The COVID-19 pandemic has triggered an acute contraction in the global economy, which is reflected in the repricing of financial assets. Uncertainty regarding the severity and duration of the health crisis and its consequences present challenges for companies that must report the fair value of complex and illiquid financial instruments. Practitioners may find some solace in the fact that the tenets of fair value accounting remain the same:
“Fair value is the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date.”
Since the publication of FAS 157 (now ASC 820), fair value accounting has emerged as a replacement for historical cost-based measurement. The fair value movement is grounded in the view that the disclosure of fair value measures provides useful and actionable information to investors and market participants. This framework is intended to establish a consistent approach to valuation that allows for comparability across entities.
During periods of market disruption characterized by sharp declines in the prices of financial instruments, fair value accounting is often caught in the crosshairs. Critics argue that mark-to-market accounting can trigger unfavorable outcomes or exacerbate market downturns, be difficult to apply in periods of uncertainty, or be inappropriate for long-term buy-and-hold investments. In response to these critiques, accounting standard setters and regulators have reinforced the benefits that transparency and price discovery provide to capital markets. For example, in a fall 2019 speech, Jay Clayton, Chairman of the Securities and Exchange Commission (SEC), highlighted the social value derived from observable market prices for financial assets:
“Prices for stocks, bonds and other assets, generated by markets that are transparent, information rich and fair, are of immense value to our economy. They are – to cite Paul Samuelson – ‘public goods.' Generally, once prices are published, we can all use them. Like light houses, they are in economic speak ‘non-excludable’ and ‘non-rivalrous.’ In most cases, I cannot keep you from using price information and my use of price information does not affect your ability to use that information.”
In a more recent public statement addressing COVID-19, Chairman Clayton acknowledged that while financial reporting will not be “routine,” there is a need for robust, forward-looking disclosures at a time when investors and analysts are thirsting for information and public policy makers are requiring feedback to gauge the effectiveness of government programs.
We provide recommendations for those facing the challenge of preparing fair value estimates in a tumultuous environment. We cover the following topics:
We recommend reviewing existing standards and resources to provide structure and context to the valuation process. Adhering to authoritative guidance and practice aides also serves as a defense against ex-post disputes regarding management’s (often fiduciary) duty to report to investors and stakeholders. The following reference sources are recommended:
For U.S. generally accepted accounting principles (GAAP), the core principles of fair value measurement have remained relatively unchanged since the initial pronouncement. This guidance defines fair value, identifies valuation techniques and valuation inputs, and dictates required disclosures, including the Fair Value Hierarchy and significant inputs for instruments that are more difficult to value. In Section 5 below, we discuss key terms defined in ASC 820 that are pertinent to the current market.
In response to criticism from the SEC and other regulatory bodies, valuation professional organizations (VPOs) have developed a new credential for the valuation profession. The Mandatory Performance Framework was developed specifically to address the question of “How much work is required?” when preparing financial reporting valuations for public companies. This framework sets the minimum requirements for the valuation work product and can be applied to valuations for a range of valuation matters, including corporate entity assets, intangible assets, and financial instruments.
The American Institute of Certified Public Accountants (AICPA) published a private equity venture capital guide in August 2019 to “harmonize views of industry participants, auditors, and valuation specialists” regarding “how to” value private portfolio company investments. This document, which was also developed in part in response to a divergence in practice among practitioners during the credit crisis, covers the application of fair value to investment company instruments, including private debt and private equity holdings in simple or complex capital structures. The guide includes 16 case studies that demonstrate the application of valuation techniques and provide tangible examples of how valuation specialists exercise judgment to develop their conclusions of value for illiquid or complex subject interests.
The PCAOB revised its standard on auditing accounting estimates, AS 2501, in 2018. This was done to address the audit risks related to estimates, including fair value measurements, largely in response to observed SEC and PCOAB enforcement cases and PCAOB audit deficiency findings in the wake of the global financial crisis. Auditors must now directly address the risk of management bias in the development of fair value estimates characterized by measurement uncertainty and subjective assumptions. AS 2501 describes the methods by which auditors may test fair value estimates and places significant emphasis on maintaining “professional skepticism” regarding management assertions. Valuation specialists can use the PCOAB standard, which describes how valuations are reviewed by auditors, as a reference, as well as, by extension, the documentation and support that are required for their testing process.
FAS 157 became effective in the 2008 fiscal year for most filers, resulting in a baptism by fire for fair value accounting. Although there are significant differences between the global financial crisis and the COVID-19 health pandemic, important lessons can be learned by evaluating how different market actors and institutions responded to the previous market downturn. For public accounting firms, more focus is now placed on the use of estimates and the potential for management bias. Accounting firms are now subject to oversight and enforcement by the PCAOB, and the name of the audit engagement partner is disclosed in public company audit opinions. Corporations, investment funds, and other asset managers have implemented policies and structures to enhance fair value reporting by hiring dedicated resources, establishing valuation committees, and increasing the use of independent valuation specialists. Investors and their representatives have also become more attuned to valuation risk, often requesting enhanced disclosures or obtaining full transparency through separately managed accounts.
The global financial crisis prompted changes in transaction terms and investment structures, which have shaped the current landscape. Certain asset managers and investors favor permanent capital vehicles that are intended to inoculate the funds from asset price fluctuations that can trigger withdraw or redemption requests and forced selling of investments at market lows. In derivatives markets, on the other hand, concerns about counterparty risk have transferred trading volume to exchanges and clearinghouses with strict margining and collateral requirements. The regulatory response to the global financial crisis will also affect how market participants react to the volatility caused by COVID-19. Relevant examples include institutional investors who employ risk and liquidity models informed by the crisis, banks that enter this downturn with capital buffers build to withstand “severely adverse” credit scenarios, and credit rating agencies that enter the fray after being admonished for their delayed reaction to the mortgage crisis.
Firms that have a robust valuation framework in place are best prepared to handle the operational challenge of reporting fair values during periods of market stress. A sound valuation framework consists of multiple elements, including policies and procedures, corporate governance, information sources, and internally or externally developed models. Ideally, these elements are supported by a culture of fair value across the firm’s front, middle, and back office. Many asset management platforms create a separate valuation function to liaise between the portfolio managers in the front office, who are closest to the investments, and those in the finance department, who are tasked with fund reporting. The following structural items should be evaluated amidst the market turmoil:
Institutions are generally best served by following their established valuation policies in times of financial stress. To be effective, these policies and procedures should provide enough flexibility to allow adaptation to changing market conditions. Such provisions include a ranking of alternative valuation approaches, a challenge process for reconciling disparate indications of value, a mechanism for escalation, and more generally, rules that dictate how the valuation policy itself may be amended.
Clearly defined roles and responsibilities provide necessary structure to valuation exercises. There are multiple firm constituents involved in the derivation of values, the review of valuation models and assumptions, and, ultimately, the approval of concluded values and accompanying disclosures by the valuation committee. Membership of the valuation committee should be based on multiple criteria, such as the individual’s functional role, career experience, asset-specific knowledge, accounting and fair value expertise, objectivity, and potential conflicts of interest.
Developing estimates of future asset performance and determining how market participants will price the inherent risks (required returns, volatilities, credit loss assumptions, etc.) require judgment. For asset classes in which greater judgment is required in fair value estimates, firms have engaged independent valuation firms to provide independent estimates or corroborate management’s values. While third-party pricing firms provide myriad benefits, we caution that the use of valuation specialists should be integrated into a comprehensive valuation framework. Regulators have emphasized that management is ultimately responsible for reporting fair values and must gain an understanding of the approach used by external providers. Management is therefore expected to take ownership of third-party sources (broker quotations, vendor prices, etc.) used during the current crisis, which involves getting behind COVID-19-specific inputs and assumptions.
Although the fair value standard is applicable to all companies that report under GAAP, the consequences of fair value accounting are not the same across firms. Fair value guidance is intended to provide consistent measures across firms; however, the effects of dramatic swings in the value of financial assets can vary significantly, depending on the structure of the reporting entity. As we have observed recently in the mortgage real estate investment trust (REIT) sector, assets financed with short-term debt are subject to margining requirements based on market values. If margin calls cannot be satisfied, lenders can liquidate the underlying assets as a remedy. Similarly, investment vehicles such as exchange-traded funds (ETFs) or interval funds that offer daily liquidity through redemptions can be forced to transact at distressed market prices – a problem that is exacerbated when the underlying investments are complex or illiquid. Alternatively, investment platforms with term financing or long lock-up periods for redemptions are largely insulated from the effects of market value swings, and periods of extreme volatility and uncertainty may provide opportunities for investment platforms that hold dry powder and have longer time horizons.
Certain corporate transactions and fund transfers warrant special attention due to the potential risk of post-transaction disputes. The global financial crisis gave rise to a litany of commercial litigation concerning hard-to-value financial instruments. Such post-transaction valuation disputes are often adjudicated years after the date of the contested action and are subject to hindsight bias. The following cases illustrate the need for heightened documentation and disclosure:
Private equity and private debt funds have heretofore been the winners of the post-crisis financial market regime. The current financial downturn may expose the potential for conflicts of interest between debt and equity asset managers. Investors in distressed companies face the difficult decision of whether to inject new capital into a business. If full and equal participation in follow-on capital infusions does not occur, the risk of post-deal complaints alleging that the consideration paid or received was not fair to all stakeholders rises.
The current environment will give rise to transfers of illiquid and complex financial assets and liabilities. One area that is likely to draw enhanced scrutiny involves transfers of such assets by asset managers between related funds and different groups of investors. These inter-fund transfers are more likely to occur today, as diversified alternative asset management platforms have grown significantly since the global financial crisis. Example transactions are related-party transfers, the transfer of assets from a mark-to-market vehicle into a permanent capital vehicle, transfers in and out of publicly listed or retail held funds, and the restructuring of fund investments, management fees, or incentive payment terms.
As a corollary to the previous example, any transfer of an illiquid or hard-to-value asset into a side pocket may require special consideration. These internal transfers impact net asset value, which is the price at which an investor exits and enters a fund. In the context of an uncertain and volatile market environment, side pocket transfers invite scrutiny as to whether the recorded price represents fair value.
Fair value triggers can have immediate and actionable consequences for investment vehicles, corporate borrowers, and derivative counterparties that transact in a margining regime. Potential exists for the litigation surrounding the determination of asset values used by lenders to calculate margin requirements. Lenders who elect to liquidate borrower collateral should follow protocols to reduce the risk of ex-post claims that assets were sold at unreasonably low prices.
We close by reviewing selected terms from the fair value standard and providing commentary in the context of distressed and turbulent markets.
Fair value measurement is conducted from the perspective of market participants who have reasonable knowledge of the asset/liability, access to all available information, and are willing and able to transact for the asset without being compelled to do so. In times of market turmoil, stepping into the shoes of these stylized market participants admittedly requires significant judgment. However, the guidance is clear that the market participant view should reflect current market conditions and that it is distinct from management’s opinion regarding investment value.
The hypothetical transaction referenced in the definition of fair value is an orderly transaction that allows for a period of customary marketing and due diligence activities. An orderly transaction is not a distressed sale or forced liquidation. Forced sales may be more prevalent in dislocated markets, and practitioners should investigate the circumstances surrounding observed transactions to determine whether these trades meet the orderly criteria.
The hierarchy within ASC 820 assigns instruments into three categories (Levels 1, 2, and 3) based on the inputs used to determine their value. These levels serve as a proxy for the relative precision of the estimate. This is consistent with the statistical concept that estimates should be represented as a confidence interval or a range of likely outcomes. During periods of increased uncertainty, we expect an increase in the number of assets classified as Level 3. The market approach to value is difficult to apply when quoted prices are unavailable for comparable instruments, when significant adjustments are made to quoted prices, or when matrix pricing for securities is unreliable. Similarly, cash flow models are affected when inputs for credit losses, prepayment speeds, market yields, and volatilities are not observable or not applicable to the subject instrument. While Level 3 measures are derived using unobservable inputs, the definition of value remains the same. Recall that the standard dictates an exit price notion of value driven by market participant assumptions. Level 3 valuations involve more judgment, and the required disclosure of the methods and inputs provides valuation information to users.
The principal market is the most active market and the most advantageous for transacting the subject instrument. In times of market distress, the principal market for an asset may change. For consumer and commercial loan pools, the new issue securitization market becomes frozen, thus allowing the secondary market or whole loan market to be considered alternatives. In the case of rated corporate debt and other fixed income securities, downgrades to non-investment grade status may alter the principal market as well as the profile of a “willing buyer” for the subject asset.
The fair value definition assumes that the hypothetical buyer and seller possess the relevant facts pertaining to the subject instrument. This set of information is what is “known or knowable” as of the measurement date. The COVID-19 pandemic delivered a sudden shock to the economy that reduced the relevance of historical performance data. For example, the payment status of consumer and commercial loan pools is often delayed by several weeks or months. Similarly, financial reports and forecasts for private equity portfolio companies tend to slow down the timelines for public company disclosures. Valuation specialists should endeavor to gather all observable information that is known or knowable about the measurement data and the informed and objective assumptions about forward-looking performance. There are two potential issues to consider when developing valuation inputs that can cause distortions in measuring the impact of an economic shutdown. Analysts will understate the impact of COVID-19 if they place significant weight on historical performance metrics and previously developed forecasts. On the other hand, the effect could be overstated if a down-case scenario forecast is discounted using a rate that incorporates high uncertainty or if guideline public company multiples are not appropriately adjusted to reflect revised, forward-looking estimates for both the listed company and the subject company.
The valuation of illiquid and complex financial instruments is challenging in periods of market distress and turbulence. The uncertainty surrounding the impact of the COVID-19 pandemic affects a wide range of assets. Market participants want to know the answers to the following questions:
Fair value accounting is intended to provide a consistent approach to estimating asset values that allows for transparency and meaningful comparisons to be made across asset classes. Investors will require timely and reliable estimated fair value to make investment decisions during the downturn and the subsequent recovery. In this period of market disruption, we advise valuation practitioners to revisit the published guidance and consult available resources, maintain sound operational practices, and reflect on the examples drawn from the global financial crisis.