The ‘coronavirus-triggered economic downturn could lead to many performing loans to become distressed, especially for highly-leveraged companies,’ says a new client advisory from Houlihan Lokey, the global investment bank and valuation firm. The authors (Cindy Ma, Terence Tchen, Chris Cessna, and Andrew MacNamara) remind practitioners ‘when a debt security becomes distressed, a traditional [income approach] yield analysis may not be appropriate.’

Lenders may not receive contracted cash flows for industry-specific or company-specific reasons in addition to broad market volatility of the type we’re now seeing every day. Using a higher discount rate may not be enough to reflect the fair value of the distressed liability.

The authors advise analysts to watch for warning signs of financial distress including:

[F]inancial metrics like insufficient enterprise value coverage or asset coverage, cash flow measures such as declining interest coverage ratio, the breach (or anticipated breach) of financial covenants, or other qualitative and quantitative indicators.

Houlihan Lokey offers business valuers a list of considerations when valuing distressed debt:

• What were the causes of the company’s underperformance?

• Is the underperformance temporary, or is it expected to continue? What are the company’s plans to address the underperformance and the costs associated with these plans?

• What are the expected future cash flows for the company and what are the risks around achieving these cash flows?

• What is the seniority of the distressed debt? Does it have any collateral or guarantees? Does the company have other securities that have a priority claim on company assets?

• Is the borrower currently in default, or expected to be in default, under any of its credit agreements? If so, what are the likely outcomes (e.g., amend and extend, acceleration, voluntary or involuntary bankruptcy)? What is the timing of the outcomes and the probability of each outcome?

• What is a realistic enterprise value for the company? How much value coverage is there for the distressed debt?

• Does the company need to raise additional capital? If so, what form will that take and how will that impact the securities in the existing capital structure?

• Is a restructuring of the company likely? If so, will it be an in-court or out-of-court financial restructuring, and what are the implications on the valuation?

• Is a liquidation of company assets likely? If so, what are the expected recovery rates for each type of asset and how would those proceeds be distributed? Is the sale or closure of a business segment more likely?

• What are the expenses that would impact expected proceeds from a capital raise, restructuring, or liquidation?

• What are the negotiating dynamics between the various classes of debt and equity holders? Will this impact the allocation of proceeds differently than a simple waterfall through the capital structure?

• Is the borrower in default, or expected to be in default, under any of their credit agreements?

‘It is critical for the valuation provider to be fully transparent about the limitations of his or her analysis and the assumptions that are made in its preparation,’ the HL authors conclude.

BVR will present Extreme Uncertainty: How Valuation Experts Should Respond to Today's Volatility and Risk, a free webinar, on 7 April. The session brings together a panel of business valuation leaders to discuss how valuation experts can respond to today's volatility and risk—and the challenges of staying in business.

In these anxious days, all BVWire—UK readers can perhaps take comfort from Andrew Strickland, former corporate partner at Scrutton Bland Chartered Accountants (UK), now a consultant to the firm, who reminds us that, professionally at least, we’re prepared.

We are in a privileged position. We are members of a profession which has developed the techniques to value that which cannot readily be valued: fractional holdings in private companies are assets for which there is no ready market, yet we are prepared to ascribe values to them using our professional judgement and training within a discipline developed over many years. We all see further by standing on the shoulders of giants. We therefore have the skills to value businesses when the lubrication in the market runs dry.

As the coronavirus pandemic continues its relentless march, we reached out to members of BVR’s Business Valuation Update Editorial Advisory Board for their thoughts.

From Hong Kong: Edwina Tam, partner at Deloitte: ‘For the development of cost of capital, given the market uncertainty, one needs to critically consider the impact of the current market uncertainties (COVID-19, U.S.-China trade war, etc.) on the business operations in developing the forecast. In determining the nature and extent of the impact on the business and valuation assumptions, the following potential issues may need to be considered:

• ‘Store or facility closures;

• ‘Loss of customers or customer traffic;

• ‘The impact on distributors;

• ‘Supply chain interruptions;

• ‘Production delays or limitations;

• ‘The impact on human capital;

• ‘Regulatory changes; and

• ‘The risk of loss on significant contracts.

‘Implicitly, these uncertainties need to be reflected in the cash flows; however, a risk-appropriate discount rate also needs to be considered. There is no set approach to account for market uncertainties as the impact will be different for different businesses in different regions.’

From Australia: John-Henry Eversgerd, senior managing director of the valuation and litigation consulting practice in the Sydney office of FTI Consulting: ‘I’m expecting some significant asset impairments in a number of industries, particularly in Australia, since we have some every strict “continuous disclosure” rules. Those rules require public company boards to announce almost immediately any impairments or other factors that would impact the share price significantly. It is a very low bar, which means boards have little choice but to impair.’

From the U.S.: Gary Trugman, Trugman Valuation (Plantation, Fla.): ‘Developing cost of capital in troubled times should be nothing new. We saw this in 2008 after the financial crisis and it should be dealt with in a similar fashion. What is critical to remember is that we value businesses based on what is known or knowable at the valuation date and we must consider what the investing public is thinking at the date of the valuation.… You need to use common sense and think about how the risk of receiving the cash flows is impacted at the date of the valuation.’

The risk-free rate includes risk: Ron Seigneur, managing partner, Seigneur Gustafson LLP (Lakewood, Colo.): ‘My sense in all of this is the “risk-free” rate is not really risk free and we will see more emphasis on how to get our arms around the unsystematic risk associated with investments as this is where I think the extra risk we now have ahead of us should be captured.’

DLOM analyses have been influenced: Gilbert E. Matthews, chairman of the board and a senior managing director of Sutter Securities Inc. (San Francisco): ‘Since volatility is a factor in discounts for lack of marketability (DLOM), the extreme volatility of the market in recent weeks will materially increase DLOMs. In addition, I would argue that DLOMs should be adjusted upward because:

• ‘The abnormal conditions in the market will necessarily cause buyers to be reluctant to invest in illiquid securities; and

• ‘The restrictions being put in place to limit the spread of COVID-19 are limiting the ability of prospective buyers of restricted securities from conducting due diligence and even to meet with financial and legal advisors.

‘There is no data to quantify these factors, but they should be considered, and valuators should use their professional judgment.’

Harold Martin, partner-in-charge of valuation and forensic services for Keiter (Richmond, Va.): In terms of what was known or knowable, ‘the issue actually goes back to late February and early March when the virus started to spread, and the stock market began to reflect the expected economic impact. For purposes of assessing the impact on a valuation completed on or after those dates, an appraiser would essentially do what they always should do for any valuation:

• ‘Perform an analysis of the current and expected economic and industry conditions based on what was known or knowable as of the effective valuation date;

• ‘Assess the impact of these factors, as well as the financial and operational characteristics of the subject company, on the subject company’s expected growth rate; and

• ‘Assess the risk resulting from these factors on the company’s ability to achieve projected future cash flows and reflect this in the company-specific risk component of the discount rate.

‘Further, to the extent that there is a lapse of time between the valuation date and the report date, the appraiser should consider reporting material developments as a subsequent event.’

And, back to the UK: Andrew Strickland again: ‘In the UK, the short-term risk-free rate was reduced from 0.75% to 0.1% in short order. The impact on the cost of equity must be far more than that movement of 0.65%, and in the opposite direction from that indicated by CAPM. Times like these lead us to challenge the very fundamentals of our training. But challenge and enquiry are always positive attributes, making us into better valuers.’

The Financial Reporting Council (FRC) and Department for Business, Energy and Industrial Strategy (BEIS) released FRC/BEIS letter on accounting and corporate reporting during transition period and FRC/BEIS letter for auditors during transition period late last month. Each letter summarises the regulatory schemes that have been introduced prior to the Referendum, and assures business valuers, auditors, and accountants that, at least through the end of the transition period on 31 December, no significant surprises are expected.

Deliberations about the UK’s financial reporting regime afterwards continue, overshadowed by the public health situation.

Accountancy Daily provided a short summary of the major points in the two new releases. The good news: ‘For financial years beginning after 31 December 2020, UK incorporated companies and groups that currently use EU-adopted International Accounting Standards (IAS) will instead be required to prepare accounts using UK-adopted international accounting standards. There will be no change for UK incorporated companies that use UK GAAP—FRS 102, for example—to prepare their annual accounts.’

In addition, the EU Audit Regulation and Directive (ARD) will continue to apply in the UK during the transition period.

Those searching for business valuation professional training or CPD have few places to turn in the UK at the moment. ICAEW, which provides the bulk of such opportunities, has cancelled most of their dates, including the spring ICAEW Annual Valuation Conference, originally set for 28 April in London. And the HMRC Shares and Assets Valuation Fiscal Forum, intended for last week, has yet to be rescheduled.

Extreme Uncertainty: How Valuation Experts Should Respond to Today's Volatility and Risk (free webinar), 7 April (webcast)

ASA-Europe Business Valuation Conference, 24 September, Prague (details available soon)

IVSC Annual General Meeting, 14-16 October, Chicago

EACVA 14th Annual Business Valuation Conference, 29-30 October, Munich

Our thanks to Marianne Tissier, Andrew Strickland, and Nick Talbot for their valuable contributions to BVWire—UK.

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