FINANCIAL SPONSORS: COVID-19 valuation considerations for fund managers

Private equity fund managers are in the midst of estimating the fair value of their investment portfolios for their Q1 reporting. Even under normal circumstances, estimating fair value following the guidance of FASB ASC 820, “Fair Value Measurement,” requires significant estimates, assumptions, and judgment. The impact of COVID-19, characterized by market volatility and uncertainty, creates further challenges in determining the fair value of portfolio company holdings. 

Fair value implies an “exit” value and is defined in ASC 820 as the price a willing seller would receive “in an orderly transaction between market participants at the measurement date.” An “orderly transaction” is not a forced sale or distressed sale. This is an important consideration as many face difficulties related to shutdowns of non-essential businesses. 

So the question is, “How do we adjust our valuation techniques to incorporate the impacts and risks of COVID-19?”

Not all businesses will be impacted the same. Consider the macro/micro effects on each of your holdings, and consider segmenting the portfolio into red, yellow, and green categories. The impact of COVID-19 on every portfolio company needs to be considered.

Document what was known and knowable at the valuation date. Because most of the impacts of COVID-19 occurred in late Q1, the impacts on YTD December 2020 likely are not known as of March 31. Therefore, there is a high likelihood that many Q1 marks will be based on Dec. 31, 2019, information, with the risk adjustments reflected in the market approach multiples. Consistency with metrics utilized will require additional diligence. 

EBITDA-C. Begin the process of assessing the impact of COVID-19 on earnings before interest, tax, depreciation, and amortization (EBITDA) to support future adjustments, such as impacts to backlog, lost customers, and contract terminations. The list will vary by company; however, determining the impacts and gathering the supporting documentation will take time.

Enterprise valuation considerations and risk ratings. Begin to assess the impact on revenue, EBITDA, working capital, covenant compliance, liquidity needs, and the entity’s ability to continue as a going concern. Update risk ratings and specific company discounts, as needed.

Be consistent in your method, but consider the potential impacts of COVID-19. If you are using an income approach, do the forecasts consider the impact of a potential recession? What is the impact on discount rates? If you are using a market approach, are recent transactions still relevant and comparable? What is the impact on how calibration is performed? 

Reconsider your definition of “recent transaction.” Investments closed within the quarter were generally marked at invested cost. This will no longer be appropriate given the post COVID-19 environment.

The current environment has made it much more difficult to determine fair value. Significant judgment will be required in determining fair value. Yet general partners (GPs) have a fiduciary responsibility to their limited partners (LPs) and others to report investments at fair value using the best available information known as of the valuation date and estimating the impact to their investments. 

Please join us April 24 for a webinar in which we will explore these issues and others related to the impact of COVID-19 on valuations.