Alternative asset managers (GPs) and their investors (LPs) have financial reporting requirements, internal management needs (asset allocation, incentive compensation, portfolio construction, etc.) and a fiduciary duty to measure and report investments at “fair value.” Fair value is defined as the “price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”(FASB ASC Topic 820/IFRS 13) The first quarter public market sell-off and the expanding uncertainty and unknown impact of the coronavirus create a situation where it is more difficult to apply judgment in determining fair value. Yet, fair value must be determined and determined consistently and objectively even in a highly subjective and changing environment.
Fair Value Framework
While market perceptions, government actions and individuals’ behavior is changing rapidly with the current health threat, the framework for determining fair value remains consistent. In general, fair value is determined by taking into account key factors, including, but not limited to:
- What is “known and knowable” as of the measurement date?
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What is an “orderly” transaction?
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How would market participants transact (especially in times of increased uncertainty)?
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What are the drivers of value; revenue, cost, growth, competition, market conditions, etc.?
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How much weight should be placed on observable market transactions?
- What are the short medium and long-term impacts of a market disruption on the business and operations of an investee company?
There are numerous other factors and judgments required in estimating fair value, but for purposes of this discussion, the above highlight key considerations.
It should be noted that historically, private investments have been generally less volatile than actively traded public market investments. During a rapid public market upswing, private investments tend to lag and increase in value at a slower pace, and during periods of rapid market downturns, private investments tend to decrease in value at a slower pace. This is because the drivers of value for non-traded or infrequently traded investments are not specifically or uniquely tied to the second-by-second trading vagaries of the public markets.
Estimating Fair Value in the Current Environment
When approaching quarter end on March 31, 2020, it is important to thoughtfully and objectively consider the impact of the significant uncertainty created by the rapidly spreading coronavirus and its ancillary impacts on the global economy and public markets. More importantly, when estimating fair value for a specific investment, both the macro environment and investment specific value drivers should be considered. These include, but are not limited to, the following:
- At the macro level, the current crisis is no different than any other external impact (i.e. significant public market volatility, Brexit, political events, natural disasters, etc.). The impact on the value of a specific investment should reflect a market participant’s consideration of uncertainty in the macro environment. Uncertainty has increased, and therefore a market participant would take the increased uncertainty into account. This may be represented through decreased return assumptions, extended exit assumptions, delayed investment assumptions or a wait and see attitude.
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The public market sell-off provides an indication of the increased uncertainty but may or may not be useable as a benchmark for the increased uncertainty with respect to a specific non-traded or infrequently traded investment. Uncertainty may differ by geographic region, industry and other factors.
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On the individual investment level, consideration should be given to the short, medium and long-term impacts of the coronavirus epidemic on the investee company’s performance compared to prior and future expectations. What is the impact on customers (revenue), supply chain (costs, delivery times), employees (productivity) and growth? In most cases, if not all, it would be expected that projections should be updated to consider, to the extent possible, the impact of the epidemic. The impact on an individual company’s results and outlook may be positive or negative. A market participant would expect to see updated projections. If updated protections are not available, value drivers may need to be adjusted to account for increased risk and uncertainty.
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Up-to-date projections should be used with appropriate value drivers to estimate fair value. Care should be taken not to double count the impact of uncertainty. For example, if projections have been updated it may not be necessary to reflect an increased company specific risk premium (alpha) at the same magnitude as would be required if projections have not been updated. Similarly, if projections have been updated it may not be necessary to reflect a change in market multiples, or credit spreads, at the same magnitude as that indicated by changes in comparable public companies or actively traded investments. Value drivers will also need to be updated but need to be congruent with projections to which they are applied. New forecasts and outlooks should be well documented, especially in a situation where the subject company’s prospects may seem to diverge from prices in public markets for similar companies or from other market data specific to that company or the industry in which the company operates.
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Difficult subjective judgments will be required in assessing the timing and impact of the crisis on future investee company performance and the ultimate exit.
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In all cases, a market participant viewpoint should also be considered–how would a market participant think about increased risk and uncertainty?
- All judgements, supported by objective data and subjective considerations, should be clearly documented to support the ultimate fair value conclusion.
For non-traded and infrequently traded investments, the specific characteristics of the individual investment must be considered when determining fair value. Macro events also impact fair value but must be considered in context of the value indicators for the individual investment.
Estimating fair value requires significant informed judgment in the best of times. The current environment requires enhanced consideration of individual facts and circumstances with a rapidly changing macro overlay.
In December 2018, the public markets declined significantly. As investors in alternative assets approached the valuation of the non-traded and infrequently traded investments at December 31, 2018, the question was posed, how does the downturn in the public markets impact the value of private investments? Interestingly, the public markets recovered during January of 2019. While it was not known or knowable that the public markets would recover, that January 2019 recovery gave some cover to judgments which did not show on an overall basis a significant decrease in aggregate value of private investments at December 31, 2018.
As we approach March 31, 2020 we will be faced with a similar and maybe an even more severe conundrum. What is known and knowable at March 31, 2020 and how should we take into account new information which will be available after quarter end? We stand ready to assist our clients and contacts with making these difficult and critical judgments.
We will discuss these concepts and respond to your questions in more depth on our March 18 webcast. Register now.
