Valuation With A Capital V
Dow Jones Daily Bankruptcy Review. October 10, 2007
Over the last couple of years, valuation seemed to be a dying discipline. After all, in endlessly rising markets where everyone seemed to be making money, there weren't too many arguments over valuation anyway. It was all good. Now, however, the recent enthusiasm in equity markets notwithstanding, it seems that what we at Miller Mathis fondly refer to as the days of "surreal valuation" are gone - and good riddance too. The huge surge of liquidity flooding into financial assets over the last few years contributed to asset bubbles in real estate and private equity, as well as in structured finance vehicles based on those assets (even just bets on the performance of assets).
Somewhere along the way, price became disconnected from value, the divergence facilitated by the fact that, more than any other time in the history of modern financial markets, so much money was invested in illiquid and/or opaque vehicles whose value relied more on the say-so of vested interests than it did on the independent analysis of a multitude of players in an active market. Now, however, the extent of the divergence has truly begun to reveal itself. With the stark realization that investments can actually diminish in value, "Valuation" itself has again begun attracting attention and we expect to see much greater scrutiny given to its methodologies and outcomes going forward - in financial reporting, for sure, but also in litigation which will undoubtedly pick up, as it has a tendency to do when people lose money.
We have already seen intense debate over the recent earnings releases from major financial firms, delivered as they were under the new construct of FAS 157, Fair Value Measurements, and within a market downdraft in the pricing of myriad securities. Analysts have spent hours scouring the releases trying to determine whether reported write-downs really reflected all the damage that the markets were levying on bank holdings in subprime and derivatives and leveraged loans. But trying to get a solid handle on the numbers produced by the FAS 157 three-tiered valuation matrix - Level 1 covering instruments that are valued using quoted prices in active markets, Level 2 pertaining to investments valued using observable data "inputs" and Level 3 valued on the cryptically named "unobservable data" - is proving difficult.
Among the concerns are the differences in the extent of write-downs among firms - leaving observers with the unanswered question of whether a bigger writedown implied a less tolerant view of the value of dubious securities or recognition of past practices that were riskier than the norm. What about positions that were moved from Level 2 to Level 3 - what were those shifts all about? Did there cease to be observable inputs for those valuations or did someone just not like what he saw? And while justifiable attention is being paid to the treatment of Level 3 assets, now popularly referred to as "marked to myth", a few questions are also being directed at Level 2
accounting which offers perhaps more room to maneuver than was initially realized. At the end of the day, it's not clear that any real conclusions can be drawn about whether a balance sheet is sitting on embedded losses that, in the absence of a return to the halcyon days of 2006, will be dribbled out over time or is, in fact, a reflection of the reality that exists today. Time will tell. If it turns out that companies have been blindly optimistic on their valuations even after the wakeup call delivered by the end-of-summer market action, assume that the class action bar will jump all over overly generous valuations, marshalling a platoon of witnesses to demonstrate what should've been known and should've been reported earlier. As we approach year end, it is likely that we will see similar attention directed at the valuations produced by hedge and private equity funds. Hedge funds, who benefit most directly from optimistic valuation (given a compensation package that rises and falls with valuation changes whether realized or not) will likely be asked to provide greater substantiation of the validity of their positions - relying on Cayman Island administrators to compute complicated net asset values or attest to the accuracy of some vague quote on a five-dimensional never-traded security may not be enough anymore for investors who've taken a beating.
Private equity firms will not lag far behind in the valuation scramble, but compared to hedge funds, they may find the heat on current carrying values is only turned up a little (although the recent write-downs of loans across the leveraged finance market certainly beg the question of whether the private equity deals which sucked in all those loans themselves should receive some sort of downward valuation adjustment). More likely, private equity firms will find themselves thrown into the valuation arena on deals gone bad. With the betting money on a sharply higher leveraged loan default rate over the next few years, those days may be coming soon. Should a private equity portfolio company go truly sour, battles for control or, worst case, distributions from the corpse, may be epic. Many of those skirmishes will begin and end with valuation.
Second lien holders, who in happier times may have thought that their lien actually meant they were secured by something, may become activists in valuation fights - either early, to demonstrate at least some level of secured status and accrue rights as secured creditors, or later in fraudulent conveyance actions, perhaps to challenge some pre-bankruptcy dividend recapitalization with the belief that recoveries from such actions may be not be subject to a first lienholder's unsatisfied lien. Of course, if they are slow off the valuation mark, other creditor classes will be happy to fill the vacuum with their own valuations, or perhaps with pleadings to the court asserting that the desperate straits of the debtor do not leave time for valuation challenges.
Players gearing up for valuation battles should be forewarned, however. Judges have grown quite sophisticated about valuation in the past few years. Many are completely cognizant about the relative appropriateness of differing methodologies and discount rates and perfectly capable of sussing out biased assumptions. Those who would play fast and loose with valuation models may
find, as did the company and the financial sponsors in the Nellson Nutraceutical bankruptcy, that they'll have their heads handed to them. Even in court, it seems, surreal valuations are losing their hypnotic powers.