Determining impairments despite the rebound in both equity and debt markets

Steve Katz  0:09
Hello again and welcome to the Hilco Global Smarter Perspective podcast series. I’m your host Steve Katz. Today we’re speaking with John Fenn, Senior Managing Director of Hilco Enterprise Valuation Services about the importance of a continued commitment to determining impairments despite the rebound in both equity and debt markets, as well as recommended best practices in both enterprise valuation and portfolio review during the ongoing pandemic. John’s enterprise valuation team is part of Hilco Valuation Services and is a global leader in providing reliable opinions for financial institutions, investment firms on the realizable value of going concerns, intangible assets, illiquid investments, and other specialized business assets. With that said, welcome to the podcast, John.

John Fenn  0:52
Hi, Steve.  Thanks for having me on today.

Steve Katz  0:54
Yeah, absolutely. We’re glad you could join us today. So John, I know there’s widespread relief that debt and equity markets have largely recovered on both price and spread. And that current valuations are also significantly elevated as compared with what we saw, say at the end of Q1 and the start of Q2. So given this, why, in your opinion, is it still so important for businesses to remain diligent in determining impairments right now?

John Fenn  1:19
Well, Steve, I think there are a lot of reasons for the increased diligence. I think one is a requirement, by the SEC, that if there is an impairment out there, you need to declare it as quickly as possible. But I think more importantly, as we think about what happened at the end of the first quarter, the market sold off significantly, there was an absolute rush to get impairments assessed, and there were certainly significant impairments that were identified at the time, spreads were wider risk was off, the Fed came in with significant liquidity and obviously saved the day we got both a cannon shot from the Fiscal side as well as the monetary side. But if you really think about the valuations that are in the marketplace today, particularly on the equity side, there is a case of the haves and the have nots, the stay at home stocks, that technology-based stocks have significantly rallied. While a lot of the old school industrial names and industries have not performed nearly as well. Those aren’t necessarily impaired but it’s not necessarily universal that all ships have risen with this massive amount of liquidity that ultimately came into the marketplace. I think is pretty well noted that the S&P 500 is being carried by five names or so which make up more than 20% of the overall valuation. So if you look at certain industries, retail, airlines, leisure, hospitality, the hotels, and gaming names, those are still significantly impacted. It’s not really clear as to when many of those industries will recover. And the fact of the matter is if you did a first quarter impairment, and you identified an impairment, the lack of improvement in some of these industries, in fact, some perhaps even continued deterioration in some of these industries, you’re going to see that there may be a need to reassess and take that impairment down, or take the asset value down another notch or two. It’s just not safe to assume that given the rally in the equity markets, given the tightening of the credit markets, that impairments are not necessarily an issue anymore. I think that as a requirement for financial reporting, investors, companies need to continue to stay on top of these things.

Steve Katz  3:40
It makes sense.  So given those points about the lack of improvement and reporting requirements, can you then layout for us how your team goes about accurately distinguishing between a temporary shock to a company’s cash flow and true impairment? And then also why it’s so critical for a company to leverage the right expertise to undertake and document the assumptions that are made as part of that process.

John Fenn  4:03
Sure, this is really the crux of how impairments are being assessed in the marketplace today by companies as well as investment management firms and those who have financial reporting requirements. To some extent, company management is a big part of this assessment impairment, whether or not they think that this is something that just creates a temporary blip, or whether or not it’s something that is ultimately long term. And I think you ultimately have to focus on a number of these types of situations. Take automotive suppliers for example, manufacturing was shut down. New vehicle manufacturing in this country will go from 17 million in 2019 to about 13 and a half million in 2020. That impacts every supplier through the supply chain. Does that mean that those suppliers are impaired? Not necessarily. It could be that if they drop off of certain platforms they may be impacted longer term, but the idea that they just don’t have as much work in 2020 doesn’t necessarily mean it’s an impact. So whether management thinks that they can come out of this in 2021 at a same run rate they would be at in ’19 or it takes till 2022, those will be embedded in the projections. The real question is, how long does it take to get back to prior run rates? How much are the finances ultimately impacted by that? Retail, another perfectly good example of this thing. There are great stories in the retail space. The big-box guys are all performing very well. Those who had adapted to e-commerce as opposed to just a bricks and mortar strategy have not necessarily suffered at all. And yet, we have a very, very high level of retail bankruptcies. Those who were already on a path to careen into a problematic place in the retail space, really probably just saw that problem exacerbated and accelerated by the pandemic.  No customers walking in, not really a well-developed e-commerce platform, and therefore you have a formula for a significant run-off in your cash flows in the like. We’ve seen a spike in bankruptcy in the fitness center space. Now, does that mean people are no longer interested in fitness? Of course not. Peloton is performing well. The stay at home stocks and stay at home pieces of that industry are performing well. Yet, we’ve seen all these major fitness center bankruptcies and frankly, if you ran into a liquidity crunch, and you have the content to needing to file, you saw your valuation collapse significantly. Whereas if you were able to survive, and you had a business model that wasn’t necessarily contingent upon members paying their dues, and you were on more of a franchise model, you perform quite well. So in a name, like Planet Fitness is actually still thriving with a very solid stock valuation, whereas those who have gone through the bankruptcy process now wind up trading for ultimately pennies on the dollar.

Steve Katz  7:09
Yeah, it’s amazing how some businesses within the same category managed to escape just based on the model, right? So in light of the lingering impacts of COVID, and factors, including those run rate considerations, you can probably guess that my next question is about step-ups in the value of assets on the books. Specifically, how do you go about assessing whether a business is still worth the stepped-up amount that’s reflected in goodwill? And how frequently should an assessment like that be done in this type of an environment?

John Fenn  7:39
Well, the frequency of it is at least once a year, if not more, depending on how much fluctuation you’re ultimately going to see in market value. But I think the assessment and what you’re getting at is really the crux of the whole impairment assessment game. There are two factors ultimately, that drive whether or not stepped-up asset values are actually worth it. The market is going to tell you what an investor is willing to pay for a unit of earnings to the extent that an industry has gone from 10 times earnings to 6 times earnings. Well, you’re getting a very solid signal that the market no longer values the earnings of a given industry as strongly as it had previously. And you try to do this on an apples to apples basis to make sure that you’re not getting caught up in the noise of lower earnings, which have an ability to ultimately increase your multiples. The second factor that you would obviously look at is just what the projections are with respect to earnings. If management’s view is that we’re not going to be as profitable in the future, and that lack of profitability in future years draws on for multiple years, well, I think it’s fair to say that there needs to be some type of an assessment of whether or not those stepped-up the asset in the goodwill is quite appropriate any anymore. Now, one of the things that one might say, to me is, well, aren’t they one wanting the same thing? And they actually are, it really comes down to what the strength of a signal is to the investor, the retail investor sitting at home who’s not necessarily involved in private equity or private companies that need to go through these types of things. They’re going to see what the multiples are. They’re not necessarily going to get a clear view on what management’s assessment are of a unit of earnings. But the factors are still there. And I still think that as management teams think about whether or not to take impairments or to ultimately write down asset values, they have to really assess their own internal models from a standpoint of thinking are these assets going to prove out to be worth what we ultimately paid for them in prior years. And that’s really the thought process behind having companies true up the books to reflect market reality and why impairment assessments are part of the financial discipline that’s imposed on you by the Commission.

Steve Katz  10:05
Yeah, makes sense. I like that strength of a signal thought too. I never really thought about that way. So that was very interesting. And I’m curious, and I’m sure our listeners are as well about how your team at Hilco is looking at factors such as discounted cash flows and terminal value in the work that you’re performing on behalf of clients during the pandemic. Is that somehow different now than it was pre-COVID? And if so, how?

John Fenn  10:31
Well, I think there are a couple things that ultimately, you know, we think about as we look at projections. I think one, you take projections with a lot more of a grain of salt these days, given the amount of uncertainty that exists in the marketplace, I don’t necessarily know anybody can say, with a tremendous amount of certainty that ’21 is a recovery year, as we think about the possibility of vaccine and the like, ’21 becomes a lot more optimistic and robust. And certainly, I think that’s reflected in the marketplace. I think if you look at things like bank stocks, and the like potential for release of reserves, lack of credit losses, etc., there’s a lot of optimism that’s embedded in the marketplace. That being said, for private companies, if you hand me a set of projections, that don’t necessarily reflect an impact of ’20, or an immediate recovery into ’21, despite the fact that you’re in an industry that has shown little ability to drive pricing or things of that nature, we’re going to probably take a lot more of a skeptical look at your numbers. We have to think about working capital. We have to think about CAPEX. Is CAPEX even necessary right now? Do companies stop going into growth mode, where working capital might have been a source of cash in ’20 because you weren’t doing as many sales? What’s the impact for ’21-’22 as your sales ultimately start to rebound? With respect to terminal values, I think that the one important thing to think about is if you had a set of projections at the end of ’19 and your terminal year in ’24 showed an EBITDA number that was in line with how your business was operating, the quicker you can get back to that point where that ’24 EBITDA kind of remains in line with expectations as to where you were pre-COVID, I think one pretty clear signal that you’re one not impaired, and two, that your valuation is going to hold up that much better. Because their thought process is your short term blip is ultimately driving an ability for management to have confidence that the profitability is ultimately there. We spent a lot of time looking at terminal values because we think the terminal values are going to be a pretty particularly for management projections is going to be a pretty clear impact as to whether or not there ultimately isn’t an impairment. I think with respect to the DCF, one of the things that we have obviously done is put a additional premiums into the way the average cost of capital the discount rate that we’re ultimately using, simply because of the uncertainty embedded in the projections. And I think this is something that any good valuation specialist is going to wind up doing just the fact is uncertainty should be addressed through the discounting mechanism, and what investors are going to do. If I expect a 20% return on my money, and I feel like there’s uncertainty as to whether or not that 20% is good, I might seek 22 or 25 in the future, knowing that I may only get the 20 anyway.

Steve Katz  13:40
Yep. Good points. Well John I’m thinking and I can’t believe, you know, we’re at the end of the podcast already. But I’m thinking it would make sense to wrap it up today with your overall viewpoint on the state of private asset values as they stand today, versus where they were pre-pandemic. And then if you have any final thoughts or watch-outs that you think would be worth sharing as we head into the new year, it would be great if you could topline, for our listeners as well.

John Fenn  14:08
Sure. I mean, I think in terms of private asset values, they’re probably more fair today than they were pre-COVID because I think with pre-COVID numbers, that there were probably an imbedded sense of optimism that there was growth. And those valuations were probably predicated on a robust underlying equity market that would have been supportive. We’ve had an accommodative Fed for quite some time. So certainly in the debt markets, the cost of debt has been cheap, you know, credit spreads have been tight. So those types of assets, particularly middle-market, debt assets, probably traded at a premium to what might have been argued as consistent with their underlying fundamentals. COVID took some of that out. I think given the fact that there is uncertainty surrounding private assets, how quick are the recoveries thinking about the fact that most of the private assets that we deal with, and I think most of the private assets that exist, regardless of whether we deal with them, are going to not necessarily be price leaders, and they’re going to be down the food chain, down the supply chain, they’re going to be price takers, as opposed to price leaders. The fact is, discount rates ought to be lower. One of the issues that we do have with some of these valuations and some of the uncertainty surrounding them is, do we assess you on 2020 earnings? Do we assess you on a less 12 month EBITDA number? We’re not going to do that, because there’s too much noise in the numbers. We’re trying to benchmark you to ’19. We’re going to see how you shape up ultimately, relative to your 2021 forecasts. Management teams are not necessarily making those forecasts, certainly not making them public. But what are the analysts ultimately saying about these things? I think these are all kind of factors that have driven the underlying valuation in the private markets to a little bit more of a, I’ll say realistic because fair value is fair value. And you were supposed to be reporting fair value previously. But the fact is if there’s a little bit less optimism that’s embedded in the marketplace itself probably takes the values to a place where it’s more in line with underlying fundamentals and not necessarily driven by growth rates that may or may not be achievable.

Steve Katz  16:40
Okay. Well, as you pointed out, this process is definitely a complex undertaking, and perhaps more important than ever, in a market like the one that we’re experiencing currently, where there certainly could be a tendency, I would say, to look at the recovery and assume that these types of assessments may not really be needed, or that a detailed level of documentation isn’t really all that critical. Clearly, though, as you’ve explained, those types of assumptions would be ill-advised. So for those of you listening today, whether you manage the financial reporting function within a business or you manage a portfolio of businesses, we encourage you to reach out to John and his team at Hilco Enterprise Valuation Services for any needed guidance or perspective regarding a pyramid testing, quarterly portfolio review, or other related matters. John’s email is jfenn@hilcoglobal.com. That’s jfenn@hilcoglobal.com. John, thanks again so much for joining us today.

John Fenn  17:39
My pleasure, Steve. Thanks for having me on.

Steve Katz  17:41
Absolutely. And listeners, as always, we hope that today’s Hilco Global Smarter Perspective podcast provided you with at least one key takeaway that you can put to good use in your business or share with a colleague or client to help make them that much more successful moving forward. Until next time for Hilco Global, I’m Steve Katz.