Q&A: Valuation challenges in distressed situations
January 2015 | SPECIAL REPORT: DISTRESSED M&A AND INVESTING
Financier Worldwide Magazine
FW moderates a discussion on valuation challenges in distressed situations between Tony Loughran at Cushman & Wakefield, Cindy Ma at Houlihan Lokey, Jeremy Handley at JLL, and Gardner Dudley at Liquidity Services.
FW: Could you outline some of the main reasons why distressed investors seek independent valuations? How do such valuations assist the process?
Ma: Distressed investors seek independent valuations for a number of reasons. Most alternative asset managers face increased scrutiny of their financial reporting from the SEC and other regulatory bodies and so look to independent valuation firms to assist them in increasing their transparency. Many asset managers are also looking to independent valuation firms as a means of obtaining a second opinion on an investment thesis before deploying or investing large amounts of capital. An investor may also engage an independent valuation in order to improve their understanding of an emerging asset class and so improve liquidity. Regulators continue to focus on the capital adequacy of banks and other financial institutions within their purview. We expect to see these institutions continue to shed assets that are seen as high users of capital, with a particular focus on shedding distressed assets. Investors in distressed assets have been actively raising funds to capitalise on this theme of late. As these distressed assets get put into play, we expect to see more demand for distressed valuation from both the financial institutions that hold them presently, and the new investors that ultimately purchase them.
Dudley: Independent valuations provide outside, objective expertise from a third party utilising asset, industry and market knowledge. Well-researched market based valuations serve as reliable indicators. They can help inform the buying or selling price for the purposes of negotiations as well as providing a ‘worst case’ asset value.
Handley: Investors in distressed real estate and non-performing loans use valuations not only to ascertain current market pricing but also to provide due diligence. A well instructed valuation can add significantly to the understanding of the property and portfolio and provide significant input which will allow an investor to make the commercial decisions necessary as part of the purchase process. Borrowers or current owners of distressed real estate or loans will often use a valuation to allow them to have a more informed conversation with other parties, such as lenders. The valuation process can add much to this conversation by providing clarity on the current market, but also input on the value implications of business plans and an analysis of the future risk.
Loughran: We have worked with many opportunity funds over the last 3-4 years. They have a common trait of seeking to appoint non-commission based real estate advisers in order to avoid potential conflicts of interest arising that may compromise the objectivity of the adviser’s opinion. The fact is that information is usually limited and timelines are tight, hence there is scope for considerable subjectivity in the analysis. Often it will be the case that, rather than appointing one sole adviser, the investor client wants as many opinions as possible, using contrasting views and data sources to home in on where market value lies. If information were more complete, then the analysis could be more akin to a traditional real estate investment deal with virtually full disclosure on the part of the vendor and the client being advised by a single specialist real estate adviser who runs the analysis and advises on the optimum strategy and business plan.
FW: How does the nature of distressed assets, as well as different asset classes, impact the valuation process and the approach used?
Dudley: The nature of distressed assets and the variety of potential uses for the valuation process means that selecting the appropriate basis of value is paramount. High risk aspects such as asset condition must be considered carefully as maintenance can be neglected due to a lack of funds. Certain assets may be inextricably tied to the company’s products and may therefore have a lower value in a distressed scenario. Market evidence for similar assets is typically the ideal resource, but it requires an experienced valuer to interpret the data as it applies to the specific assets and also provide realistic and robust appraisals where there is a limited amount of data available. A good partner can identify the important points to be aware of regardless of the industry and market.
Handley: The valuation process for assets or loans which are distressed is fundamentally no different to any other valuation. However, the circumstances are very often different, in that there is either time pressure or a lack of detailed information on which to base the advice. In particular, properties which are held within a cash-starved vehicle often lack the capex necessary to maximise value. In addition, active management is often neglected. The challenge for the valuer is to ascertain the latent value of the asset and the extent to which the market will pay for it. Correctly positioned, this is often the reason for buying this type of asset.
Loughran: Distressed assets come in many forms, ranging from leased commercial investments to vacant residential property and land. Each category of property will appeal to a distinct target market, with different categories of buyer employing different thought processes and methodology. The principal approaches to value are based on cost, comparable and rent capitalisation methodologies with many buyers, especially of distressed product, often analysing on the basis of all three of these methods. Where the distressed target is a loan rather than an asset, the approach becomes more complex, with less emphasis on the value today and more on the likely evolution of value towards the expected timeframe when possession may be taken of the underlying asset.
Ma: Distressed assets encompass a wide variety of asset classes and situations involving ‘stressed’ issuers and portfolio companies. Due to the nature of distressed assets, their valuation requires a more exhaustive process which involves different valuation methodologies and wide-ranging considerations in the analysis. Depending on the type of asset, the valuation may employ, to name a few, a yield approach, asset coverage method or liquidation analysis, or a combination of these methods. Furthermore, the techniques used to value distressed assets need to take into consideration the circumstances surrounding the issuer and investors. This involves estimating a range of possible outcomes or an expected outcome, understanding the extent to which the investor can influence those outcomes, and evaluating the risks and uncertainties around those outcomes. The greater the uncertainty involved, the more difficult the valuation, and distressed assets often have a high level of uncertainty.
FW: Are you seeing more focus on strategic value, potential recovery and future realisation when valuing distressed assets?
Loughran: Whether the target acquisition is a distressed loan or asset, the emphasis tends to be on where the value is headed. Often the future exit value is the primary consideration, with all of the emphasis on strategy and business plan during the hold period in order to achieve a certain target exit price, although subject to different scenarios as to market evolution. This isn’t to say that today’s scenarios are not relevant, it is simply that the value today can only be justified via a clear thought process that shows how required returns can be delivered.
Ma: Strategic value, potential recovery and future realisation are all critical factors that need to be focused on and carefully considered when valuing distressed assets. However, timing and probability of success are arguably equally, if not more, critical to the analysis. As we all know, a dollar today is worth more than a dollar tomorrow. In the same light, a dollar of recovery later this month is worth more than the same dollar of recovery years from now. Estimating potential recovery and future realisation is a necessary step in the valuation process, but if it is not coupled with reasonable timing and probability assumptions, the analysis, at the end of the day, failed to fully capture all the applicable risk factors, and as such, the resulting value may be quite misleading.
Handley: The market has moved on very significantly in the UK in the last 18 months. A year or two ago investors were looking at investing in distressed situations as an opportunity to buy unloved assets with good recovery potential at the bottom of the market. The investment of time, expertise and capex should drive significant recovery in values. In many cases, the market has performed this function, so value investors are finding it more difficult to source potentially undervalued assets in the market. That said, this is still a focus for many buyers seeking to buy in bulk, investing both time and money in assets and looking to capitalise on a break up scenario.
Dudley: Investors in distressed assets need to consider the variety of potential outcomes as early as possible. Nowadays, it is rare that an investor will want to face a wholesale closure and disposal of individual assets, but it is a scenario they need to consider in the event that a business cannot be turned around. They may also seek to sell individual lines of equipment, raise capital or consolidate existing finance agreements to support a business going forward. A valuation report giving multiple bases of value, combined with a risk-based approach, will allow companies to consider the various options available. In particular, a valuation company with good links to the asset finance industry, as well as active experience selling assets, ensures that all advice is relevant and comes from direct experience.
FW: To what extent do intangible assets pose significant valuation challenges? How can parties ensure that their value is recognised correctly at the outset?
Ma: When considering distressed situations, some investors will look to the value of the underlying assets of the entity in distress, including the intangible assets. There are a wide variety of intangible assets, including trademarks, trade names, patents and other related intellectual property, service and management contracts, supply and off-take agreements, real property leases and customer lists, to name a few. In most non-distressed situations, the value of intangible assets is generally considered as part of a going concern. That is, they are valued ‘in use’, considering the value they add as an integral part of the entire entity and not necessarily their value on a standalone basis. However, in distressed situations where a going concern assumption is in question, the investor may be more concerned with the value of the asset on a standalone basis, or in liquidation. In many cases the liquidation value and the ‘value-in-use’ may be materially different. Distressed investors should carefully consider the nature and use of the intangible assets that underlie an investment, as well as the impact that the distressed status may have on that intangible asset.
Dudley: While market evidence is the best approach for most surplus assets, intangible assets can pose a challenge due to a lack of similar assets in the market to provide a readily available benchmark for measurement. From customer lists and technologies to logos and web domains, intangible assets can vary greatly and each requires a custom approach from an expert valuations provider. Opening up the owner or seller’s financial books to view historical and projected cash flow – utilising discounted cash flow or DCF methods – provides a reliable starting point for an informed valuation. Furthermore, a firm experienced in valuing intangible assets will undertake a significant amount of research using the data available.
Loughran: If the target of an acquisition is a company, then intangibles may well form part of the analysis, considering items such as brand, goodwill, intellectual property, and so on. However, there will normally be a multi-disciplinary team involved in any such acquisition with the property professional unlikely to advise in this area, limiting or caveating any advice to tangible assets and, more specifically, what constitutes the real estate element of the business.
FW: Distressed situations often demand an accelerated process. How do valuation professionals overcome the issue of working quickly with limited data sets?
Handley: The key to advising in distressed situations – where limited information is available and the timeline is often demanding – is twofold. Firstly, it is important to set a trusted and clear process which allows for the teasing out of as much information as possible. Secondly, use an experienced and confident team to be able to make appropriate assumptions based on their experience. Both require specialist experience and often a large team with the emphasis on deep local market expertise. As part of this approach, it is clearly important to ensure that the client has a full understanding of the limitations of this type of exercise. On the other hand, even with these limitations in mind, valuers can provide greatly enhanced knowledge and understanding of the portfolio and allow potential investors to make their decisions based on the best advice and information available.
Loughran: Opportunity funds will often employ more than one valuer to assist in the assimilation of data and its analysis in order to arrive at an understanding of the deal as quickly as possible. Also, with different professionals involved in the process, each with contrasting views, this facilitates productive debate on the key issues and assumptions of the analysis. Nevertheless, the lack of base data provided by the vendor can often pose such difficulties that the only option of both valuer and client is to act as prudently as possible. Generally, the better the quality of base data that vendors can provide, the better the offer levels that they receive.
Dudley: Non-urgent scenarios for distressed assets are the exception, rather than the rule. Any valuation professional active in this market knows that the advice needs to be turned around quickly without any compromise on accuracy. Access to an in-house comprehensive database of asset sales can accelerate the speed of turnaround. Where data is limited, there is no substitute for a wide range of industry experience. Often it is equally important to identify risk factors that can impact the value of the assets. Performing this function in a timely fashion requires a team of professionals that have a breadth of experience.
Ma: The nature of valuing a distressed asset may, at times, need to account for compressed timing issues, limited availability of information, or both. When undertaking a distressed valuation in such circumstances, it is critical for the valuation analysis and report to clearly lay out the limitation of such information, as well as the necessary underlying assumptions that are made in the absence of such information. Ultimately, the valuation analysis and report should discuss the impact on value resulting from such limited information and related assumptions. Depending upon the purpose of the valuation and the needs of the client, it may also be helpful to lay out the impact that a change in one or more assumptions would have on the concluded value of the asset. Furthermore, in such situations, it is helpful, if not critical, for the valuation professional to be familiar with the specific industry, market and general environment in which the distressed asset resides.
FW: Could you provide an insight into the legal and fiscal challenges that might apply when valuing assets for cross-border distressed deals? How beneficial is local market knowledge in these circumstances?
Dudley: Local market knowledge that comes from having professional valuation teams distributed worldwide can make a big difference in cross-border deals. Getting people on the ground quickly is only possible when the valuation firm is a truly global operator. Local regulations and legislation – such as VAT and duty, export and import regulations, certificates of origin, and other legal and financial factors – must all be considered.
Ma: All assets, whether distressed or not, face numerous valuation challenges when confronted with cross-border circumstances. However, distressed assets have a tendency to only further this complexity. Apart from the obvious language, cultural and even currency differences, cross-border distressed deals may bring to light some of the more complicated tax codes and bankruptcy laws that may be unique to a local jurisdiction. While comparable and reliable liquid market data may be readily available for the US and other developed markets, this is generally not the case when valuing distressed assets from less developed or emerging markets. In addition, the expected cash flows, applicable waterfalls and ultimate timing could vary significantly depending on the applicable bankruptcy laws for a particular jurisdiction. The bankruptcy and restructuring framework in the US and Europe are fairly well known, understood and documented. However, applying a precedent previously set by one of these better known bankruptcy jurisdictions may generally not be applicable or reasonable for all geographies. Therefore, it is absolutely critical that the deal team is equipped with local market knowledge and experienced legal counsel in these particular circumstances.
Handley: The main legal challenges are centred on having an understanding of the legal framework of property ownership as well as knowledge of landlord and tenant law in different jurisdictions. Experience in these areas is pivotal to providing accurate advice as they will have a significant bearing on how a valuation is approached. Fiscal challenges include the need to reflect country level economic policy in valuations. This varies between jurisdictions and is more difficult to reflect as it has no direct quantifiable impact on real estate pricing, which tends to be slow to react to changes in fiscal policy. The key to providing good advice in distressed situations is to use an experienced team with local knowledge and strong central coordination. This is even more vital when dealing with different jurisdictions and less transparent markets. On this basis, having local teams who are not only experienced in terms of valuation, but also have immediate access to leasing and capital markets colleagues to provide input in real-time, is essential.
Loughran: Costs of purchase, landlord and tenant law and practice, yield definitions and many other aspects vary across borders. Local market knowledge is therefore essential, especially when working to tight timeframes.
FW: How can valuation professionals ensure their process and approach is fully transparent? How important is it to conduct valuations of distressed assets on this basis?
Loughran: Often the full workings that support the value opinion are entirely shared, with either the valuer adopting the client’s model or the valuer providing the client with access to full workings. With tight timeframes there is often no option but to work closely together, sharing in every detail of the analysis. Besides the technical analysis of value, there will also be close collaboration in sharing market intelligence on past and current market activity, in respect of comparable pricing evidence and so on. Ultimately, there are numerous variables in any valuation where both valuer and client need to quickly form a consensus in order for the investor to confidently progress to the offer and closing stage of any deal.
Ma: When it comes to valuation process and approach, transparency is crucial. Clients and, as importantly, their constituents, whether it is LP investors, auditors or regulators, all have an expectation that valuation processes and approaches will be well articulated, well defined and properly documented. Historically, the valuation profession has been highly fragmented and has not necessarily been consistent in its approach to the fair value of illiquid or distressed assets. As such, the goal of the International Valuation Standards Council (IVSC) is to set principles and requirements aimed at ensuring appropriate rigour and transparency in undertaking and reporting valuations for all major asset classes. IVSC aims to help the valuation profession make progress in harmonising the views of industry participants, auditors, and valuation practitioners. Valuation reports should be designed to ensure that clients can identify the key assumptions and limitations underlying a valuation. Accordingly, a significant amount of judgment is required when valuing any illiquid assets. For valuation providers, a critical part of the job is to make sure that each of these judgments is identified and discussed as part of the overall analysis. When distressed assets are the subject of the valuation, such considerations may become even more important, as the ultimate value of a distressed asset may be extremely sensitive to the assumed recovery, timing and strategic value of that asset.
Dudley: Any asset valuation should be conducted in a transparent manner, and distressed asset appraisals are no different. Valuers are professionals with a code of conduct regardless of whether they are accredited by the RICS, ASA or another body. Asset values are not simply pulled from the air – any good valuation report should be clear about the methods used and the sources of data, as well as indicating the level of risk and potential inconsistency in a market. For example, in a large and active market, such as motor vehicles, there is a smaller range of likely realisations for a given item. For specialised assets with a limited market, it can be about maximising the exit period to find the optimum buyer. Any limitation on the timescale, as is often the case in distressed scenarios, can impact the actual realisation from a sale.
Handley: The speed and lack of information which often typifies valuation advice in distressed situations means that clients need to understand the limitations of the exercise when compared with the more traditional ‘belt and braces’ style of reporting and due diligence. It is imperative both from the valuers’ point of view, as well as from the client’s perspective, that these limitations, and the risks they represent, are fully understood and mitigated wherever possible. As always, the circumstances will often dictate the extent to which it is possible to undertake detailed market research and detailed due diligence. For example, internal inspections are often not possible in distressed situations as frequently the borrower or tenant is not aware of the process. A partnership approach between advisory and client, with an open dialogue, will help to ensure that both the client and valuer are pulling in the same direction and that the advice that is required for decision making is provided in the most transparent way possible. As part of this, there needs to be a clear understanding of the information available and the approach to the due diligence to allow clear decision making on the part of the investor.
Tony Loughran is a partner and head of valuation & advisory at Cushman & Wakefield in Spain. He joined Cushman & Wakefield in September 2000 and prior to that, worked in London for Colliers as an office agent, active in the Thames Valley and the South East of England. He has acted on behalf of a number of leading funds, property companies and banks in Spain, handling valuations for financial reporting purposes, loan security as well as deal related advice. He can be contacted on +34 91 781 0010 or by email: firstname.lastname@example.org.
Dr Cindy Ma is the Global Head of Houlihan Lokey’s Portfolio Valuation & Advisory Services practice, focusing on illiquid and complex securities valuation. She is a member of the firm’s Technical Standards Committee and is also a member of the Standards Board of the International Valuation Standards Council (IVSC). She is based in Houlihan Lokey’s New York office. He can be contacted on +1 (212) 497 7970 or by email: email@example.com.
Jeremy Handley is a director in Loan Security valuation at JLL, a financial and professional services firm specialising in real estate services and investment management. With 28 years of valuation experience, Mr Handley provides investors and lenders with advice relating to real estate valuation, strategic advice, risk assessment and valuations for secured lending purposes. He can be contacted on +44 (0)20 7399 5813 or by email: firstname.lastname@example.org.
Gardner Dudley serves as president for Liquidity Services’ Capital Assets Group, which includes Liquidity Services’ award-winning marketplaces Government Liquidation, GoIndustry DoveBid, Network International, and Truck Center. As the top executive for the Capital Assets Group, Mr Dudley’s team is shaping the way that surplus capital assets are managed, valued and sold. In this role, he is furthering the company’s ability to meet client needs for superior service, scale and results while expanding and unifying its capital assets business. He can be contacted on +1 (713) 590 1575 or by email: email@example.com.
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