quick recovery, a quick rebound. Some people have been saying that. I think that is possible.

[PJ:] Yes, I think you’re right Justin. The timeframe and the uncertainty in the timeframe is, I think, a really critical part of this. You know, it almost seems like the ground is shifting beneath us daily.

John, how about for yourself, what are you seeing in your markets and maybe you can touch on the disconnect between price and value as well?

[John Czapla, Chairman:] In the portfolio space with most of my clients being on the financial side, private credit, private equity, clearly, I agree with Justin. The biggest comparison—or the best comparison—is probably the Great Recession of 2008. Very different. That was caused by illiquidity in the market. It’s clear that’s not the case here. There’s plenty of liquidity in the market. Purely health-driven, which has become company fundamental or demand-side driven as opposed to money and supply-side driven.

You’ve clearly seen a lot, especially in the credit market, buyers have shown. The public equity markets, a big outflow of retail of money, which is driving down prices. Probably just like 2008, below what we think is probably fundamental values. You’re seeing the same thing in the credit markets. If it’s the bond market or more upstream in the loan market. An initial wave of outflows from retail accounts really pushing down prices.

But what we’ve seen, it’s been low-volume. You can see the numbers on the screen of how low they are in terms of 70 cents, 80 cents on the dollar for loans and bonds. Lower for bonds obviously. But we haven’t seen the institutional sellers. Those being like CLOs and big structured funds on the bond side being sellers, which are probably 70 or 80 percent of the market.

What we can tell and what we’ve been told, and with some of our clients, what we can see, it’s been pretty orderly from that standpoint. They’re strategically picking off from the retail market on some of these low prices. There haven’t been big sellers at this point. So again, it’s been more retail-driven.

What that means to us when doing valuations is that it looks like some sort of divorce between fundamental value, even on the credit side, from the technical side that we’re trying to read.

We’ve done about 50 surveys with our private clients and where they are. Clearly there’s been a repricing of risk that it is embedded in what you see in the private, or in the public markets, either equity or in the credit markets. We don’t think it’s been that big of a trade-off. Again, there’s had no impacts from retail selling in the equity and debt markets. That doesn’t impact the private side, and our job is trying to read that. Clearly, again, repricing risk and there’s going to be fundamental issues.

This time it’s really identifying which industries. People are starting to label it now—low-impact, high-impact, medium-impact by industry that are being impacted by COVID-19. Clearly, with restaurants being shut down, gyms being shut down, various public places being shut down—those types of businesses are clearly impacted. Airlines. And how anyone comes out of it, as JJ said, it’s anybody’s guess. It’s the markets trying to speculate.

But interestingly, there have been some winners. Anything online, or in shipping—certain industries like that are obviously benefiting including healthcare. And they may benefit in the long-term. It could be a shift in paradigm impacting the retail industry with more people. Those that were late adopters to the internet, and they’ve all adopted now. And you can see some permanent shifts now. So that’s what we’re seeing.

[PJ:] And Justin, what about on the PE side? What are you seeing? Is deal activity continuing? Or, is it at a bit of a standstill? What are you seeing right now?

[Justin:] I think it’s mixed on the PE side, PJ. I think in talking with our clients, it really depends on where they are in the lifecycle of their fund. For example, if you’re trying to raise money right now, it’s gonna be a little tougher. If you’re, fully invested and you’re kind of in a hold and harvest mode, then I think it also could be tough.

Particularly as John touched on, we have private equity clients with investments in gyms and movie theater concepts. Obviously, these things are getting very materially impacted by what’s going on. Others have investments in restaurant concepts and retail. That’s also getting hit pretty hard. So they’re really worried about valuations and exits and how that’s going to impact their portfolio.

In contrast to that, we have private equity clients that are towards the beginning of the fund life and they have a lot of dry powder left to invest. They’re viewing this very differently. They’re viewing it, I’d say more opportunistically.

For example, I spoke with a client where there were companies they diligenced previously and took a pass. They now continue to monitor those companies and if the valuations come down, I think that they would maybe take a second look at those companies. So I think it really depends on where the private equity firm and their funds are in the lifecycle, and that dictates how they’re viewing this market disruption.

[PJ:] Justin, would you say that those clients have continued sort of “business as usual” or maybe are they taking a little bit of a pause, still optimistic of the mid-term and the long-term? Or is it something different? What are you seeing?

[Justin:] I think whenever you have this kind of dislocation in the market everyone’s just going to put everything on hold for a little while. So I wouldn’t be surprised if in the very near-term deals slow down. And even slow down by a lot once we start to get visibility on just how bad this is going to be and we get more information and more data on COVID-19, I think you’ll see people start to participate in the market more.

But even at that point, I think there’ll be a period of price searching. You know, you’ve got to have buyers and you’ve got to have sellers. Sellers may be thinking “I’m going to wait until valuations revert to pre-crisis levels.” So there will be a period of price searching. On the other hand, certain industries, like the ones we talked about that are getting hit so hard by this market period, might be forced to sell. They might be distressed.

So I think as those valuations get pushed down from that type of activity, I think even amid some continuing uncertainty in the market, you will see buyers come out and make a move. So I think in the near term, to summarize, we’ll see slower deal activity but that will eventually pick up as some of these market forces unfold.

[PJ:] Interesting.

Larry, how about the clients you’re talking to? You’re working more with the private equity portfolio companies and the public companies. Are they thinking about impairment testing as an example for Q1 or Q2 or both? What are they doing with projections and forecasts? Thoughts that you can share on that?

Larry: Yeah. Sure. So we’ve been fielding a number of calls both on the private and public companies kind of concerning quarterly impairments, and I kind of characterize it on two sides of the fence. On the one side, we’ve got, similar to what JJ was referring to, we’ve got certain industries. So we’ve got tourism, hospitality, transportation, retail, for example. Even some manufacturing industries that are obviously experiencing some issues.

And on the one side of the fence, you’ve got certain companies that think that again, the underlying fundamentals haven’t changed. That this is a temporary blip in the radar and therefore, really don’t think they have impairment issues. However, given the stock market activity, some of the auditors are pushing back saying, hey, you might have a triggering event in which you need to show us something. And so we’re being asked to help them with modeling. And most of the modeling that we’ve been seeing, you know, companies again, just don’t really know, as we all wish we could have a crystal ball, right?

But at the same token, what they’re trying to do is to try and help get through the triggering event process is show some sort of impact over a three, six, maybe even a nine month period in that, whatever’s left in their 2020 time period, and kind of show the rest of the forecast or expectations remaining constant.

Again, there are some companies though on the other side of the fence which, in maybe tourism or hospitality, where they can definitively see an issue maybe going out farther in which they try to predict, you know, how are people gonna respond to an amusement park? Are you gonna go back there very quickly? Is the response gonna be quick? If you host large events, like a public forum or a tradeshow, will folks go back in a rapid fashion after that or is it gonna be a very slow response?

So basically, we’ve been talking about both supply chain operational issues, whether that, you know, is short-term or long-term. And again, the definitive thing from our perspective, PJ is, is this a temporary disruption that just may not indicate impairment, but just need additional disclosure or some evidence to your audit firm? Or is this something that has a longer impact and may lead to impairment kind of considerations? And those are discussions we’re having.

[PJ:] Got it. Yeah. It’s interesting. I think, one of the things that I’m seeing is, you know, as we get towards the end of Q1 here, it seems like there’s not enough known to really maybe show impairment today. But then picking the ball back that maybe in three or four weeks from they’ll see if this is going to be a longer-term issue? Sounds like you’re probably seeing something similar to that?

[Larry:] Yes. And really for some of these companies, the trough happened at the end of March, right before the quarter-end. So is it a Q1 or is it a Q2 impact? And how long do you look at the stock market price? All of these thoughts play into that process and whether you do a Q1 or Q2 test.

[PJ:] Interesting.

John, you talked earlier about the repricing of risk. So what does that mean? Does that mean a higher expectation of yields? Clearly this is a ‘black swan’ sort of event, how do you account for that? Is it a probability of higher-expected returns, or something else?

[John:] Yeah. I mean I think on the credit side it means higher-credit spreads. Obviously, you’re going to see a reflection of that in the secondary markets, how much they’ve traded off. But again, we’ve assessed that’s probably below what we think the fundamental value is. Right now we’ve done about 40 or 50 client surveys with banks and various private clients, private equity clients, law firms, people that do deals, and data service providers, like S&P and Reuters, to try to get a flavor of what activity is going on in the market.

Clearly, it’s limited. If we look back to the beginning of the month of March everybody was pretty optimistic. A lot of people have a lot of money in their funds and in private equity and private debt. They thought “we’re going to get a wave of cheaper deals for private equity and better terms on credit.” That’s now quickly moved to portfolio monitoring mode.

And then for us, a handful of deals are progressing because they have the money, and private equity firms are completing some deals. Private credit is funding those. And in our data gathering, we are seeing that it’s at higher and wider spreads. Probably 100 basis points, at least down the fairway, but that fairway is much narrower for the regular laid deal. Clearly, the industries that are impacted by COVID, even if it’s a medium impact, they’re being signaled out of not getting done. So that fairway is definitely getting narrow with higher pricing.

And then also we’re seeing better terms on the credit guide side and better documentation, better covenant protection, lower addbacks to EBITDA, lower leverage levels coming along with what people think are lower enterprise valuations. Private equity valuation levels as well. So basically, higher spreads on lower leverage, higher risk-reward profile early on. And it’s very low volume.

I think that’s what we’re going to see. And, similar to what happened in the Great Recession, very low volume. You start to get in a little bit of price recovery. You had wider spreads, better terms on the best deals getting done is what you see. Clearly lower valuations on the equity side, enterprise valuations side across the board on the private equity. Again, lower volume. These guys are completely in portfolio management mode right now; they’re not thinking about deals.

The funds, as JJ mentioned, that have liquidity is being used right now to identify those industries and put liquidity where it’s needed. On the private debt side, some of those are being asked to convert their cash pay to PIK pay, which is clearly having an impact on valuation for those high-impact industries. So for those industries, everybody’s trying to guess “How long is this going to last? When can you turn it back on?”

Right now the thought is really just to hunker down and figure out if there is enough liquidity and manage those industries. And clearly those valuations are pretty far down on the equity side and the credit side. Much, much bigger credit spreads are being used in yields for those types of industries.

[PJ:] Justin, I know this market disruption is in the early days for you on the PE side. Have you seen anything yet, maybe any sort of repricing of risk through higher IRR on deals or anything like that? Or is it still too early to tell?

[Justin:] I think we’re still early. I think a lot of people are going to stay on the sidelines. There’s just still a lot of fear and uncertainty out there in the general markets. And I think private equity investors look to the markets and say “It’s going to be potentially tougher for us to exit and it may be tougher for us to exit at the valuations we want.”

So I think they are going hit the pause button at first. But then eventually, I do think valuations are going to come down, multiples are going to come down. I think the big question is “How prolonged will the shutdown be?” Because as I indicated before, this is really kind of a self-imposed market situation and that is so different than the Great Recession, which was a financial crisis.

And will this last a long time? If it is prolonged and does last a long time, then certain industries are going to become distressed. And that will have a very material direct impact on valuations. If the shutdown is relatively short, then I think we could see a bounce back or a fairly quick recovery in valuations. But I think it’s still early to tell. We’ll have to monitor the situation very closely.

[PJ:] Interesting. You bring up a good point. I mean I think what we’re seeing, in some cases, it’s not a 10, 15 or 20 percent reduction in business activity. We’re seeing an 80 percent reduction in business activity and there’s no discount rate that can really account for that. I mean that’s just got to be a change in cash flow.

Larry, what about from your standpoint, as you’re talking to companies, whether public or private, are you seeing changes in how they’re viewing risk, and how they’re looking at values going forward?

[Larry:] I definitely think that consensus would be that there is a higher level of risk. It’s just unknown, and to JJ’s point, how long is that going to last? And I think with those kinds of tenuous situations companies are fairly aware of risk.

On the other hand, there are companies, like healthcare companies, where they may see the ballgame may becoming a bit more tenuous. But they see it as an opportunity and they’re functioning at a high-level, and they’re not seeing maybe as big of an impact. So there are pockets where maybe the risk levels aren’t as enhanced. But I would say for those industries that are impacted, yes, we’re seeing a higher level of risk.

[PJ:] Anything else anybody would like to share that we haven’t covered here? Any thoughts on anything else that you’re seeing in the market?

[John:] I think generally, and I think we touched on it, but what’s a little different with this time around, is the liquidity in the markets. And there’s plenty of liquidity in the private space. Even the public space and the banks. I know there’s been plenty of studies. You know, most people are seeing, especially the high-impact industries as I noted, hunkering down and trying to shore up liquidity. You see a massive wave of revolver draws.

So immediately that creates a panic “Who’s going fund all this?” And the banks are funding most of the revolver, the government’s come out and they’ve done their studies. And the banks this time are all well-capitalized. No one thinks there’s an issue with funding revolvers or delayed draw term loans.

Same thing on the private side. In talking with our clients, most of the funds have good dry powder. Yes, a lot of it’s going to be diverted from the new deal flow and it’s going to be more on the portfolio management side. Getting some of these high-impact industries. I’ve given them the proper liquidity on the credit side and on the private equity side, we see the same thing. Some of that money’s going to be used to bail out some of these companies.

The consensus is that the industry is supportive—private equity is supportive of their deals. They have a lot of skin in the game. This is what these guys do. They’re going to be able to bail out these industries. I mean granted, you have no idea as to how long it’s going to last. And everybody throws out buzzwords, JJ mentioned it in asking “How quick is the recovery going to happen? And to answer that they’ll throw out terms like “U-shaped curve”, meaning that the market is going turn itself back on and there’s going to be a big recovery and everybody’s just going to start working.

But, no one knows what damage is being done. Obviously, businesses go out of business and it is hard to get those started back up. So what everybody’s trying to do now is bridge them for as long as possible to keep people working and to keep the businesses up and running, and open. So if you can just turn things back on then we’re not talking about an empty shopping center.

[PJ:] Yes, got it. Justin?

[Justin:] One thing that is clear is that the longer the shutdown or the more prolonged the shutdown, the greater the probability that this is going to be with us longer. That it could pull us into a recession or even a severe and prolonged recession. But I don’t think the country will allow that. Certainly, I don’t think the country will allow us to get into depression or let this go into a severe recession. I’ve heard a lot of talk about the cure being worse than the disease, and I think in the coming days and weeks, we’re going to see a lot of people weighing that and assessing that as we go forward.

[PJ:] That sounds right.

Larry, anything else to add? Final thoughts?

[Larry:] No, just echoing what everyone’s been saying—unknown situations and unknown circumstances. It’s not that VRC has all the answers, but we’ve got a process and an approach, and we’ve seen similar circumstances like this. Everything has its unique sets of facts and circumstances. But obviously, that’s what we’re here to do—to address this kind of thing and the valuation issues that come with that.

[PJ:] Got it. Thank you, gentlemen, thank you for your time.

[Larry:] Thank you.

[Jennifer:] Yes, gentlemen, thank you so much for taking the time to speak with us today.

For those of you watching, we welcome you to connect with any member of our panel or your VRC professional.

Please visit us at valuationresearch.com as well as our global organization, vrg.net. Thank you.