As recent market events surrounding the COVID-19 pandemic have reminded us, markets can change quickly. This volatility enhances the need to assess the timeliness and applicability of information used to estimate fair value. For investments deemed not active but valued using observable inputs (so called Level II inputs) additional scrutiny is needed in times of market dislocation. In particular, broker quotes and transaction data must be assessed in the context of the broader market environment and the unique circumstances surrounding each quote, transaction and price.
In March 2020, transaction data in the over the counter and private markets became less readily available, and new issuances in many asset classes has slowed or ceased entirely. Compounding this challenge, the credibility of observed market information has become harder to validate. As secondary market transactions become less frequent and market participants deal with forced selling due to capital or margin calls, infrequent transaction observations must be examined individually to assess if they represent orderly transactions or forced sales.
As brokers and dealers grapple with the rapidly changing economic environment, market quotes are being issued less frequently, if at all, and many quotes that were once actionable are now significantly caveated and deemed indicative at best. The source and reliability of quotes must be assessed carefully as was illustrated during the 2008/9 financial crisis, in particular as quotes may not be independent, contemporaneous or actionable. Additionally, as the gap between the bid and the offer price widens, valuation policies such as utilizing the mid or bid of a broker quote may need to be reassessed in the context of current market conditions.
The Public Company Accounting Oversight Board (PCAOB), the Alternative Investment Management Association (AIMA) and the American Institute of Certified Public Accountants (AICPA) provide guidance that when a company's fair value measurement is based on a quote from a broker or dealer ("broker quote"), the relevance and reliability of the evidence provided by the broker quote depend on whether:
- The broker or dealer is free of relationships with the company by which company management can directly or indirectly control or significantly influence the broker or dealer;
- The broker or dealer making the quote is a market maker that transacts in the same type of financial instrument;
- The broker quote reflects market conditions as of the financial statement date;
- The broker quote is binding on the broker or dealer; and
- There are any restrictions, limitations or disclaimers in the broker quote and, if so, their nature.
Estimating fair value requires significant informed judgement in the best of times. If the consistency, quantity or actionability of broker quotes or transaction data declines sufficiently, it may be necessary to move to alternative Level II or Level III (unobservable model-based) inputs. The rapidly changing current environment requires enhanced consideration of individual facts and circumstances.
At March 31, 2020, we will almost certainly be faced with challenging valuation circumstances. What is known and knowable at March 31, 2020, and to what extent would it be allowed to take into account new information which will be available at quarter end requires significant judgment. In many cases, as broker quotes become less available and reliable, a model-based approach to valuation using discounted cash flows or other market inputs will likely be necessary. We stand ready to assist our clients and contacts with making these difficult and critical judgements required to estimate fair value.
David L. Larsen, CPA/CEIV/ABV is a managing director with the Alternative Asset Advisory practice at Duff & Phelps and serves as a member of the Standards Review Board of the International Valuation Standards Council, an advisor to International Private Equity and Venture Capital Valuations Board, a member of the AICPA PE/VC Valuation guide taskforce, and former member of FASB’s Valuation Resource Group.
Jennifer Press is a managing director with the Alternative Asset Advisory practice at Duff & Phelps where she is responsible for service capabilities in structured credit and whole loans.
Robert Maxim is a director with the Alternative Asset Advisory practice at Duff & Phelps where he leads a team focused on valuation and advisory services for commercial real estate loans and structured products.
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