ASC 820 requires valuation of liabilities, whether debt, contingent consideration, real estate, deferred revenue, or other class. And ASU 2011-04 has an impact on the these fair value analyses.
In most debt cases, "the income approach should always be considered because it forces the analyst to consider factors such as timing of principal and interest payments, credit quality of the issuer, and likelihood of default," said Bernard Pump (Deloitte), leading off the ASA Advanced Business Valuation Conference session on valuing liabilities held in Phoenix this afternoon.
The hard part is the market yield. If you're lucky, the subject company has publicly traded debt, so you'll just have to make adjustments for where in the capital structure the debt lies. Sadly, this is rarely available, so you end up with a credit scoring analysis. Or you can look at comparable company debt analysis. There can be a single fixed yield, or it may be a series of "strip yields."
Credit scoring is based on the methods used by credit rating agencies, using key metrics. These include:
- Operating income before depreciation;
- EBIT interest coverage;
- EBITDA interest coverage;
- FFO interest coverage;
- Return on capital FFO to debt;
- Free operating cashflow/debt;
- Discounted cash flow/debt;
- Debt to EBITDA; and
- Debt/debt plus equity
S&P fortunately has key industrial financial ratios for long term debt in the U.S. Sadly, however, it's "rare that you'll end up in the same rating, such as AA, for every metric," he comments. "We also don't know every method S&P uses to score debt, since the weighting and other factors are propriety. So, you'll have to use some judgment, no matter how consistent the metrics are. "
For this reason, the standard approach at Deloitte is to present a range of ratings...for instance A to BBB. Currently, he points out, there's very little dispersion in yields at any of the A rating levels--less than 50 basis points between AAA and A. As you go further down, there's wider variability (though S&P no longer provides disaggregated ratings for debt quality level at C or below).
Distressed debt often requires a market approach based on debt coverage analyses, he argues. This requires developing an enterprise value as a basis for repayment of the outstanding debt. "This requires a lot of caution," he argues. Since this requires control of the enterprise, this technique is not appropriate for minority interests.
There are alternative models: for instance the callable/putable instruments method or the convertible instrument method, which is a lattice model that accounts for the lower required yield when the conversion feature is in the money. This will lower the required yield since the likelihood of default decreases, and it tends to systematically under-value the instruments.
When debt is distressed, the income approach can fail; other methods are required, such as a "back-solve method," he argues.
Contingent considerations are another liability that needs to be valued. PwC has analysed M&A deals from 2000 to 2011 ("Contingent Payments in M&A Deals"); the ABA and D&P (" 2012 Continent Consideration Study") also have smaller studies. Most of the contingent considerations are tied to revenue or earnings, but both D&P and the ABA show that 26% of contingent considerations are related to other factors such as a certain term.
Generally, the term (in 60% of the cases, according to the ABA) is two years or less. "This fits with my experience," commented Dwight Grant (PwC). And, most data he's reviewed show that the average value of the contingent consideration is in the area of 20% of the total deal. Grant has written on how to do the valuation in Business Valuation Review (Winter 2011) in his article "Valuing Contingent Consideration Using Option Pricing." A key point he distinguishes is the three earn-out categories:
- Payoffs tied to variables with no systematic risk.
- Payoffs with systematic risk but short terms to maturity (generally two years or less). "Because the term is short the influence of the discount rate is small and errors in estimating it have relatively little influence on the values of the earn outs," Grant says.
- Payoffs with systematic risk but with longer terms to maturity.
The third category is often where the most judgement is required, particularly when the payout is a significant percentage of EBITDA. Asymetric payouts are another problem area, though PWERM and/or OPM analyses.
Lawrence Freundlich (KPMG) tackled the issues around real estate liabilities. First, he talked about the treatment of risk in either the discount rate (indirect method) or the cash flows (direct method). "We rarely see the market approach because there are few observed market com parables, and the cost approach is essentially never used," he said. Start with the risk free rate, and then add the cost of capital in excess of the RFR, a liquidity premium (excess of the AAA rate over market rate, the market risk/interest rate risk, and servicing costs premie when doing the direct method, he advises.
There are some common flaws that he sees in auditing:
- Including recovered principal in the active outstanding balance;
- Discounting credit adjusted cash flows using a market yield, which double counts credit risk;
- Pooling liabilities and not selecting weighted average characteristics for terms;
- Modeling cash flows for floating rate loans and ignoring caps, floors and periodic change limits on rates and/or spreads;
- Not making sure all payments are captured when modeling loan amortization schedules and cash flows; and
- Using models that have changes without updating assumptions to meet changing market conditions.
Sources. Freundlich recommends Bloomberg's BMMI screen which offers access to a variety of trust reported data. But "old fashioned cold calling to sample indicative retail origination rates" should not be overlooked. KPMG also uses risk analytics solutions such as Moody's CMM or MPA; or even research reports from Wall Street firms or CoreLogic LoanPerformance.