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Valuing in a Down Market – Implications from the New AICPA PE/VC Guide Amanda Miller, EY Shaan Elbaum, PwC Overview: the AICPA PE/VC guide

The final version of the new AICPA PE/VC Valuation Guide was released on 15 August 2019.

Goals of the guide: • Harmonize the diverse views of industry participants, auditors and valuation specialists • Provide user friendly guidance with case studies that can be used to reason through real situations faced by investment fund managers, valuation specialists and auditors

Final version released August 2019: • Non-authoritative (like all other AICPA guides issued) • Reflects consensus, including input from industry • Comments from review period on working draft were helpful and resulted in minor changes. • Funds should expect to consider the impact of the guide for 2019 valuations.

Scope of guide • Applies to companies covered by FASB ASC 946 – Investment Companies, reporting fair value in accordance with FASB ASC 820 – Fair Value Measurement • Valuation guidance may apply to investments valued under IFRS and for corporate investors as well • Assets covered: portfolio company investments, defined as and debt instruments in privately held enterprises and certain enterprises with traded instruments • Does not address disclosures Debt valuation – When debt is the unit of account

• Fair value of debt instruments • If you have a traded price as of the measurement date this may be the best estimate of fair value, assuming the transaction is determined to be orderly. • When a traded price as of the measurement date is not available or is deemed to not be determinative of fair value, the typical valuation technique is the yield method. Debt valuation – Value of debt for the purposes of valuing equity

The value of debt reflects the cost that market participants Estimate the transacting in the equity would and then subtract the value of assign to this liability given the debt. expected and principal payments over the expected time horizon for the debt.

Funds may use the , The choice for whether the face value, book value, or payoff payoff amount or fair value amount as a proxy for measuring amount is used should be the value of debt for the consistent with market purpose of valuing equity when participant assumptions, it is consistent with market inclusive of the time horizon of participant assumptions. the investment. Debt Market Highlights: Current Trends & Market Dynamics Debt product highlights by type

Debt type Product type Market observations

Non-structured Corporate Debt • Leveraged loan volume down 39%, high yield volume up 28% • Downward rating migration trend, high compression

Commercial Real Estate • Rising Commercial real estate prices - industrial up 10.4% and retail up 2.5% TTM from April 30, 2019 (‘CRE’) • Debt service obligations ease with decreasing interest rates

Sovereign Debt / • Trade war concerns and geo-political uncertainty are among key issues for investors Municipal Bonds • Strong demand for Municipal Bonds through the first half of 2019 • Tightest spread levels in over a decade: 10 yr A-rated & BBB-rated tax-exempt bonds reached 36 and 70 bps, respectively

Structured CLOs • Continued issuance mitigating loan fund outflows. CLOs represent 68% of Institutional Investor base - 1st Half 2019 • Credit deterioration of B rated corporate loan issuers

CMBS • Limited supply on new issue private label CMBS • Lower interest rates reducing borrower debt-service obligations

RMBS • New issuance increasing, driven by non-qualified mortgage deals and declining interest rates. • 1st half of 2019 - deals backed by alternative forms of documentation represent 51% of new issuance.

ABS • Esoteric ABS driving volume, with whole business securitization growing by about $10 billion over the last two years. • Worldwide ABS issuance down ~ 7.2 % YTD • Asset backed bond values rise amid anticipated rate cut Market performance

Source: S&P Capital IQ YTD data as of August 9th

Source: LCD, an offering of S&P Global Market Intelligence YTD data as of August 9th Market trends - Corporate debt

Average New Issue Yield-to- • Corporate Debt Yields among B/BB rated notes have trended upward over the last 2 years, but are down slightly from December 2018. • Most recent issuances of B/BB rated notes have been issued at a discount, which makes this rating category more attractive to investors. • Key takeaway: While fed funds rate is down a quarter basis point it’s unknown how yields will react going forward. Yields have remained relatively flat. Duration extensions are a component of steady yields. Source: LCD Market trends- Corporate debt credit metrics

Key Takeaway: • Debt multiples continue to trend up pushing leverage higher on institutional loans. • 2008 - today 44% increase in average debt multiples over the last 10 years.

Source: S&P LCD Covenant lite - Increased amount of institutional loans are Cov-Lite Covenants are less common – Cov-Lite terms include: • Maintenance covenants - Interest coverage - Cash flow coverage - Debt/EBITDA • Securities are senior in • Secured by the company’s collateral Markets continue to issue cov-lite • Seen as less risky • Investor confidence • Trend of issuance to larger companies

Key Takeaway: • Cov-lite, may not be indicative of an issue... Market summary

1. Volume of issuance continues to increase while volume of is decreasing, which is increasing leverage for senior securities 2. Structured debt products continue to attract investors and volumes remain high 3. Spreads/Yields on Corporate Debt have remained relatively flat, as durations lengthen 4. Fewer covenants on larger issuances have become market norm

Key Takeaway: Market bubble or healthy economy? Leading Practices: Debt Valuation The fair value of debt depends on cash flows and the market’s required rate of return

• ASC 820 considers a hypothetical sale of the securities, not the immediate sale of the underlying assets. • Debt investors typically cannot put the investment back to the issuer – instead, they receive contractual rights to cash flows (interest/principal). • Exit market is the assumed sale of the to another investor. • The valuation methodology should consider the effective maturity of the debt, given the contractual maturity and any change of control or prepayment options, as well as other debt features and covenants. • Issuers typically seek investment only when they cannot obtain less expensive bank debt; thus, it may be challenging to find good comparables for valuation. • Calibrate to the debt value at issuance, then analyze the change in market yields since inception: • Change in the credit risk for the subject company • Change in the market spreads that investors demand for that level of risk • Change in the risk-free (for fixed rate securities) Myths vs. realities

“We have a buy and hold strategy, so current measurement is irrelevant.” • Intent is not required – ASC 820 requires an exit price based on a hypothetical transaction at the measurement date. “We take a long term-view – current prices/yields are irrational, so fair value should be based on a longer- term perspective.” • It is not appropriate to discard observable market prices. “Fair value should be based on evidence of a full return of principal; if there is no impairment of the principal, then fair value is equal to par.” • ASC 820 states that market participants must consider current market rates of return and look to current primary/secondary market evidence. “There is no current exit market.” • ASC 820’s intent is a hypothetical sale at a particular measurement date and there should exist primary/secondary market evidence. More myths vs. realities

“Our warrants aren’t worth anything, since the current price is less than the strike price.” • The degree to which the is out-of-the-money is part of the valuation model; there will still be some probability of a payoff at expiration. “There haven’t been any recent transactions, so we should hold the value at cost.” • The current fair value of the investment can change even when there are no transactions; investors should consider how things have changed. • Also, marking up an investment to the latest round is not appropriate when the preferences are different between the different rounds. “We don’t believe the model prices, so we applied a discount to be conservative.” • The goal of ASC 820 is to identify an exit price, not a conservative price. • Selected discount rates should consider risk and time to liquidity. Models should consider the specific characteristics of the debt instrument

• Several debt characteristics should be considered in estimating the fair value of debt securities: • Change in all-in yields after subtracting original issue discount • Prepayment, redemption rights, and conversion rights • Maturity (expected maturity, including prepayments and optional deferrals) • Leverage/collateral (one factor in assessing the risk of the investment) • Covenants (another factor in assessing risk – for example, EBITDA coverage requirements can force early payments or increase interest rates if the company’s performance deteriorates) • These characteristics can have a significant influence on value. • Consider the quality of the companies the fund is lending to today vs. the quality of the fund’s existing portfolio companies, given the changes in the markets and the performance of the portfolio company since inception. • For example, debt that was issued in some environments (such as 2007 or 2016) may have weak covenants, and would demand a higher yield in today’s market than debt with stronger covenants. • If the subject company can prepay the debt, the value should be capped at the payoff, even if market yields decline or the company’s credit rating has improved. Common corporate debt valuation approaches and considerations

• Credit profile considerations: - Form of rating: Private (credit estimate), public, internal rating/mapping - Rating agency downgrade implications - Outlook/credit watch - Split rating and timing of rating change - Synthetic credit rating analysis • Market approach • Income approach • Market & Investment considerations - Obligor “current state”/“future state”- balancing debt service & growth expectations - Yield Approaches - Performing vs Distressed- Selecting valuation approach and Yields - Yield adjustment considerations (industry, market, issuance size) Leading Practices: Value of Debt for the Purpose of Valuing Equity is frequently measured as the enterprise value less the value of debt

• Two perspectives on enterprise value: • Cash flows under current ownership, discounted at the investors’ required rate of return, over the expected time horizon of the investment • Value that could be realized in a sale of the enterprise on the measurement date If the investor are aligned, unless selling today would erode value, these two perspectives result in the same value of the investor interests.

• Many perspectives on debt value: • Par value (principal amount owed) • Payoff value (e.g. 102% of par, if there is a 2% pre-payment penalty) • Book value (e.g. 97% of par, accreting toward par, if there was a 3% OID) • Fair value (the price at which the debt would transact between market participants transacting in the debt)

• The value of debt for the purpose of valuing equity may be different from all of these measures EXAMPLE – Fund buys $500m company, for $200m in equity with $300m third-party debt

• If debt has a 10% prepayment penalty during the first year, an assumed transaction on the measurement date would result in a day 1 loss:

Sell enterprise on measurement date Transfer interest to realize value over time horizon Enterprise value $500m Enterprise value $500m Debt payoff $330m Debt value $300m Equity value $170m Equity value $200m

• Assuming a sale of the enterprise on the measurement date is inconsistent with market participant assumptions and leads to a counterintuitive result SOLUTION – consider the market participant expectations for time horizon

• In many cases, an actual sale of the company on the measurement date would trigger a change of control, which could reduce value; for example: • Debt pre-payment penalties, or fair value below the payoff amount • NOLs • Including these negative ramifications effectively results in placing 100% probability on the occurrence of a contingent event (that is, the change in control) on the measurement date • The actual probability that market participants would place on this event would be much lower. • Consider the actual probabilities and time horizon in the analysis, rather than assuming a forced sale. This approach is analogous to the treatment of restrictions under ASC 820

• Fair value for an asset with a restriction equals the price that would be received in a transaction for the unrestricted asset, adjusted for the effects of the restriction • Value of unrestricted asset = price realized if could sell the position without the change of control impacts • Effects of the restriction = assume that market participant assuming the position would then be subject to the same restrictions; evaluate any incremental rate of return that market participants would demand due to the illiquidity of the investment • Calibrated IRR at the initial investment date already includes the impacts of the restrictions at day 1 • Later, may adjust if needed to reflect the price that could be realized upon transfer of the asset to another fund • What would a market participant pay to “step into your shoes”? EXAMPLE – Two years later, company value falls to $350m; debt payoff 103%, trading at 80%

• Could repurchase debt at 80% of par = $240m, but likely couldn’t purchase all of it without moving the market • Could payoff debt without negotiating at $309m • Equity value is thus somewhere between $41m and $110m

Sell enterprise on measurement date Consider full benefit from below-market debt Enterprise value $350m Enterprise value $350m Debt payoff $309m Debt fair value $240m Equity value $41m Equity value $110m EXAMPLE – Two years later, company value falls to $350m; debt payoff 103%, trading at 80% (cont’d) • Conceptually, need to measure cash flows to equity and market participant required rate of return for those cash flows • Equity holder benefits from below market on the debt, so want to capture that value – don’t assume have to payoff • Equity holder also has to hold the investment to realize that value => market participants wouldn’t pay full value for benefit Consider full benefit from below-market debt, but adjust for illiquidity Sell enterprise on measurement date, but negotiate debt Enterprise value $350m Debt fair value $240m Enterprise value $350m Marketable equity $110m Negotiated debt $270m Discount for illiquidity ($30m) Equity value $80m Equity value $80m What if the controlling equity investor also holds debt?

• If the reporting entity has control of the debt issuer (the subject company), the assumed transaction considers the reporting entity’s combined holdings in the subject company • Consider market participant assumptions regarding the timing of exit • Fiduciary duty to other equity holders (if any) • Can perform the valuation in aggregate, then allocate to estimate the fair value of the debt and equity on a reasonable and consistent basis • As shown in the example, the whole may be greater than the sum of the parts – if the equity holders also have the debt, no need to negotiate or consider illiquidity • In February 2013, AICPA released a technical practice aid (TPA) addressing this issue • TIS Section 6910.34 “Application of the Notion of Value Maximization for Measuring Fair Value of Debt and Controlling Equity Positions” Valuation Methodologies Steps to valuing debt securities

• Identify the features • Estimate the cash flows-either expected or contractual • Select the discount rate • Present value the cash flows Primary debt features to consider

• Maturity • Coupon rate • Prepayment options/penalties • Conversion rights • Put/Call rights • Currency denomination Estimating the cash flows

• Contractual cash flows • Primarily used in debt valuation • Expected cash flows • Takes into consideration probability of default and loss given default Annual average default rate

18.00%

16.00%

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%

All Corporate Speculative-Grade

Source: MOODY’S Average corporate debt recovery rates

Issuer-weighted Volume-weighted recoveries recoveries Priority Position 1983-2018 1983-2018 1st Lien Bank Loan 67.19% 64.07% 2nd Lien Bank Loan 32.27% 28.68% Sr. Unsecured Bank Loan 45.75% 40.29% 1st Lien Bond 53.99% 55.23% 2nd Lien Bond 44.07% 43.74% Sr. Unsecured Bond 38.15% 33.87% Sr. Subordinated Bond 31.08% 26.33% Subordinated Bond 31.98% 27.52% Jr. Subordinated Bond 23.67% 26.78%

Source: MOODY’S General risks to consider in valuing debt

• Interest rate risk • Credit/Default risk • Liquidity risk • Currency risk

• Capacity • Collateral • Covenants • Character Common credit ratios used

• Profitability ratios • Debt/coverage ratios • Capitalization ratios Credit scoring models

• Moody’s RiskCalc • S&P Credit Analytics • Internally developed models Credit scoring, cont’d

Selected Financial Data

Total assets Total debt Revenues EBIT Net income Company 1 1,788 820 1,724 71 (144) Company 2 4,925 854 5,455 411 283 Company 3 1,976 1,071 1,458 271 129 Company 4 861 239 1,035 85 36 Company 5 1,340 412 866 32 (178) Company 6 3,935 645 3,756 418 235 Company 7 1,467 622 1,041 137 95

AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- Company 1 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.1% 0.3% 1.0% 1.2% 3.0% 7.5% 13.2% 19.6% 31.4% 15.6% 6.7% 0.3% 0.1% Company 2 0.0% 0.1% 0.1% 0.3% 0.7% 1.5% 2.0% 7.0% 19.1% 15.0% 19.3% 17.6% 9.2% 4.5% 2.7% 0.7% 0.2% 0.0% 0.0% Company 3 0.0% 0.0% 0.0% 0.0% 0.1% 0.2% 0.2% 0.9% 3.4% 4.0% 8.8% 17.8% 21.1% 19.0% 17.0% 5.4% 2.0% 0.1% 0.0% Company 4 0.0% 0.0% 0.0% 0.0% 0.1% 0.1% 0.2% 0.6% 2.2% 2.7% 6.2% 13.9% 19.4% 21.0% 22.4% 8.1% 3.0% 0.1% 0.0% Company 5 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.2% 0.7% 0.8% 2.1% 5.5% 10.4% 17.1% 33.2% 19.9% 9.5% 0.4% 0.1% Company 6 0.0% 0.1% 0.1% 0.2% 0.6% 1.2% 1.6% 6.0% 17.0% 14.2% 19.6% 19.1% 10.6% 5.3% 3.2% 0.8% 0.3% 0.0% 0.0% Company 7 0.0% 0.0% 0.0% 0.0% 0.1% 0.2% 0.2% 0.9% 3.3% 3.8% 8.6% 17.4% 21.0% 19.2% 17.4% 5.6% 2.0% 0.1% 0.0% Distribution of credit ratings Credit curves

6%

5%

4% Yield (%) Yield

3%

2% 0 5 10 15 20 25 30 Term (years) 2018 Annual default rate by industry

Aerospace & Defense 0.00% Media: Advertising, Printing & Publishing 7.05% Automotive 0.85% Media: Broadcasting & Subscription 0.96% Banking 0.00% Media: Diversified & Production 0.00% Beverage, Food, & Tobacco 1.13% Metals & Mining 1.87% Capital Equipment 0.00% Retail 7.27% Chemicals, Plastics, & Rubber 0.00% Services: Business 1.86% Construction & Building 3.53% Services: Consumer 0.00% Consumer Goods: Durable 5.88% Sovereign & Public Finance 0.00% Consumer Goods: Non-durable 1.43% Telecommunications 1.04% Containers, Packaging, & Glass 0.00% Transportation: Cargo 1.92% Energy: Electricity 6.88% Transportation: Consumer 0.00% Energy: Oil & Gas 3.12% Utilities: Electric 0.24% Environmental Industries 0.00% Utilities: Oil & Gas 0.00% Finance 1.32% Utilities: Water 0.00% Insurance 0.00% Wholesale 3.18% Real Estate Finance 0.00% Forest Products & Paper 2.70% Healthcare & Pharmaceuticals 1.24% High Tech Industries 0.39% Source: MOODY’S Hotel, Gaming, & Leisure 0.00% Thank you!