Why Covid-19 has made private assets' valuation nuances so important
Investors have experienced a high level of public market volatility in recent weeks. Sharp declines in prices have been followed by quick recoveries, all whilst much of real impact of Covid-19 remains uncertain.
Valuations for private assets thus far, have not varied much. This is in part because private asset valuations are generated less frequently, with a delay commonly referred as “valuation lag.” As we move further into the second quarter of 2020, we do expect private asset valuations to reflect the impact of the current crisis more fully.
But private asset values are a product of far more than simply delayed public market valuations. Fundamentally, private asset valuations are anchored on capturing idiosyncratic risks and returns of individual assets over longer investment periods. The nature of valuation frameworks means that overall we expect valuations to provide comparative stability during the times of market turbulence.
However, the wide variety of valuation approaches used in private assets can have profound effects on the way they should be interpreted. We explore some of these nuances below.
How valuations differ, and why
As with public markets, valuation impact is of course expected to vary significantly by industry sector through the Covid-19 crisis. We have written recently on expectations that, for private equity investors, industries linked with travel or hospitality will be amongst those hurt most by social distancing. The oil and gas industry has also been hugely disrupted recently. Industries we expect to be less impacted include consumer staples, healthcare and e-commerce.
But material differences in valuation can also be down to the actual valuation approaches used by various private asset classes. There is generally sound reasoning behind the approach chosen, but knowing how and why valuations are conducted is essential if investors are to meaningfully interpret them.
To use private equity as an example, buyout valuations might use an average from a collection of relevant listed companies, as well as precedent transaction comparables, based on the privately transacted deals in the multiple preceding years. These methodologies reflect the likely exit avenues for buyout investments, and that the exit timing could be contemplated over a relatively long period of time. In addition, it is not uncommon for the valuation of a buyout investment to utilise normalised earnings figures over several quarters. These contribute to a “smoothing” of valuations reflecting the longer holding period, and the control over the potential exit timing.
In contrast, venture capital investments, in particular early-stage investments, will have the tendency to rely on the valuation from the most recent financing round. This is particularly likely if the company has not experienced a material degradation of its business prospects, i.e. its trading environment is still healthy.
In another area of private assets, infrastructure debt resembles private equity in some ways, but differs in others.
Like private equity, as an illiquid instrument, infrastructure debt cannot be valued using mark-to-market and has to rely on “mark-to-model” techniques
Conversely, as a debt instrument, the valuation is anchored around the borrower’s ability to service the debt and interest rate sensitivity (as opposed to estimated future cash flows, cost of capital or exit multiples). Therefore, as long as infrastructure debt remains backed by creditworthy borrowers (as demonstrated during the global financial crisis), swings in valuation should be limited.
For real estate investors assessing Covid-19’s impact upon portfolios, differences in valuation approach can be especially pronounced. Mark Callender, Head of Real Estate Research explains this in more detail below.
Is value in the eye of the beholder?
“Valuing commercial real estate is not an exact science, because of the variety between individual buildings and the low rate of trading compared with financial assets.
“The standard approach to valuing an asset is to look at the yield (“cap rate”), on two or more recent sales of similar buildings. The valuer will then make a series of adjustments for differences in location, internal specification, the unexpired lease term, as well as the financial strength of the occupier, etc.
“The extent to which valuers mark to market also varies across countries. In part this is due to different national standards. For example, UK valuations estimate the best price which could be achieved in today’s market, whereas German valuations estimate the average price in normal market conditions.
“However, it also reflects fundamental differences in investors’ attitudes towards commercial real estate and whether they regard it as a proxy for bonds, or for equities or as an entirely standalone asset class. Although national stereotypes are crude, it is probably fair to say that most German investors regard real estate as a long-term store of value and their main focus is on income. By contrast, UK investors are typically more concerned about anticipating the market cycle and maximising total returns.
“The huge uncertainty surrounding European economies and the difficulty of carrying out inspections during lockdowns has led to a sharp fall in new investment transactions since early March. In addition a number of deals which were agreed but had not completed before the virus struck have unravelled and some purchasers have walked away and forfeited their deposit.
“The sudden drop in transactions has left valuers in a quandary and valuers who work to Royal Institute of Chartered Surveyors (RICS) Red Book standards added material uncertainty clauses to their valuations for the first quarter of 2020. Some valuers decided to simply leave values unchanged, citing a lack of comparable evidence.
“Other valuers made marginal cuts to valuations to take into account the delay to rent payments during the lockdown. A third set of valuers chose to make bigger downward adjustments, increasing yields in order to recognise the greater risk of tenant insolvencies, the weakening in investor sentiment and the tougher stance of banks on new loans. Since March banks across Europe have raised margins on new commercial real estate loans by between 0.25-0.5%. The lack of consensus among valuers meant that the first quarter saw an unusually wide range in valuation movements and fund returns.
“How far capital values fall in 2020 will largely depend on whether government measures to keep businesses afloat through the lockdowns are successful. If they succeed then the fall in capital values should be limited and we should see a recovery later this year, as business activity picks up and investor sentiment revives. However, if there is a wave of insolvencies, then a lot of space could be left vacant and the recovery in rents and capital values is likely to be delayed.
“UK style valuations could decline by 10-15%, while German style valuations might fall by roughly 3%. Of course, these are averages. Non-food retail, hotels and student accommodation are likely to suffer a bigger hit than office, food retail, industrial, or social supported housing. Data centres and laboratories might buck the downturn entirely. There will also be a big variation between prime assets with long secure income streams and secondary assets where the rent is in jeopardy.
“We do not anticipate a repeat of the death spiral of falling prices and forced sales which occurred during the global financial crisis. In general, investors have borrowed less over recent years than in the run up to the global financial crisis and banks will probably tolerate temporary breaches of loan terms, provided there is a good prospect that rent and interest payments will resume once the lockdowns are relaxed.”
The importance of looking closely
We continue to believe that private assets offer a valuable source of comparative stability for investors that also allocate to publicly traded securities. Overall, the valuation frameworks are more tightly aligned with changes in the fundamental of underlying investments. However, because of the variety of techniques used, the implications of valuations can differ a lot. Working with a trusted and experienced partner - in any area of private asset investment – is always essential if investors are to know how to interpret valuations. But never more so than during a crisis.