Valuation can help communicate performance to LPs
In light of the recent scandals resulting from mispriced assets, and the broader impact of Covid-19 on the global economy, the need for accurate financial and valuation reporting in private markets – where the underlying assets are largely illiquid and hard to value – is a germane issue for investors.
From a balance sheet perspective, the amount of debt a company is carrying needs to be transparent and accurate in order to help fund managers and investors determine the fair value ranges on the equity positions they hold. Once things start to deviate, from a valuation perspective, it can expose investors to potentially serious write-downs and subsequent liquidity issues.
This was evidenced in the Neil Woodford episode in 2019, when, faced with investor withdrawals, he was unable to uphold the fund’s daily liquidity profile because of the portfolio’s exposure to hard-to-value unquoted companies. H2O Asset Management is another example of how things can go awry in public markets, when its two flagship funds fell by over 50 per cent because of the Covid pandemic last year.
As Hedgeweek reported at the time, Adagio and Allegro were two of the six H20 funds that came under pressure last summer following concerns over certain illiquid bond positions. Portfolio losses stemmed from a widening between long positions in under-valued and volatile assets, which sold off, and short positions in over-valued less volatile bonds, which duly surged in value.
One can therefore appreciate why valuation methodologies in private market funds take on even greater importance than public market funds.
“Investors require a lot more transparency around the valuation process. Some larger investors want to see the valuation report to crosscheck with their own methodology. There is a trend of increased scrutiny of the valuation process and the governance of private market funds, and it’s here to stay,” comments Milko Pavlov (pictured), Managing Director and Head of EMEA of Houlihan Lokey’s Financial and Valuation Advisory business.
Independent valuation reports have always been a vital aspect to any private markets investor to keep track of how well their portfolio investments are doing; be they in private equity, real estate, infrastructure, private debt and other asset-backed investments. Valuation specialists first rely on receiving all of the necessary fund information from the manager, following which they then conduct a detailed analysis of the data, looking at each individual exposure in the portfolio and how it was originated, in order to consider:
- What was the investment thesis for that asset?
- How has the asset performed vis-à-vis that investment thesis?
- How has the market developed at the same time?
- Have there been any changes in market dynamics that need to be reflected in the valuation methodology?
- Has the relative positioning of the asset changed compared to its peers?
Valuation specialists like Houlihan Lokey also look carefully at the manager’s legal documents and discuss details of the due diligence process, as well as ascertain how the ongoing relationship is playing out between the PE sponsor and the underlying management team, in the case of a private debt fund.
The aim is to achieve a consistent, accurate valuation methodology that investors can readily monitor.
Within private debt, the frequency of assessing a portfolio’s fair value will vary depending on the type of strategy the manager is running. A dedicated distressed debt strategy, that actively seeks out special situations and PE-like ‘distress for control’ investment opportunities, will arguably involve a more regular valuation reporting framework than a mid-market direct lending strategy where the majority of assets are performing, and impairments relatively rare.
“Investors in performing debt funds will understandably get nervous when assets become non-performing,” says Pavlov. “What our valuations in distressed situations focus on is how the particular case will be resolved and the anticipated path to recovery for the security holders. Is it associated with a temporary fall in performance, which may be recovered, as we are seeing in areas like leisure and retail as the economy re-opens?
“In other situations, however, it may be that the asset is permanently impaired and the only path will be through some form of restructuring. Investors and regulators would be interested in the measures the fund manager would be implementing to resolve the situation. The manager needs to look at all the various intricacies and have the expected outcomes in order to establish the fair value of the exposure.”
If one considers best practice, at a broad level one should expect managers running performing debt strategies to generate valuation reports on an annual or semi-annual basis.
For a distressed debt fund, the frequency of reports will tend to be higher; this could be quarterly or monthly, depending on the manager, their fund administrator and their investors, who might want an external valuation provider to monitor the changes being enacted through a restructuring, as these can be quite significant over a short period of time.
“Post restructuring, depending on whether any haircuts (valuation discounts) have been applied, the capital structure will change and the business will likely need to go through a lot of operational changes. This can all flow through and impact the financials on a monthly basis, in which case managers of distressed debt funds will put in place processes to have a much more regular independent valuation process,” adds Pavlov.
Another point to refer to is the use of leverage in private debt funds.
In the current market, leverage providers are keen to get external verification on the underlying assets, especially if they become distressed. In such a situation, they will want details on what the turnaround plan will be so that they can understand if a distressed asset can, or should stay, within the pool of collateral. As Pavlov states, “a bank’s facility agreement might require assets to be replaced if they become impaired or something goes wrong”.
The aviation industry is one stark example of how the pandemic has impacted what was generally a robust area of the economy, but which has led to serious impairment and a number of restructurings over the last 12 months, such as Virgin Atlantic, Malaysia Airways and many other.
Pavlov notes that oil and gas is another sector providing opportunities, “where we’ve seen a lot of restructurings. In the shipping sector, most of the activity we’ve seen has been in Southern Europe, where certain financial institutions are looking to reduce their exposures to that particular industry.
“Overall, non-performing loans haven’t materialized to any great extent yet in the hotel industry. Much will depend on how the recovery plays out.
“If there are national guidelines that don’t allow for hotels to open, it doesn’t make sense for the banks to consider offloading loan portfolios until there’s a clearer understanding on how the hotel industry will recover. This will show who is able to recover and who needs to go through a restructuring process.”
One of the main benefits to a robust valuation process is that it can translate to increased reputation by the LP community.
Also, by having an independent valuation process, as opposed to an internal one, it gives investors more comfort from an independence perspective.
“It is important to have a valuation committee with members not remunerated by the marks that does not take the views of the portfolio manager without applying scrutiny on the assumptions utilised, and which can ensure everything is in line with best practices, in order to have a fair value range at the end of the particular period,” asserts Pavlov.
Having a robust valuation framework plays a key role for those managers seeking to use the secondary market for portfolio rebalancing purposes.
The basis of determining what the valuation of an asset is (or group of assets), in a GP-led transaction, for example, starts by having an accurate NAV that reflects fair value. The risk is that it is overly conservative or overly optimistic.
“If your NAV is accurate and there’s sufficient demand, the expected price of an asset will be close to the NAV. If the NAV is too optimistic, the asset will be priced at a discount which may lead to LPs not supporting the deal,” says Pavlov.
He goes on to say: “The portfolio value is the most important element but not the only element, in secondary market transactions. It will also depend on deal dynamics, how the portfolio is spread out across different assets, what industries those are in, and also how good the GP is. Not to mention the size of the transaction being offered to the market; all of these factors will go into determining what price a buyer is willing to pay.
“Valuation is a way to communicate performance. If you have a robust, independent valuation process it reinforces the level of communication between the GP and LP.”
In this current period of uncertainty, that can go a long way to reinforcing the bonds of trust.
Statements and opinions expressed herein are solely those of the author and may not coincide with those of Houlihan Lokey.