Heightened market volatility increases the pressure on many investors to make decisions quickly. When equity markets fell at record speeds as the coronavirus pandemic worsened, many investors rushed for the exit.
At times, stress judgments surrounding valuations are often made at pace. But given the correlation between market stress and valuation uncertainty, firms must be sure they didn’t cut any corners, particularly with hard-to-value assets.
It is therefore vital that processes used to establish the fair value of holdings are well documented, transparent and easy to replicate. Valuations of complex or hard to value assets and liabilities, with little evidence to support them, should be a great cause for concern for senior managers and boards, even more so during times of volatility and when investors may be looking to get their money out. Firms need to consider how they can ensure that they are giving fair valuations to those exiting, while not exposing investors that remain invested to losses as a result of paying too much value away.
Grasping Fair Value
In accounting terms, fair value is the estimated price an asset can be sold in an orderly transaction to a knowledgeable third party under normal market conditions. Context is crucial here though, which is why documenting the wider market conditions in which a trade was made is fundamental.
In many cases, deciding an illiquid or complex investment’s fair value can involve as much judgement as it does science. With publicly traded companies, however, establishing what a share in that entity is worth is more straightforward. After all, its price will be listed on several readily accessible sources, and the security will usually have an active market of buyers and sellers, unless a holding is particularly large.
When assets become more complicated, such as complex derivatives, or with unique features, such as airports or retail parks, establishing their worth becomes far more complex. In these cases, assumption and judgment become more prominent, as data can be scarce and comparable trading levels harder to find.
The Perfect Illusion
The more illiquid or complex an asset is, the harder it will be to ascertain exactly what the correct value is. However, the perfect should not be the enemy of the good.
What firms must do is ensure that any and all assumptions about an investment’s valuation are clearly documented, and that any data sources are recorded. It is important, too, for anyone valuing an investment to document the market context at the time of the valuation.
For instance, if an investor is trying to value an airport, this would clearly be impacted by external events such as the current COVID-19 crisis. Noting details like these could be crucial if a firm ever has to justify a valuation in the event of a future investigation.
Investors usually associate major fund collapses with issues surrounding liquidity. This is often the case, however there is a valuation for every asset. Take a property, for example—liquidity may be hard to find at a value that is out of kilter with the market but may appear very quickly when prices are reduced.
Liquidity is inherently linked to valuation, and where there are poor valuation practices, it is much more likely that there will be poor liquidity—especially at times of stress. It’s arguable that one of the main reasons an asset is hard to sell is because the owner has mis-valued it.
Of course, various factors can influence buyer behavior, but being able to confidently, clearly and precisely explain how a complex asset has been valued is of utmost importance to prospective purchasers, management, investors and regulators alike.
Any risks and caveats that have been attached to the valuation should be clearly identified and recorded to ensure full transparency. And while it can be tempting to simply trust the investment manager closest to the market on matters of valuation, firms must have a robust process in place to rigorously test any prices and manage the inherent conflict of interest that arises.
More Than Sure
Experienced investment managers will often have a gut feeling about the price of an asset, but they may suffer a higher level of bias because of their proximity to the trade. Every firm should therefore have valuation policies in place that allow individuals to record their data sources, explain how they have adhered to accounting standards and detail any assumptions they’ve made. Other key information, such as the market backdrop, should also be documented. There needs to be robust governance around these processes, including independent challenge, which will help management receive the right kind of information to give them the assurances they need.
Essentially, if firms can show that the valuation was the product of a process involving sound data gathering, market research and modelling, it will put them on firmer ground if the valuation is ever questioned. However, the process itself must be logical, consistent and, vitally, be repeatable for anyone who might retrospectively scrutinize a trade.
The Senior Managers and Certification Regime (SM&CR) puts greater levels of personal accountability on senior individuals at investment firms. As a result, those at the top of an organization need to be able to demonstrate that their valuation methodologies and processes are robust, even though they are unlikely to have been directly involved in the valuation processes themselves.
In response, firms might be compelled to implement a system whereby valuations—particularly those in Level 3 (which are in the least transparent markets)—are analysed by independent committees, board members or valuation experts, to provide them with reasonable assurance. This should be the case in ‘normal’ times, as well as the more unusual circumstances experienced so far in 2020, when such processes are likely to be put to the test and be subject to intense scrutiny.
While COVID-19 has created higher levels of market volatility, it has also created an extra external factor that will have to be considered in the valuation of assets for months, if not years, to come.
Take an asset such as a corporate loan. The probability of certain borrowers being unable to finance their debts has likely risen given the huge economic impact of COVID-19. But given the government support schemes now available for workers, and the grants and low-interest loans for companies, the probability of a default might be lower than it initially appears.
Firms that maintain sound valuation governance and who diligently allow for all relevant external factors—including COVID-19—within their valuation processes should be well positioned to retain investor confidence in this period of extraordinary stress.
This article was first published in International Investment on July 17, 2020.