Special Pricing Challenges of Lower Quality, Private and Illiquid securities.
By Jordan Barnett, CFA
Director at Murray, Devine & Co., Inc.
Over the past few years, the private debt markets have grown rapidly driven by reduced participation of traditional banks and increased demand for yield from investors. As a result, the private debt market has seen an influx of alternative finance providers and an increased need for fair value estimates.
FASB ASC Topic 820, Fair Value Measurement and Disclosure, defines fair value 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.”
While it has been an exciting time to work with asset managers in a growing market, the valuation of illiquid loans can be challenging due to a lack of transparency. When working with level 3 assets, or securities that have no observable market price info, professional judgement becomes a significant component in the valuation process.
Maintaining accuracy and consistency in the application of valuation assumptions is important when working with large loan portfolios on condensed timeframes. A robust valuation analysis requires proper research and analysis to identify the appropriate facts and reach a supportable conclusion. Adding to the complexity in these limited scope engagement are lack of direct contact with management of portfolio companies, detailed industry studies and various other procedures that might otherwise be performed in a full scope valuation.
The following commentary highlights some of the special challenges Murray Devine encounters as valuation specialists with significant exposure to lower quality, private and illiquid loans. An illiquid security is identified based on the ability to exit the position and typically includes any security which cannot be disposed of promptly in the ordinary course of business without taking a reduced price.
From a high level, our process, as it relates to the valuation of illiquid loans, can be broken into three major buckets:
- Collecting independent market data, such has active market yields, broker quotes in non-active markets and spreads on newly issued loans;
- Reviewing client information, such as investment memos, credit memos and financial statements of the subject companies; and
- Concluding on loan values based on the first two steps.
Issues with market data – Lender Survey
The largest issue in valuing private debt is a lack of transparency in the underlying market. Regular communication with lenders play an important role in the process to incorporate market participant feedback. One way to facilitate this communication is to conduct a lender survey. The goal of the survey is to talk with deal teams about what they are encountering in the current market place.
A few sample questions to consider when discussing the private debt markets include:
- Are you observing an increase or decrease in new deals?
- What is the composition of your loan pipeline?
- Have you noticed material changes in spreads or coupons?
- Have you observed any material changes in deal structures relating to OIDs, upfront fees, leverage ratios and/or covenant levels?
A consistent survey over extended periods will help identify a shift in trends. When changes occur, this identifies areas for further follow up and research.
Issues with market data – Yield Matrix
Another approach in dealing with the lack of market transparency is the compilation of a market yield matrix. This will allow for the aggregation of various data sources, improving the consistency of decision making by providing a framework for selecting market assumptions. A commonly used matrix plots the relationship between a financial metric (i.e. total leverage ratio or loan-to-value) to an appropriate market yield, a key assumption in a loan valuation.
It is important to build a matrix that is highly supportable by specific independent data sources. Example of relevant data points to consider are yields on newly issued loans segmented by facility type (i.e. 1st lien vs. 2nd lien) or market type (i.e. middle market vs. large corporate or sponsored vs. non-sponsored).
It is important to address any outliers and understand why a specific observation falls outside the matrix parameters. For middle market loans, pricing is highly deal specific. Pricing, or deal terms, can vary depending on the size of the deal and sophistication of the borrower/lender. The following is a sample yield matrix for selection of yields utilized in the valuation of private debt. (The table displayed below is for discussion purposes only and does not reflect current market data)
Issues with market data – Broker Quotes
Another common issue with market data relates to broker quotes for loans that are not actively traded. The challenge here relates to reconciling a quoted price to the price derived from a valuation model. If there is a large discrepancy between the two prices, additional questions should be raised to determine the quality and usefulness of the quoted price.
Examples of relevant questions related to broker quotes for illiquid debt include:
- How many brokers are providing a quote?
- What is the range of quoted prices?
- Are the quotes actionable?
- Does the quote incorporate all recent/relevant info?
The answers to these questions should lead an analyst towards an accept/reject decision in deciding when to rely on a broker quoted price as an indication of fair value. If the quoted price is determined unreliable, the valuation report should acknowledge the data point and ensure the reader of the report is aware why it was ultimately not used.
The quality of a broker quote can change over time for a specific loan. Sometimes we value investments that relied on broker quoted price that is no longer available or static for several quarters. In this case, it would be appropriate to change the valuation methodology to a price derived from a valuation model. This can also work in reverse where previously there were no quoted prices available but then the loan becomes active. In this example, the quoted price would take precedent over a calculated price derived from a valuation model.
As highlighted in the example below, the utilization of broker quotes can result in different firms concluding on different values for an identical security. Working with service providers, like Advantage Data, we track cross holdings for securities held at multiple funds. When alerted to the discrepancy in pricing, we discuss with our client to ensure we have all relevant information. In this example, a deeper dive into the data revealed that only one broker was quoting the loan, which was at a depressed price looking to draw a buyer into the market. Based on the information available to us, we did not consider the quoted price reflective of fair value and, therefore, we did not change our conclusion.
Issues with client info – EBITDA Adjustments
A key input in the valuation of a loan is the calculation of a borrower’s EBITDA, which is commonly used as a proxy for earnings available to service debt. In the private debt markets, deals are highly competitive and lenders compete on the ability to tailor credit documents to facilitate transactions. This often results in complex calculations of EBITDA that allow for adjustments for certain expenses used in covenant ratios to test for compliance with a credit agreement. The increasing allowance for EBITDA add-backs typically occur in a borrower friendly market.
According to a recent article published by LevFin Insights, EBITDA adjustments, as a percent of total EBITDA, increased during 2017 representing nearly 33% of reported EBITDA through May 2017, compared to 22% for the fourth quarter of 2016.
Several valuation issues come into play when a large portion of EBITDA relates to adjustments. In particular, it raises concerns around the quality of earnings and the favorable impact on financial ratios used to measure credit risk. If available, the valuation analyst should review EBITDA calculations and relevant adjustments.
Questions to ask relating to EBITDA adjustments include:
- What does the borrower’s operating income look like on a normalized basis?
- Does the borrower have sufficient liquidity to service fixed charges (i.e. principal and interest payments associated with funded debt)?
EBITDA adjustments are commonly used when the initial transaction involves the combination of two companies. In the example shown below, we were engaged to determine the value of 2nd lien term loan issued to partially fund the merger of two business process-outsourcing companies. The bank model utilized to underwrite the credit included add backs totaling ~25% of EBITDA. The adjustments related to unrealized synergies from the combined company, such as cost savings from overlapping operations expected within 2 years following the merger. When excluding the unrealized synergies the total leverage ratio increased by 1.0x, indicating greater credit risk than the initial underwriting case suggested. As part of our valuation analysis, integration risk was identified as a potential risk with the achievement of synergies tracked against budget in future analyses.
Issues with calculating values – Distressed Debt
Difficulties with the valuation process can arise when the borrower’s operations become distressed. In this instance, future cash flows of the portfolio company become highly uncertain, raising concerns about the borrower’s ability to meet scheduled debt service payments.
A distressed company can trigger a change in valuation approach. For a typical performing loan, values are usually derived from a discounted cash flows analysis incorporating a risk-adjusted market yield. In a distressed situation, it is common to utilize a liquidation approach with the value of the loan dependent on the sale of the company or liquidation of the underlying assets.
When utilizing a liquidation approach, the valuation needs to consider a waterfall of the liquidation value based on the priority of creditor claims. The analysis should also consider the willingness of equity holders to support the business. In the leveraged loan market, private equity sponsored firms are typical market participants. Sponsors rely heavily on the debt markets to finance portions of their acquisitions. In periods of distress, Sponsors could be called on to support the business through an equity cure or sponsor guarantee of the portfolio’s debt. When this happens, the value of the underlying loan can be greater the liquidation value.
Additional due diligence for distressed debt should consider feedback from the lender group leading restructuring talks, review of cash flow estimates from turnaround consultants and possible strategic alternatives. Additional documents to request at this point could include 13-weeks cash flow forecast to monitor liquidity, wind-down / divestiture plans, or internal memos detailing pre-packaged bankruptcy expectations.
As highlighted in the example below, one common issue we typically see with the application of the liquidation approach is a large range of values for the underlying debt. This is particularly true if the subject company has a highly leveraged capital structure, which can result in residual values being highly sensitive to changes in recovery expectations. It is difficult to determine the appropriate width of concluded values for distressed debt. In our experience, the range of values with regard to performing debt investments is typically 1% to 5% depending on time to maturity. For underperforming assets, the range on debt can widen to 5% to 20%. With distressed debt, or equity-like investments, the range can be much larger and dependent on the amount of leverage with a 10% range in enterprise values potentially leading to a 15% to 100% range in value for a security deep in the capital structure.
Murray Devine specializes in valuation and valuations only. Since 1989, we have provided a wide array of valuation services that include financial opinions, financial and tax reporting and entity, or asset, valuations to private equity and venture capital firms, hedge funds, private and public debt funds, banks and corporations. Murray Devine has the professional sophistication required to provide reliable analyses in every situation.
Jordan Barnett, CFA
Jordan Barnett joined Murray Devine in 2007 as an analyst, learning the fundamentals and intricacies of the valuation profession. He is a Director and an active member of the firm’s management team where his day-to-day responsibilities are centered on project execution and business development. Jordan serves as lead professional working across a broad range of clients, industries and engagement types conducting financial analysis, research, and due diligence related to the valuation of business enterprises, complex securities, intangible assets, corporate debt and a variety of other valuation needs related to tax planning and financial reporting.
Leveraging his strong credit background, Jordan is a key member of Murray Devine’s portfolio valuation practice assisting asset managers, such as BDCs and other private debt/equity funds, comply with valuation requirements under FASB ASC 820, Fair Value Measurements and Disclosures.
Prior to joining Murray Devine, Jordan worked as a Portfolio Manager with Sovereign Bank, managing a loan portfolio focused on the healthcare and education sectors. He was responsible for several aspects of the underwriting process and portfolio maintenance in connection with the financing of various capital projects related to hospitals, health systems, nursing facilities, colleges and private schools.
Jordan received a Bachelor of Arts degree in Economics from the University of Vermont in 2001 and a Master’s in Business Administration with a concentration in Finance from Villanova University in 2007. Jordan holds the right to use the Chartered Financial Analyst (CFA) designation.
This article originally appeared in the Fall 2017 edition of Voltaire Advisor’s Valuation Risk Review: Valuation of Alternative Assets | Private Debt, Equity & Real Estate