Investors looking to finalize the carrying values of their investments at 31 March 2020 are doing so in a period of unprecedented social and community disruption, as governments seek to counter the spread of a new coronavirus that causes the COVID-19 disease. These necessary measures will likely lead to an extended period of economic downturn and profound disruption to established business and financial systems.
Given the limited time available to assess the impact of the current environment on the cash flows and inherent risks of the investment companies, the initial reaction of some may be to apply an ad-hoc adjustment to equity returns to address potential value impacts. We firmly believe any adjustment to value should be assessed on an individual investment basis, keeping in mind a number of factors.
To assist you in setting your carrying values at 31 March 2020, we have set out below our considerations when thinking about the key issues that will shape the extent of the value impact on any individual asset, as well as the implications on equity returns.
For context, there are currently more issues at play than just COVID-19. The equity markets had been on a strong run since the dislocation of the Global Financial Crisis (GFC) and European Debt Crisis passed in 2012. Throughout 2018 and 2019, central banks sought to take measures to unwind the monetary stimulus that had been applied during the GFC as equity markets surpassed record levels. Pressure from political leaders and the business lobby stifled the central banks efforts and as a result, expectations of continued economic growth through 2020 were being tempered by the end of 2019 as economic pressures built. Whilst COVID-19 proved to be the catalyst, amplified by concerns over the oil price tensions between Saudi Arabia and Russia, the reaction of the financial markets finally reflected concerns for short-term growth and the deeper risks in the economy, which were starting to be considered in the valuation of unlisted investments through a dampening of growth expectations, subdued inflation and increasing cost control measures. The impact of this position was seen in a diversion in the capital growth of unlisted investments against the pricing of listed comparables over 2019 and early 2020.
The profile of the recovery will be a bigger determinant of value impact than the movement in equity markets. We have a sense of the potential duration of the government measures to arrest the spread of COVID-19 – two to four months of broad “lock-down” measures (China is just now starting to re-engage its factories, some two months after initial lock-down measures). From that point, there will be a period to return to previous activity levels or, for some sectors, establish a new normal. The shape of this return, whether it is an optimistic “V” shape, a more realistic “U” shape or a more concerning “L” shape will be a major contributor to the overall value impact on investments, as well as the timing of the recovery of equity markets in general. Contributing to the speed of recovery will be the success of the widespread global government stimulus measures announced to support industries and individuals in negotiating the downturn. However, whilst these measures may soften the immediate impact, the cost of funding these measures is likely to create a prolonged longer term drag on economic performance. At this moment, it is difficult to estimate what the impact on European economies in 2020 and beyond will be. According to the UK’s latest quarterly Economic Outlook, the impact of COVID-19 is expected to see the UK economy contract by 2.6% in 2020, assuming the pandemic can be contained by the summer, with a sharp recovery in the first half of 2021 as uncertainties around the pandemic dissipate. If the pandemic persists however until the second half of this year, Gross domestic product (GDP) could contract by 5.4% and by another 1.4% in 2021. No doubt in the coming weeks, we will get a better view on the actual economic impact thus far (Q1), which should allow to update the projections.
The value impact is dependent on the characteristics of the individual investments. Demand based assets are most at risk from a downward value adjustment, particularly those investments exposed to the travel sector (e.g. airports) and directly correlated with GDP performance (e.g. ports). Availability based or regulated assets are expected to be more stable at a revenue level, unless broader economic pressures force changes to contractual mechanisms. However, demand based assets will have the potential to recover quicker when economic activity returns and will also be potential beneficiaries of initial government stimulus measures. As a result, it will be important to assess the opportunities available to manage cash flows to mitigate short-term revenue impacts and scenario modelling of adjustments to capital expenditure profiles operational expenditure and distribution/financing flows will be important in understanding value impacts.
The capital expenditure profile may provide flexibility in managing cash flow. Discretionary capital expenditure spend, particularly when associated with expansion programs, will provide an opportunity for investment companies to manage cash flow in the short- to medium-term through the deferral of projects. This may mitigate adverse short-term value impacts, although it will also potentially affect growth in the medium- to long-term. For those assets with high capital expenditure requirements, a reduction in the capital expenditure profile may also reduce equity risk to the extent delivery and execution risk had been previously factored into the assessment of the overall equity return.
Gearing position and timing of refinancing events can increase risk. Governments have taken action to maintain liquidity in credit markets. However, consideration will need to be given to the funding position of each investment, particularly if there are indications that the credit markets may be constricted. Of particular interest will be:
Counterparty risk will be amplified. A broad economic downturn will increase counterparty risk and the potential for default on existing obligations. Those investments more exposed to counterparty risk (low credit rated counterparties or operating in high risk industries and/or jurisdictions), will be viewed as higher risk.
The value impact may be greater for shorter life assets. Those investments with a shorter concession period or asset life, will feel the impact, on an absolute value basis, of any short term cash flow impact to a greater degree than longer life or perpetual investments. The shape of the recovery (“V”, “U” or “L”) is important for all investments but is critical to investments with shorter lives.
The value contribution from the terminal value may increase. For those companies that do not have whole of life forecasts it is likely that a greater percentage of overall value will be associated with the terminal value period. Inherently, this will require increased focus on the assumptions driving the terminal value and the supporting evidence utilized to establish the long term growth assumption.
Equity returns are being influenced by a range of factors. Whilst investors may see equity risk as being higher today than it was a month ago, it is difficult to derive the impact of the crisis on the different components. One of the complications is the robustness of the indicators flowing from the markets – since early January 2020, Belgium’s 10-year government bond yields declined from 0.089% p.a. to a low of -0.316% p.a. on 9 March 2020, after which a steep increase was witnessed to 0.413% p.a. on 18 March 2020 (just nine days later), possibly as a result of further risk aversion driving funds away from bonds to cash. By the end of March, it had decreased again to 0.05%. The same volatility that we see in bond markets is being seen in equity markets, meaning the quantification of adjustments based on market data in an unstable market may be problematic given the difficulty in identifying the factors driving the market movements – is it repricing of equity return expectations, short- to medium-term earnings reductions, or purely market sentiment driving market performance?
Introducing an equity premium based on share market performance since the emergence of COVID-19 may overstate the potential value impact to certain defensive asset classes. The reaction of equity markets in periods of significant dislocation is often one that initially reprices all equities in a similar fashion, before the defensive characteristics of certain sectors are recognized and repriced appropriately (companies which are not otherwise expected to be impacted can initially be sold to cover liquidity requirements elsewhere in broader investment portfolios). Valuers of unlisted investments have generally sought to separate the emotional response of markets which tends to drive “price”, both on the upside and the downside, as opposed to “value”. This is particularly necessary in periods of market dislocation.
The period by which you measure relative equity market performance is important. Equity markets have declined substantially from their peaks in early 2020. Notwithstanding that we consider a relative assessment to the performance of equity markets in times of dislocation flawed, any assessment should be done over a consistent time period. For many infrastructure asset classes, equity market performance over the course of 2019 was very strong, meaning year-on-year price movement, even post recent market declines, was positive or at worst, flat. Therefore making adjustments based on a short period of market dislocation may not be appropriate.
Use the valuation range where necessary. Valuations are typically presented as a range, with the mid-point of that range often being the stated point-estimate of value. Given the uncertainties that exist and the limited information initially available to assess the impact, we consider the risk is currently skewed to the downside. Therefore, consideration should be given to where in the valuation range the point estimate of value is selected, with the lower end perhaps better reflecting the increased risk aversion of market participants.
The frequency of valuations should increase. The balance date of 31 March 2020 is the first quarterly period where the extent of the COVID-19 issue is known, and at this time, detailed analysis of the cash flow impacts and potential mitigations have not been made. As a result, subsequent valuation processes will have access to deeper information to allow a progressively more informed assessment. This may result in changed views as to the inherent risks of specific sectors, as well as the differing profiles adopted by participants within any given sector as they return to “normal”.
For that reason, it is recommended that those investors who do not undertake quarterly valuation cycles adopt a more frequent valuation cycle during this period and all investors initiate the reforecasting and valuation processes earlier than usual.
Macro-economic assumptions also require review. The dislocation in the financial markets is also impacting the sources used to support macro-economic assumptions, such as base lending rates, exchange rates and inflation rates. Simply adopting forward curves is not recommended in any valuation, but it is particularly so in the current environment.
Financial reporting and impairment considerations. Impairment assessments will be a key focus of forthcoming audit processes. Evidence to support that underlying financial information has been prepared on a reasonable and supportable basis will be an important part of the process. Demonstrating an appropriate balance of risk assessment between the discount rate and the cash flows will be required to give the auditor appropriate levels of comfort.
Jorn De Neve
T: +32 2 708 47 78
T: +32 2 708 38 55