Q&A: Current Trends in Valuing Complex Financial Instruments
Q&A: Current Trends in Valuing Complex Financial Instruments
This Q&A was published as part of PitchBook's 2021 Annual US PE Middle Market Report sponsored by Stout.
What challenges do current market conditions present in valuing complex financial instruments and alternative assets?
Justin Burchett: The current market portends challenges for performing company valuations that account for significant market variables. The sharp increase in inflation measures, expectations for a Federal Reserve (the Fed) Rate tightening cycle and increase in geopolitical uncertainty have caused a repricing of many financial assets and corresponding volatility in the capital markets. Abrupt changes in these market factors make estimating company forecasts, market multiples, and required rates of return more difficult. These challenges are compounded when practitioners are asked to price hard- to- value positions including complex financial instruments and other illiquid investments.
Complex financial instruments and other alternative asset values tend to exhibit more sensitivity to changes in primary inputs, due to structural features of the instrument. Similarly, complex instruments are frequently priced using second-order market variables that react more strongly to changes in market factors. As an illustrative example, the valuation of common shares in a private company involves market inputs for the discount rates applied in an income approach and market multiples derived from public companies and prior transactions. Valuing an option instrument for the same firm will require the selection of additional assumptions for volatility. This relationship means that complex instrument valuation becomes more challenging when multiple model inputs exhibit higher variability or are difficult to measure.
The Fed has forecasted several rate hikes next year. How do your clients expect to navigate a rising rate environment, and how might this affect valuations within the financial services industry?
Justin: For commercial banks, the prospect of rising interest rates can benefit the profitability of the business. Because these firms operate in a spread lending model, increasing rates are generally expected to increase the net interest margin, or the difference between interest income received on loans and interest expense costs. In the textbook scenario, rising rates are also expected to coincide with a benign economic environment with strong growth and lower default risk. It remains to be seen whether the Fed’s tightening cycle will benefit banks and other financial services firms, as the anticipated rate hikes will occur following a sharp rise in inflation caused in part by government economic intervention as a reaction to the COVID-19 pandemic.
Non-bank consumer lenders are an example of a credit- sensitive business model that could be tested in an inflation-driven rising rate environment. With the slowdown of government payments, non-prime consumers may be tested, as real wages decline due to increases in the cost of living. Fintech-enabled consumer lenders have grown new lending products — point-of-sale loan portfolios in a benign default environment that did not provide a test of credit underwriting models and loan pricing. A more volatile interest rate and credit spread could stress leveraged consumer credit underwriting models to sort out the platforms that will be most successful across market cycles.
What trends are you seeing as it relates to portfolio companies?
Jamie Spaman: First, we have noticed that leverage on private credit transactions has continued to rise, notably, the share of transactions with leverage at 7x or higher is on the rise.
Overall, the market seems borrower friendly. Loose-covenant structures continue to be the norm as borrowers can take advantage of the large amount of money available to lend. A newer trend in lending is (annual recurring revenue (ARR))-based loans for primarily tech companies that have little to no EBITDA as they focus on the race for growth.
Supply chain issues, labor needs, and inflation all present themselves as issues to watch going forward. Supply chain issues are more prevalent in our analyses due to transportation costs surging, though this increase in costs is often able to be passed to customers. Trends through the pandemic put many companies in a lean workforce situation — recruiting people to return or replacing them has been a challenge.
The overall mood remains optimistic, with revenues growing in a reopening environment and the ability to pass along cost increases. Many companies are budgeting to get back to pre-pandemic levels by 2022 or 2023, and many expect the supply chain and labor shortage issues to clear up in the near term.
What do you anticipate in the SPAC market in the near and long term?
Justin: The SPAC market has taken a beating in the last two quarters. The performance of de-SPAC merged companies has declined sharply, numerous announced SPAC mergers have been cancelled or delayed, and a long list of SPAC vehicles have completed a SPAC IPO and are searching for a merger partner. However, SPACs were not the only financial product to suffer in the recent market turmoil — companies that went public through a traditional IPO also experienced significant markdowns.
Market observers are tracking the proportion of SPAC shares that redeem prior to a merger. While earlier deals saw 10% redemptions, recent deals have incurred redemptions of 50% to 60%. To mitigate the effects of redeeming SPAC equity investors, sponsors have responded by forfeiting sponsor-promote shares and offering additional protections, such as convertible debt features, to PIPE investors in order to consummate a merger. We expect this trend to continue as SPAC sponsors are highly incented to close a transaction to avoid the complete loss of the sponsor economics.
Finally, we note that there will be closer scrutiny of SPAC investment terms and the valuation assumptions used to price de-SPAC merger transactions. The performance of public companies formed through de-SPAC mergers will be linked to the acquisition price and the various rights and privileges of the securities that are created as part of the deal.
Given the transition from LIBOR, what are you anticipating in terms of the valuation of transitioning LIBOR loans?
Jamie: So far, the transition away from LIBOR has been smooth. There was some speculation as to how lenders and borrowers would incorporate alternative rates and if they would use a credit spread adjustment (CSA) in their pricing. While SOFR has been the clear leader as a replacement rate, there has been some variety in implementing a CSA. Examples include a $3.6 billion financing to fund the acquisition of software company Quest Software by Clearlake Capital, which added a separate CSA on top of SOFR, plus margin terms. Other borrowers, however, have chosen not to add a separate cushion, including a $1.15 billion term loan for the spin-off of diabetes care business Embecta from Becton, Dickinson and Co. We think negotiation will continue among borrowers and lenders on how to adjust spread when changing to a SOFR-based rate versus LIBOR.
The results of those negotiations will determine where valuations land. Even though SOFR and LIBOR typically trend in the same direction, the key difference is that LIBOR has a credit risk component, while SOFR is a risk-free index. As a result, if a loan has the same spread as it transitions from LIBOR to SOFR, there will be lower interest payments leading to a lower price. However, the use of a CSA or selecting a higher margin on the SOFR-based loan will compensate for this difference, leaving the price of the loan unchanged, all else equal.