What are the challenges in valuing illiquid investments at a time of deep economic, social and political uncertainty, like the period we’re living through now?
That was my main line of discussion in my recent interview with Ross Hostetter, managing director at Duff & Phelps, North American Portfolio Valuation practice leader focused on alternatives.
Hostetter works primarily with private equity funds, hedge funds and business development companies. He has extensive experience in valuing illiquid securities and establishing best in class valuation policies and procedures. He has valued illiquid securities across capital structures, industries and geographies and has performed business valuations and intangible asset valuations for a diverse range of companies.
Prior to Duff & Phelps, Hostetter served as a director at Standard & Poor’s Corporate Value Consulting, which merged with Duff & Phelps in 2005. Before that, he was a tax manager at PwC in London in the firm’s Banking and Capital Markets group, focused on advising financial services clients on UK corporate tax and international tax issues.
Vailakis: Thank you Ross for sharing your insights with us at this time of change.
You work at the largest independent valuation firm in the world; what are your opening thoughts around valuations in the time of COVID-19? How are you conducting valuations of illiquid investments in the current environment?
Hostetter: Thank you for having me, Nancy.
These have certainly been challenging times on so many fronts, and our thoughts are foremost with the people and communities that have been and continue to be impacted by the pandemic and by current events.
As it relates to the impact on our work in the alternatives space, some things have changed and some things remain the same.
The most obvious change has been the move to a fully remote working environment. On a positive note, that transition has not disrupted our ability to communicate with our colleagues and clients and ultimately to execute on our assignments in a timely manner.
Perhaps the less obvious constant is our approach to valuation. While markets have been incredibly volatile and there is significant uncertainty, the fundamental approaches to valuation and core principles remain the same.
Vailakis: Please contrast the Q1 and Q2 2020 private company valuation environment. Please speak to valuation methods.
Hostetter: Having experienced first-hand the challenges of valuing illiquid securities in the aftermath of the 2008/2009 market dislocation, I can say that the first quarter of 2020 was the most challenging period I have experienced from a valuation perspective.
When valuing an investment, we typically consider the market for a particular asset in terms of trading multiples or required yields, for example. We also consider the underlying performance and outlook for the investment. In Q1, market indications were moving in dramatic fashion from day to day, and it was so early in the pandemic, it was very difficult to understand or assess the current and expected impact of COVID-19 on a particular investment. With that much volatility in the markets and that much uncertainty around the outlook for specific investments, it was very challenging to pin down valuations as of a point in time.
As we approach the end of Q2, markets have rebounded broadly, and have stabilized relative to Q1. With each passing day, managers have had time to refine their assessments of the COVID-19 implications for their portfolios and their individual investments. While significant uncertainty remains, the visibility around near-term performance is certainly better now than it was in Q1 when the pandemic was first unfolding. While I expect Q2 to remain a challenging period for valuing illiquid investments, the circumstances have improved relative to Q1.
In terms of valuation approaches, there is not one set of approaches for bull markets and another set for bear markets. The fundamental approaches – Market, Income, Cost — are applicable across market conditions. Obviously, the inputs and assumptions are required to reflect conditions as of the valuation date, and gathering and interpreting market data in periods of dislocation and volatility requires careful consideration. However, the core valuation approaches are still applicable.
Vailakis: How are firms successfully approaching impairment testing and contingency plans?
Hostetter: Certainly companies that were close to an impairment going into Q1 will be testing for impairment against the backdrop of the market selloff. Among the challenges will be forecasting cash flows to be used in impairment tests when so much uncertainty remains about the pace and magnitude of an economic recovery and how that factors into the subject company’s outlook.
Vailakis: Please speak to the created value attribution (CVA) model that PJ Viscio and George Pushner of Duff & Phelps developed, which takes the emphasis away from a basic EBITDA analysis, for example, and focuses more on specific components leading to value creation.
Hostetter: CVA was developed as a tool for both managers and investors to analyze how value is created in an investment. Sometimes value is created from fortunate timing and favorable markets, or it may be from effective management leading to improved margins. The CVA framework seeks to break out and analyze the key drivers of value creation (or degradation) including market, industry and company specific factors to provide the transparency needed to better evaluate performance across investments and managers.
This approach could be useful to GPs and LPs alike, during a time like this when everyone could benefit from a broader understanding around value and alpha generation.