At the time of writing, the S&P 500 has rebounded sharply on news that the US Senate has passed a $2 trillion economic stimulus package.
Nevertheless, the index is down 30 percent on its 19 February peak. US consumer discretionary stocks are down by 36 percent, energy stocks by 38 percent. Until a vaccine or cure for covid-19 is discovered and brought to market, the gnarly root of the economic crisis remains.
For private equity firms working to ensure the survival of portfolio companies that might not even be generating revenue, having to calculate December net asset values might feel like a secondary concern. They will, however, be a vital temperature check for limited partners trying to re-base their expectations.
What are December NAVs likely to look like? And to what degree should they reflect the economic chaos being witnessed in the real economy?
The answer to the first question, for most at least, is not dramatically different from usual. In 2009, the Financial Accounting Standards Board introduced guidelines allowing for valuations to be based on a price that would be received in an orderly market – with willing buyers and sellers – rather than one characterised by distress. If PE firms feel the market is ‘disorderly’, they can at their own discretion reduce the weighting of mark-to-market analysis in favour of other types of metric, such as income.
Erratic daily price shifts suggest the market is far from orderly. GPs are grappling with imperfect information, with many portfolio companies not yet having updated their forecasts for 2020 to take into account probable weaker performance. Even if they have, there is a risk that a GP will pick a comparable public market company that hasn’t adjusted its own forecast, making for an inaccurate comparison.
“With M&A all but dried up, you can’t really refresh your market comparables with any transactions at the moment,” said Richard Olson, managing director at investment bank Lincoln International. “Public comps being down will weigh on any market approach. But the income weighting will counterbalance that, as will any other approaches to valuation. This tends to decrease the rate of change in illiquid asset valuations.”
GPs will have a fair bit of first-quarter leeway, but market turmoil should still make some impression on NAVs. Sister publication Private Funds CFO last week reported on two GPs that chose to hold their valuations unchanged from 31 December, but which are to include a footnote in their audited financials noting the impact coronavirus is likely to have on the next set of valuations.
According to Ryan McNelley, managing director with Duff & Phelps, at one extreme there are GPs that will claim market turmoil has had no impact on the prospects of their portfolio, while others will apply the same 10 or 20 percent haircut to all of their companies. He believes both approaches are mistaken.
“What’s really critically important right now is credibility,” he told PEI. “If you try to pretend your businesses are immune, it’s just not credible in this environment. You don’t want to be accused of taking a blanket approach because this is affecting some sectors more than others … You have to take a company-by-company approach.”
Although GPs have some discretion over how December NAVs will turn out, they should be open and honest about the possible impact of the coronavirus. If the economic shutdown persists, LPs could be in for a shock when the next set of NAVs comes out at the end of June. The GP should help make that shock as manageable as possible.
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