New Year Brings Hot Valuation Topics To The Forefront
There is a well-known saying: “There are decades where nothing happens; and there are weeks where decades happen.” Clearly, this is a reflection of what market participants experienced in the illiquid credit and equity markets during 2020.
As alternative investment funds, both private credit and equity, complete their financial statements for 2020, Lincoln’s Valuations & Opinions Group (VOG) provide our insights into four themes we believe market participants should be particularly focused on at year end. These include:
- The power of market illiquidity and its impact on fair value;
- Unprecedented market volatility and its influence on valuations of level 3 financial instruments;
- Assessing unique and new 2021 accounting and financial issues; and,
- Proactively preparing for new valuation and auditing guidance issued from major regulatory organizations, specifically the SEC, PCAOB and AICPA.
The number and complexity of these issues will keep fund management, boards and accounting and valuation professionals quite busy throughout 2021.
Lincoln International’s Valuations & Opinions Group shares insights into the four valuation themes that illiquid credit and equity market participants should be focused on as they finalize their financial statements and prepare for 2021.
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|The impact of market illiquidity and its impact on fair value
It is easy to demonstrate the impact of illiquidity in 2020. For example, in the broadly syndicated loan market, the LPC 100, an index of the 100 largest and most liquid corporate loans was 98.7% of par on December 31, 2019 and troughed at 77.9% on March 23, 2020. As of December 29, 2020, the index value was only 1.0% lower than the start of the year, ending at 97.7% of par. Loans that were liquid at the beginning of the year, rapidly became illiquid during the first quarter only to become liquid again by the third quarter.
From a valuation point of view, for larger companies whose commercial loans or debt are actively traded it is common to fair value their debt based on its actively traded price or apply the actively traded price and yield as a reference point for valuing a credit obligation that is less liquid. However, as liquidity declined during portions of 2020, the ability to use this valuation method diminished as illiquidity increased.
In addition, the SEC has recently weighed in on instances in which the amount of valuation reliance that can be placed on single broker quotes, particularly those based on evaluated prices predicated on infrequent transactions. It is the SEC’s perspective, as well as FASB’s, that evaluated prices based on single broker quotes derived from illiquid markets does not reflect the fair value of a security and, therefore, should not be used as a sole valuation approach.
At the center of all evaluated prices are the related concepts of market depth and market liquidity. Market depth refers to the number of market participants willing to purchase or sell a security and market liquidity relates to a market’s ability to withstand a purchase or a sale of the security without a significant impact to its price. Together these concepts consider the number of market participants willing and able to trade a security, overall level and breadth of open orders, and bids and offers, including trading of an individual security.
What is certain is that as the number of market participants and buy and sell orders increase for a particular security, this greater depth and liquidity of the market for the security creates confidence that the observable price is reliable as an indication of fair value. However, the opposite is equally true; that as market participants and buy and sell orders decrease fair value estimates based on such prices become increasingly unreliable. It is, therefore, unambiguous that fair value estimates based on illiquid transactions cannot be solely relied on as a fair value measurement.
|Market volatility and its influence on valuations of level 3 financial instruments
While it is hard to believe in light of the turmoil evidenced in 2020, major credit and stock market indices will experience year over year valuation gains (or at a minimum, just small declines in fair value). Simply looking at values on January 1, 2020 and December 31, 2020 ignore the volatility that occurred throughout the year. As examples, based on Lincoln’s proprietary data from thousands of private middle-market companies (primarily owned by private equity groups) valued by us indicate that:
|Assessing unique and new 2020 accounting and financial issues
The pandemic has created several unique accounting and financial issues that will become readily apparent upon the release of 2020 financial statements as well as at the end of 2021.
Potential for Goodwill Impairments
Many analysts are expecting that the pandemic’s impact on earnings will have the potential to create a significant number of impairments to goodwill once year end results are tabulated. If companies have not already, by the time the 2020 audit is released, significant COVID impacted businesses are expected to report material goodwill impairments.
Under current GAAP, goodwill must be tested for impairment when a triggering event occurs that indicates that it is more likely than not that the fair value of the reporting unit is below its carrying value. Companies are required to monitor and evaluate goodwill triggering events as they occur throughout the year.
In what has the potential to be a significant accounting event and currently under fast-track consideration by FASB is a proposal (with comments due January 20, 2021) that would allow private companies that only report goodwill to perform a goodwill triggering event assessment on the annual reporting date only. Therefore, it would eliminate the requirement for companies that elect this alternative to perform this assessment as triggering events occur to limiting impairment testing only at the annual reporting date.
Continuing Likelihood of Portfolio Company Covenant Breaches and Amendments
As the adverse earnings impact of COVID continue to permeate earnings, we have previously reported that approximately 13% of companies Lincoln valued in 2020 Q3 breached covenants, down from 16% in 2020 Q2, but above the 10% levels in 2019 Q4.
Change in GAAP Treatment of Leases
While not related to the pandemic, GAAP ASC 842, effective at the end of 2021, will require private companies that lease to capitalize the lease on their balance sheet. Under a newly implemented accounting standard, ASC 842, all leases will create assets and liabilities for lessees. There will be a right-of-use (ROU) asset representing the right to use an underlying asset for the lease term and a lease liability representing the obligation to make lease payments. The ROU asset and lease liability measured as the present value of the lease payments discounted at the rate implicit in the lease or the lessee’s incremental borrowing rate will typically offset at lease inception.
Financial analysts will need to be cognizant that the income statement and balance sheets will be impacted differently by ASC 842; specifically:
LIBOR has been referred to as the “world’s most important number.” By the end of 2021 commercial loans using LIBOR as the reference rate will have to migrate to an alternative reference rate, the Secured Overnight Financing Rate (SOFR). SOFR is LIBOR’s replacement and is based on transactions in the US Treasury repurchase market where banks and investors borrow or lend treasuries overnight.
It was announced in November 2020 that the cessation of the 1, 3, 6, and 12-month LIBOR rate has been delayed to June 2023. Regardless, by the end of 2021, all new loans will need priced relative to SOFR while existing loans currently using LIBOR will need to terminate LIBOR as the reference rate by June 2023.
|New valuation and auditing guidance issued from the SEC, PCAOB and AICPA
Recently there has been new valuation guidance issued by the SEC in its Rule (2a-5) – Good Faith Determination of Fair Value release as well as new auditing guidance for fair value measurements issued by the PCAOB and AICPA. In total, these three new standards update and strengthen existing guidance.
Maintaining an active dialogue with our clients is very important to us. We would like to hear from you regarding your valuation thoughts for 2021. We are always available to exchange valuation perspectives.
2020 has been a year that feels like a decade’s worth of events occurred in just 52 weeks. The pandemic, unfortunately, continues. Even though the brightest minds in the world have been focused on developing a vaccine, under the best timelines, it most likely will not be widely available in the United States and in Europe, until mid-2021.
We are hopeful that 2021 will prove to be a year of strong economic reversion and expansion. Or, at a minimum, a year nothing quite like the tremendous upheaval we experienced in 2020 happens again.
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