Measuring the Fair Value of Financial Instruments Under Conditions of Significant Uncertainty—Selected Considerations

April 13, 2020

Marred by the impact of the global COVID-19 pandemic, the March 31, 2020 quarter-end valuation process promises to be challenging for management, valuation professionals, auditors, and users of financial statements.   As we assess Fair Value while the pandemic continues and the public markets sell off in response, application of sound judgment which must be exercised when estimating Fair Value and in applying the concepts of the AICPA’s Financial Instruments Performance Framework (FIPF) will be crucial.  This is especially true for investments with limited or no trading activity.

By keeping in mind a few basic premises, management and valuation professionals will stay on the path to credible, supportable valuations in times of market dislocations.

  • Ensure that sound valuation processes continue.  During periods of market dislocations and high volatility, take special care to consistently apply fair value guidance across all investment types and to adhere to valuation policies and procedures.

  • In times of market dislocation, the definition of fair value doesn’t change.  The “price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” (FASB ASC Topic 820/IFRS 13)

  • Fair value is NOT a fire sale price.  An orderly transaction assumes sufficient time in the market for customary marketing activities; it is not a forced liquidation or distressed sale.

  • Market participant assumptions in the current market environment at the measurement date should be reflected in the valuation inputs used when determining fair value.

  • Those assumptions and the resulting fair values should be based on that information relevant to the instrument which is known or knowable at the measurement date.  If it’s not known or knowable, reliance on that input should be low, or not at all.
    • We know:  Public market valuations have deteriorated, certain industries and companies have been affected more than others, central banks and governments are providing stimulus, recession probability has increased, etc.
    • We don’t know:  When treatments for COVID-19 will be available, how long shelter in place lasts, when public market valuations will increase, the full impact of government fiscal and monetary initiatives, the timing, length or depth of the economic recession, etc.
  • Incorporating what’s known and knowable into the valuation process will be instrument- specific and requires judgment and support.  Both the negative impacts of the COVID-19 fallout on valuation and the mitigants should be considered.
    • While the spike in unemployment might have a negative impact on the expected cash flows of a consumer loan pool, certain government consumer subsidies might counteract these.  However, the results of the government initiative might not be well known or might be uncertain as to how they apply to the specific pool, in which case consideration of this as a mitigating input would wait until an understanding of the impact on the pool crystalizes.
    • COVID-19 impacts on an investment during Q1 and Q2 might be relatively knowable; however, assessments over longer horizons might not provide such confidence and might not be factored into changes in projections. At the individual investment level, consideration should be given to the short, medium and long-term impacts of the pandemic, with judgment applied with respect reliance on any projections.
  • The specific characteristics of the individual investment (or collective investment, such as homogenous loan pools) should be considered when determining fair value.  Value drivers must be identified, and assumptions made, considering current market conditions at the measurement date.
  • Lack of transactional information for an illiquid investment, intent to hold it to maturity, a close proximity of valuation date to acquisition date or difficulty in accurately valuing an instrument in the current market environment are not reasons that justify maintaining an investment’s value at par or at cost.
    • Even if there is no observable trade activity, the fair value definition requires us to consider what a market participant would pay for the debt instrument in a hypothetical sale as of the valuation date, irrespective of whether the investor intends to hold the instrument until maturity or prepayment.
    • Some investment policies hold investment values at cost for recent transactions in highly illiquid or complex instruments. This is not consistent with fair value, which must be determined at the measurement date, given a market participant’s assumptions.
    • Fair value may, depending on the facts and circumstances at the measurement date, equal par or cost.
  • Infrequently traded or non-traded investments, such as individual private debt investments, are historically less volatile than actively traded investments, as they are more isolated from large capital markets inflows and outflows of the actively traded public markets.
    • Caution should be exercised when benchmarking private assets. When using yield calibration methods (to assess changes since acquisition date) for valuing non-traded debt, for example, if the instrument is less sensitive to public/observable market conditions, a 1:1 calibration factor may incorporate excess volatility that is unique to the public markets.  It may be appropriate to narrow the calibration factors.  The degree to which the private markets are correlated to public markets must be assessed, and the process and rationale for conclusions documented appropriately.
    • Prices from observable transactions (if deemed to be orderly) for investments that are not actively traded, should be given appropriate weight.
  • Care must be taken not to “double dip” with respect to valuation inputs, whether using a market method or income method via a discounted cash flow (DCF) approach.
    • If an instrument is required to be reported at fair value, market participant views at the measurement date must be incorporated.  In the current environment, there is greater uncertainty, implying there may be greater risk, and market participants will require higher returns (discount rates), which may result in lower values.
    • Market participants would likely project lower cash flows, adjust the timing and expectation of ultimate return of principal, as well as increase the discount spreads applied to the instrument.
    • The valuation assumptions must be reasonable, supportable and result in fair value changes that are intuitively correct in direction and in magnitude.  Applying higher discount spreads that incorporate consideration of higher defaults and ultimately lower cash flows, while at the same time, fully risk-adjusting the cash flows to which the resulting discount rate is applied would be inappropriate and would result in an erroneous magnitude of change in fair value.
  • If there has been a significant decline in the volume or level of activity for the asset or liability, further analysis is required.  Adjustments to transaction prices, or quoted prices, or other information historically used may be required, potentially including a change in valuation methodology; use of multiple valuation techniques and sources of information may be appropriate in order to corroborate results or derive weighted valuations.

  • In this market environment, the use of broker quotes, or automated vendor pricing that synthesizes broker quotes, should be scrutinized to ensure that the quotes are contemporaneous and actionable. That is, they should credibly reflect current market conditions at the measurement date, be free of conflicting influences, binding on the broker or dealer and free of restrictions or limitations.  If not, it may be necessary to move from Level 1 or 2 inputs to Level 3 (unobservable model-based) inputs.
    • This volatile market environment requires focused assessment of the unique facts and circumstances of each broker quote, transaction data, and valuation in the context of the broader market environment.  See guidance on the use of broker quotes and pricing services:  PCAOB Auditing Standard 2501, Appendix A, AICPA Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies, Ch. 13 and AIMA Guide to Sound Practices for the Valuation of Investments 2018, Chs. 7 & 8.

The current environment requires enhanced consideration of individual facts and circumstances with a rapidly changing macro overlay.  Following robust established valuation processes, exercising informed judgment and following the concepts outlined in the FIPF will ensure useful supportable valuations.  The contents of this article are selected considerations for estimating fair value and are not intended to be comprehensive.   Readers should use FASB ASC Topic 820 as a primary resource, along with the FIPF and other resources such as the AICPA Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies.

For more information contact Andrew J. Taddei | 212-871-0492 | andrew.taddei@duffandphelps.com

Andrew J. Taddei is a Managing Director in the Alternative Asset Advisory practice at Duff & Phelps, responsible for the valuation of financial instruments across the spectrum of cash and synthetic products, from securitization interests and their collateral loan pools, to other structured investments and derivatives. He serves as a member of the AICPA’s Financial Instruments Task Force.

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