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

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Valuing Debt in a Down Market – Implications from the New AICPA PE/VC Guide Amanda Miller, EY Shaan Elbaum, Pwc Overview: the AICPA PE/VC Valuation Guide Valuing Debt in a Down Market – Implications from the New AICPA PE/VC Guide Amanda Miller, EY Shaan Elbaum, PwC Overview: the AICPA PE/VC valuation 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 equity 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 enterprise value transacting in the equity would and then subtract the value of assign to this liability given the debt. expected interest and principal payments over the expected time horizon for the debt. Funds may use the par value, 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 bond volume up 28% • Downward rating migration trend, high yield spread 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-Maturity • 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 capital structure • 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 Senior Debt issuance continues to increase while volume of subordinated debt 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 security 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 private equity 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 yield curve (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 stock price is less than the strike price.” • The degree to which the warrant 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
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