Ryan McNelley on Valuing Alternative Assets During the Coronavirus Crisis

This article was first published in International Investment on March 26, 2020.

Writing for International Investment, Ryan McNelley, managing director in Duff & Phelps Valuation practice, explains why alternative investments could be the way forward in this time of coronavirus-induced economic crisis, and draws some important distinctions with the crisis of 2008.

The coronavirus (COVID-19) is first and foremost a public health crisis. But as non-essential businesses close across Europe, it is also rapidly becoming an economic crisis. In response, governments and central banks are unleashing unprecedented levels of fiscal and monetary stimulus. Public markets are volatile and investors are jittery. In alternative investment funds, limited partners (LPs) are also nervous.

They want to know if they will get reliable valuations at the end of the quarter and want to understand expectations for the rest of the year. Answering these difficult questions is something general partners (GPs) need to be prepared for.

In March, public markets endured their rockiest ride since the financial crisis—and in some cases since 1987. The S&P 500, which just weeks ago was heralded producing annualized total returns of more than 15% over the last decade, has slumped by almost 30%. In Europe, the FTSE 100 has lost 32%, while the Euro Stoxx 50 benchmark is off by over 35%. Volatility is everywhere with oil, for many the barometer of global demand, down 60% in just two months.

Investors can draw parallels with the financial crisis of 2008 and the resulting recession. But while there are measurements that can be extrapolated for the purposes of valuing businesses today, there are many differences.

The great financial crisis was precisely that. The collapse of the banking system highlighted systemic risk and fragility in financial markets. In Europe, it spiraled into the sovereign debt crisis that pushed individual countries into bailouts and tore at the fabric of the European Union. For investors, it was a long time before they could see light at the end of the tunnel. And yet, people still went to work, they got on planes, and they went to restaurants and bars.

Today queues are at supermarkets, not banks. Systemic risk seems limited—at least for the moment. But economic activity is grinding to a halt. Certain sectors—hospitality for example—are being shut down by direct government action. In spite of the intense disruption to everyday lives, most can see light at the end of the tunnel. We don't know how long it will take to get there, but we are pretty sure we will come out the other side, and policymakers appear committed to ensuring that businesses are still standing when we do.

Portfolio Company Impact 

In private markets, GPs and LPs are grappling with the impact on the value of portfolios. While the dislocation could signal a buying opportunity for private equity, distressed debt and special situations funds in particular, many GPs will be focused on protecting the value of their portfolio companies.

The business plans they drew up for 2020 just a few weeks ago now look overly optimistic. But how optimistic is very hard to tell. For many businesses, sales figures from the end of January or February were robust—the economic impact is only just starting to filter through. This leads to potentially difficult discussions between GPs and LPs.

Investors expect to see potentially steep write-downs on alternative assets at the end of March. A large institutional LP recently asked me whether they should take an index—the S&P 500 for instance—as the basis for adjusting the stale 31 December NAVs to roll them forward to 31 March.

GPs, however, are likely to be more optimistic. Again, as an example, a client investing in artificial intelligence believed there would be no impact on his portfolio.

How do LPs and GPs square the circle? The truth is that all businesses will be affected in some way. Those in consumer sectors directly affected by lockdowns will be hit hardest, but companies targeting other companies as customers will likely see investment decisions delayed, which will in turn impact their top lines.

Public market investors are struggling with the same issues in real time. Public markets present a starting point for private market valuations. But the reality is that GPs will need to look at portfolio companies on a case-by-case basis and assess where they stand now, and where they might be at the end of the year.

Established Valuation Principles 

In calmer times, as well as turbulent ones, the underlying valuation principles are the same. The question is: what would a market participant pay for an asset in an orderly transaction, taking into account the market conditions at the time, and all relevant known and knowable information?

In the absence of clarity on the outlook, GPs and LPs need to hold firm to their established valuation processes and discipline. They need to be clear-eyed and objective about company prospects. But they are looking for fair value not fire sale prices.

Even before the escalation of the COVID-19 outbreak globally, we saw risk in private market valuations. Prices were high and multiples were rich. In the current climate, multiples will have to come down. At the same time, discount rates will have to go up as investors go through a painful process of re-pricing of risk. These factors will push down reasonable valuations at March 31.

There are risks to the valuation process. For instance, GPs and LPs need to take care not to double dip when following a public market comparable. Applying a decreased multiple to an already discounted forecast may be too aggressive.

Ultimately, most GPs are optimists at heart. They also place a great deal of faith in their ability to add value. LPs have bought into individual funds' strategies and expect GPs to deliver—even during tough times.

Investors are going to be asking for a fair and honest reading of value at the end of March and will be asking private equity managers to justify their valuations.

Then they will ask managers to outline and defend portfolio company outlooks for 2020 and beyond. GPs must be prepared. They will need to have a clear narrative that addresses value creation or value protection strategies. LPs will have little patience for those who have any uncertainty or doubt.