Valuation of distressed assets: impact of the COVID-19 crisis

July 2020  |  TALKINGPOINT  |  ACCOUNTING & FINANCE

Financier Worldwide Magazine

July 2020 Issue

FW discusses the impact of the COVID-19 crisis on the valuation of distressed assets with Harris Antoniades, Justin Burchett, Jason Easterly and James Spaman at Stout.

FW: Could you provide an overview of the impact that coronavirus (COVID-19) is having on the global economy, and in turn the value of assets generally?

Antoniades: The COVID-19 pandemic is the most severe global crisis since World War II. COVID-19 restrictions have effectively changed how we interact with each other and have stopped economies around the world. The global economy has entered a recession the likes of which we have not seen since the Great Depression, and the magnitude of the downturn will depend on when economies around the world reopen, if there will be a second wave of the virus later in the autumn, and when an effective vaccine will be available to the broad population. The severity of the crisis is likely to have a long-term impact on the functioning of economies, supply chains and trade relations. As such, almost all asset values declined significantly during the first few weeks of the pandemic, mainly due to the huge economic uncertainty in the markets. As the economic impact is starting to become clearer, certain industries have somewhat rebounded while others are suffering from financial distress and are seeking bankruptcy relief. Companies with underlying fundamental problems prior to the crisis will have a difficult time overcoming the crisis, whereas companies well prepared with business continuity and crisis plans are well positioned to take advantage of the new marketplace.

Spaman: The COVID-19 pandemic and efforts to contain it, such as social distancing recommendations, which have included working from home, the cancellation of public events and educational classes, reduction of travel and the closure of nonessential businesses, have negatively impacted the global economy and financial markets. Specifically, investor concerns increased as the pandemic and social distancing measures interrupted supply chains, movement of labour and consumer demand. In March 2020, trade groups representing the airline, restaurant and other nonessential industries, seeking to offset the financial losses from social distancing practices and business closures, requested federal bailouts to avoid bankruptcy. Also, tens of millions of Americans have recently filed for unemployment. The pandemic and resulting investor concerns sent major stock markets into bear market territory. Great uncertainty remains regarding the full potential impact of the pandemic. Governments and central banks are, therefore, taking aggressive measures to implement fiscal and monetary stimulus packages to mitigate the pandemic’s impact and to aid in the recovery of the global economy and financial markets.

Burchett: COVID-19 is affecting almost all asset classes and industry sectors. In the first quarter of 2020, the S&P 500 fell 20 percent, high yield bonds fell 12 percent and the Russell 2000 fell 31 percent. In our recent webinar survey looking at alternative asset valuations during the COVID-19 crisis, respondents indicated a 10-20 percent decline for their primary alternative asset class. The health crisis stands out because its effects have been acute and pervasive. Take the credit market for example: there are no safe-haven segments. Each of the major asset categories face short-term challenges and long-term uncertainty: corporate bonds and loans, consumer loans, residential and commercial real estate, and municipal debt.

Easterly: In the US and abroad, the conversation is beginning to shift from the lockdowns we have seen to the reopening of respective economies. The global lockdown has had a dramatic impact on the global economy – the International Monetary Fund (IMF) is projecting a 3 percent contraction in 2020 – with most ‘first-world’ economies expecting to be officially in recession through the first half of the year. As such, real property asset values have been and are expected to continue to be impacted by COVID-19 and we anticipate that most asset classes will be affected, with the most severe economic impacts in the hospitality, retail, office and ongoing developments sectors.

FW: What opportunities is the current crisis presenting to investors seeking to acquire distressed assets? When evaluating targets, how important is it to arrive at an accurate valuation in order to optimise future returns?

Antoniades: The full ramifications of the COVID-19 pandemic are starting to become clearer. Several industries are already suffering from financial distress and are seeking bankruptcy relief, but significant economic dislocation will also be felt by many other industries, including manufacturing, transportation, and companies in the auto parts and equipment industries. A growing number of property investors are preparing for what they believe could be a once-in-a-generation opportunity to buy distressed real estate assets at bargain prices. Real estate funds have been created and have raised billions of dollars to buy distressed debt backed securities by commercial properties, such as malls, hotels, office buildings and others. Investment groups and private equity funds are looking at opportunities to acquire discounted loan pools or distressed assets or provide rescue capital to secure preferential investment positions with downside protection and upside participation. Buyers of distressed assets will be seeking to acquire real estate property at its new, lower price or buy debt secured by real estate from distressed lenders as they scramble to raise capital to satisfy margin calls. But there is a lot of uncertainty related to the depth, breadth and timing of possible distressed buying opportunities. Government assistance programmes may have given some of the distressed companies some breathing space, so true buying opportunities may still be far away – perhaps even up to a year or more away.

Burchett: Alternative asset managers have amassed significant ‘dry powder’ for distressed strategies, and many large platforms were able to raise funds during the COVID-19 lockdown to take advantage of market dislocations. One of the major catalysts for an asset sale relates to whether the asset holder can hold and manage non-performing assets. For example, regulated commercial banks and insurance companies are levied with high capital charges for non-investment grade securities and non-performing loans. In the capital markets, managed investment vehicles, such as liquid alternative funds, exchange-traded funds (ETFs) and collateralised loan obligations have structural provisions that can hasten the disposition of distressed assets. Buyers of distressed assets seek to profit from a rebound in the overall market prices, as well as improvements in the performance of the underlying asset. The entry price, or day one valuation, is crucial for the realised return for non-performing assets. All else equal, the distressed buyer seeks the lowest entry point. The opposite is true for the seller, which highlights an interesting dynamic. Many holders of distressed assets are loath to advertise problem investments, however they will achieve the best execution by running a transparent auction process with multiple buyers.

Spaman: The existence of distressed assets, by their nature, creates broad investing opportunities. The pandemic has magnified those investing opportunities. That is, the pandemic has added significantly to the existing pool of distressed assets, thereby creating broader investment opportunities across all markets. For example, stocks that will take a massive hit as a result of social distancing measures and restrictions on public activity, like airlines, restaurants and dating applications, may present significant investor opportunities after the worst of the effects of the pandemic occur. When evaluating potential investment targets, accuracy is always important, regardless of the presence of a pandemic. The unique challenge in achieving accurate valuations during a pandemic is the universal and inherent volatility and uncertainty across markets. Market participants would, however, take increased uncertainty into account as reflected by decreased return assumptions, delayed exit assumptions and reduced cash flow assumptions.

FW: Could you outline some of the latest techniques and metrics used to value distressed assets? How might the COVID-19 crisis inform the choice of valuation method?

Antoniades: Traditional valuation techniques may be difficult to implement or may need to be adjusted in order to apply to a distressed assets situation. For example, market value approaches that attempt to establish the value of an asset by comparing it to similar ones that have recently sold may not be reliable. In this market, there is no liquidity and recent transactions may not represent fair value, but fire sales instead. A discounted cash flow (DCF) valuation approach is still appropriate, but it may need to be augmented with scenario analyses, where several potential outcomes are used to estimate expected cash flows under various forward-looking scenarios that reflect the likelihood of distress. In addition, certain inputs and assumptions about both macroeconomic and asset-specific variables are stressed, with the intent of getting a better sense of the effect of the distress on the value of the asset. In this case, a simulation approach is used in conjunction with the use of probability distributions as inputs into a DCF valuation, which allows for the possibility that a string of negative outcomes can push the asset into distress. Unlike scenario analysis, where a finite number of well-defined discrete scenarios are used, simulations allow for more flexibility in how we deal with uncertainty and provide a way for examining the consequences of continuous risk. In each simulation, an outcome is drawn from each distribution to generate a unique value. Across a large number of simulations, a distribution of values is derived that reflects the underlying uncertainty in estimating the inputs to the valuation.

Spaman: A valuation principle that has resurfaced as a result of the pandemic is that fair value does not equal a fire sale price. Fair value still represents the amount to be received in an orderly transaction using market participant assumptions in current market conditions and is based on what is known and knowable at the valuation date. However, now it may not be appropriate to give significant weight to recent transaction prices in determining fair value unless all details are known and inputs can be properly adjusted. Current market values also deserve closer scrutiny given the sudden impacts of the pandemic on financial results and the comparability of impacts across business. Also, in valuing distressed assets during the pandemic, valuation inputs, such as projections and discount rates, must not account for incremental risk factors more than once.

Burchett: Taking non-performing residential mortgage loan pools (NPLs), which were a significant distressed asset class from the global financial crisis, as an example, a discounted cash flow model, which is an application of the income approach to value, is a primary technique used for NPLs. The most significant element of the model is forecasting the future cash flows at a loan level. Loan level cash flow assumptions are driven by multiple factors, such as borrower-specific variables and collateral value. These cash flows include expectations for future scheduled interest and principal payments, as well as assumed proceeds from a foreclosure or short-sale resolution. Aggregated to a portfolio level, these payments are an expression of both the magnitude and timing of the portfolio cash flows. Given the uncertainty inherent in NPL performance, practitioners frequently generate multiple scenario analysis or simulation trials to capture a range of cash flow outcomes. The last step in the income approach is to discount the forecasted NPL cash flows to a present value at an appropriate interest rate. The discount rate should capture the risk of the projected cash flows and the return expectations for market participants. For NPLs, we believe that estimation of the loan cash flows is the most important input for valuation at the initiation of the investment, and for subsequent measurement periods. Finally, due to the lack of direct comparable NPL pools and the paucity of observed transactions, we most often see the market approach used to corroborate the inputs or outputs derived from the income approach to valuation.

FW: To what extent has the scale and scope of COVID-19 made the valuation process more difficult, given the lack of comparable historical benchmarks or market parameters?

Burchett: The COVID-19 crisis has created certain unique challenges for the valuation of credit instruments held by banks and other alternative asset managers. Early in the crisis, one problem related to the availability of information regarding investment performance. Due to lags in performance reporting, in many cases companies had to complete March month-end valuations without having the benefit of the impact of the crisis on borrower payment status. One of the most significant issues for pools of financial instruments in the second phase is interpreting the performance information. Traditionally, it has been possible to predict the likelihood of default for loans that are past due or in non-payment status. In the current crisis, a crucial variable is determining whether non-payment, deferral or forbearance is a temporary COVID-19 only liquidity event or is indicative of a future default. Another difficulty caused by the current market is the disruption in the ‘primary’ market for financial instruments. In the commercial and consumer loan markets, new origination activity for more credit-sensitive products has been shut down due to the crisis. Similarly, new issue securitisations of asset-backed securities have frozen abruptly. Without these market benchmarks, valuation models for loan portfolios must rely on secondary market information in a market with spare trading activity and volumes compared to the public equity market.

Spaman: Strong valuation processes should continue to be followed and consistently applied. That said, the pandemic presents challenges that make the process somewhat more difficult. For instance, lowering the discount rate, which central banks have done, does not necessarily translate into reduced risk. Indeed, credit spreads may be widening. Also, last 12-month (LTM) earnings before interest, taxes, depreciation and amortisation (EBITDA) or other metrics in arrears need to be updated in real time. Furthermore, future cash flow projections need to be updated to consider short-, medium- and long-term expected impacts. The impact of a potential recession must also be considered. The valuation process may also be complicated by other factors, including enterprise value considerations, revenue, impact on customer demand, customer financial health, supply chain problems, pricing, timing and availability of goods, supplier financial health, employee availability, employee productivity and the ability to work remotely while maintaining appropriate cyber security.

FW: How, in your opinion, has the COVID-19 crisis impacted the value of real estate assets? Given that many portfolios have underlying real estate assets, what effect will this have on overall portfolio valuations?

Burchett: Real estate assets serve as the collateral for commercial and residential mortgage loans. The value of the underlying collateral is a primary driver for the valuation of performing loans, affecting the probability of default and the assumed loss given default. As the loan transitions from performing to non-performing to foreclosure or liquidation, the underlying collateral value becomes the most significant input in the valuation of these distressed assets. The COVID-19 crisis is expected to lead to a material decline in real estate prices. Investors are working to understand how the crisis will impact the sub-sectors of the market across diverse geographies. Take the commercial real estate market, for example, where we expect a range of outcomes for these loan types based on the timing and nature of the economic recovery: resort area hotels, office properties, multi-family apartments, mall and retail shopping centres and industrial warehouse facilities.

Easterly: COVID-19 has had an immediate, and in some asset classes a long term, effect on real estate values. We feel strongly that the bulk of the impact centres around cash flow risk due to rent relief requests, concessions and simply the inability to collect rent. The retail sector has been substantially impacted by these factors, whereas the hospitality industry has dramatically lower occupancies to contend with. Market data indicates overall occupancy rates across this sector fell sharply in March to unprecedented levels and many sources are anticipating recovery to be a two to four year process. Early in the pandemic we believed that most investors felt as though capitalisation rates remained consistent with pre-COVID-19 levels, with little to no disruption to capital market inputs in the underwriting process. However, as the crisis has continued, we have seen rates begin to rise, due, in large part, to the uncertainty of tenants returning and bankruptcies and closures across many industries.

Antoniades: Unlike the 2008 economic downturn, the commercial real estate (CRE) industry was in a strong position before the onset of COVID-19. Balance sheets, capital availability and liquidity were healthy. Companies could manage their debt maturities to longer positions and capital availability was expected to increase further. The CRE industry was affected immediately when trade activities and occupiers’ businesses were shut down overnight. Some property owners face short-term liquidity issues due to delays in rent collection or in the case of shopping centres and hotels, a decrease in revenue for the foreseeable future. As more companies realise that working remotely can be as, if not more, effective as working from the office, demand for office space in big cities may get softer in the next few years as long-term leases expire and occupants choose to rent less space. Portfolios with these types of real estate assets have already seen significant write-downs to their values and the expectation is that this trend will continue.

FW: Could you highlight any particular challenges involved in acquiring distressed real estate assets? How does the acquisition of such assets in the current climate compare to previous economic downturns, such as the 2008 financial crisis?

Antoniades: There is currently a lot of uncertainty related to the optimal timing of distressed buying opportunities. The true buying opportunities may not occur for another 12 to 18 months as more assets may require restructuring and capital infusions after the forbearance periods start to roll off later in the year. In addition, the unique nature of the pandemic creates added challenges in being able to conduct due diligence on assets or travel to sites to view properties. On top of that, there is no price discovery since there is not much liquidity and nothing is really transacting. In the last recession, troubled CRE asset prices dropped by 35 percent nationally, which wiped any equity accumulated and prompted many borrowers to default on their loans. This down cycle would probably be different than the last recession, partly because borrowers are holding loans with lower leverage. In addition, there is a lot of capital on the sidelines waiting to be deployed, which could help keep prices from dropping significantly and may also shorten the cycle. We just need to wait and see how steeply property values may be discounted and how much opportunistic capital will be deployed.

Burchett: An important consideration for distressed real estate related assets is understanding the structural aspects of the proposed transaction. For instance, the process for acquiring distressed real estate will vary based on how the asset is held by the seller. Banks are traditional sellers of NPLs and real estate owned (REO) and will have typically serviced the asset internally. Alternatively, securities such as residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) can be sellers of real estate assets but the sale may require approval from multiple investors or necessitate the transfer of servicing. The structural terms of distressed real estate transactions will also play an important role in future performance. Previous economic downturns used financial engineering and government assistance to facilitate the trading in distressed assets. The Resolution Trust Corporation used securitisation as a tool, while the Federal Deposit Insurance Corporation (FDIC)-backed loan sales drove commercial bank transfers in the aftermath of the 2008 financial crisis. Similar mechanisms are available today, including seller financing, credit risk transfer and government provided leverage in the form of Term Asset-Backed Securities Loan Facility (TALF) financing. Therefore, buyers of distressed assets must account for underlying asset performance, the operational aspects of loan transfer and servicing, and the structural overlay of the investment.

FW: How important is it for a valuer to maintain transparency and accountability throughout the process?

Burchett: In a pre-COVID-19 speech, Securities and Exchange Commission (SEC) chairman Jay Clayton highlighted the important role that public market prices serve for the proper functioning of the financial markets: transparent, information rich and fair prices serve as positive externalities that benefit market participants and investors. The same can be said for valuation estimates for non-traded and illiquid financial instruments. In the current market, there is a high level of uncertainty surrounding the performance of financial instruments. Companies and fund managers that are not transparent about asset holdings or the process used to value those assets are adding another layer of uncertainty and are expected to be disfavoured by investors. The 2008 financial crisis brought a variety of disputes and litigation related to the valuation of complex and illiquid investments. Management and independent valuation firms should be cognisant of the potential legal risks involved in reporting valuation estimates for assets that require significant judgement. The good news is that the prior crisis led to the development of resources that provide guidance on how to perform valuations, how much documentation to provide, and the relationship between management and third-party specialists.

Spaman: Transparent and accountable valuation processes should continue to be followed and consistently applied. The SEC has recently reiterated that its mission — to maintain market integrity, facilitate capital formation and protect investors — takes on increased importance in times of economic uncertainty and applies equally to the valuation process. It goes on to say that disclosure of information necessary to make informed investment decisions is fundamental to valuation during times of economic uncertainty. Companies should generally aim to provide as much information as possible about their current and future financial and operating status and planning to valuers. To that end, the SEC encourages disclosures in the following areas: where the company stands today, operationally and financially, how the company’s pandemic response is progressing, and how its operations and financial condition may change as efforts to fight COVID-19 progress. Providing a transparent message will not only benefit investors and companies, but also enhance communication and coordination across the economy.

FW: Looking ahead, do you expect to see greater demand for distressed asset valuations in connection with acquisitions and investments or for reporting purposes? Is COVID-19’s legacy set to make the process more complex for the foreseeable future?

Burchett: We are experiencing an increase in demand for financial reporting valuations, valuation diligence and dispute-related services. The increase in the proportion of distressed or illiquid investments alone tends to drive the need for independent valuation services. Institutional investors and investment consultants recommend external valuations for fair value accounting if illiquid investments comprise 5 percent of portfolio assets. The request to engage outside specialists can be triggered by discussions with auditors, independent directors, institutional investors or internal or external counsel. We also expect to see valuations incorporated into the acquisition process. First, buyers and sellers should obtain an independent valuation as part of a diligence exercise. For the buyer, this works to enhance the investment analysis and information-gathering process and provide an external check on pricing assumptions. For the seller, the pre-transaction valuations help to set expectations for the expected proceeds for an asset disposition, as well as the strategic alternatives. Transactions for illiquid assets may also require a fairness opinion that the board of directors can rely on to demonstrate that the transaction price is fair to the financial stakeholders. Finally, valuation disputes concerning distressed assets will likely increase and require the services of independent experts. These disputes tend to arise years after the litigated transaction and serve as a warning that transactions and value determination made in the heat of the crisis are subject to ex-post scrutiny by litigious parties with the benefit of hindsight.

Easterly: We are certainly anticipating increased demand for clear, concise and transparent valuations due to challenges in the commercial real estate market as a result of the impact of COVID-19. Investors, auditors and regulators require independent analysis and scrutiny of these assets in order to produce reliable and quantifiable conclusions. Given the extreme uncertainty, valuation professionals are needed more than ever. In this case, the profession needs to exact as much diligence and preciseness as possible in order to develop reliable conclusions. In a market where dynamics can change overnight, the pressure is mounting to stay in tune with these ever-changing conditions and to do so daily.

Spaman: Greater demand for distressed asset valuations is likely because more assets will be distressed. The valuation process is also likely to become more complex because of the increased uncertainty and increased risk throughout the economy. Capturing the risks in higher return expectations or lower projected cash flows will prove challenging for those involved in the valuation process.

Antoniades: We expect an increase in distressed assets in the marketplace throughout this year and next. This increase in distressed assets, along with the fact that those assets are, in general, hard to value and less liquid, will drive a greater demand for financial reporting valuations. In addition, we also expect an increase in distressed asset valuations in connection with valuation due diligence services. Due diligence valuation could be either buy-side, for providing an added assurance with regard to the asset being acquired, or sell-side, for better positioning those assets for an auction process. We also expect an increase in valuation disputes for distressed assets. This probably will occur, years after the disputed transactions occur, if the investments either do not perform as expected, or if the assets manage to recover their value after the sale at steep discounts.

Harris Antoniades is a managing director and leads the complex securities and financial instruments practice with more than 20 years of experience in complex securities and derivatives valuations, advance financial analytics and risk management issues. His valuation experience encompasses a broad range of asset classes, including all types of derivatives, structured products, fixed income securities and share based awards for financial and tax reporting purposes. He has also provided valuation advisory services to public and private companies, boards of directors and other fiduciaries in connection with strategic planning, M&A investment decisions, bankruptcy and reorganisation. He can be contacted on +1 (310) 601 2565 or by email: hantoniades@stout.com.

Justin Burchett is a managing director in the complex securities and financial instruments practice. His focus is on expanding Stout’s financial services industry capabilities by delivering valuation opinions and related advisory services to a variety of client types. These include corporations, hedge funds, private equity funds, asset managers, banks, insurance companies, real estate investment trusts, specialty finance companies and government agencies. He has more than 15 years specialising in the valuation of financial services firms and complex financial products. His areas of expertise include complex financial instruments, including derivatives, structured products, corporate and consumer debt instruments, and bank loan portfolios. He can be contacted on +1 (646) 807 4240 or by email: jburchett@stout.com.

Jason Easterly is a managing director in the valuation advisory group. He has more than 15 years of real property valuation and consulting experience, with a concentration on valuations for financial reporting and financing purposes. He has provided numerous types of valuation and advisory services for multiple property types. He has consulted globally on many engagements requiring valuations for financial reporting in connection with ASC 805, ASC 820, ASC 350 and ASC 840 related to purchase price allocations, fair value measurements, positive assurance, goodwill impairment testing, fresh start accounting and lease accounting. He can be contacted on +1 (713) 221 5148 or by email: jeasterly@stout.com.

Jamie Spaman is a managing director in the valuation advisory group. He has over 15 years of experience providing valuation services and financial opinions to private equity, corporate, venture capital and commercial banking institutions. He has experience providing fair value services to business development companies, hedge funds and other portfolio managers of illiquid debt and equity investments. He has also provided services including: solvency, capital adequacy and fairness opinions; purchase price allocations; impairment analyses; and equity security valuations. He has provided valuation services to a broad client base, including middle-market businesses, multi-billion-dollar enterprises, private equity funds and hedge funds. He can be contacted on +1 (267) 457 4590 or by email: jspaman@stout.com.

© Financier Worldwide

THE PANELLISTS

Harris Antoniades

Justin Burchett

Jason Easterly

James Spaman

Stout