2020 started off as a promising year, with stock markets performing well and alternative asset managers in search of new opportunities to invest capital. However, within a span of just a few weeks, the COVID-19 pandemic swept the investment world off its feet, which resulted in unprecedented market volatility and uncertainty. The impact of this turmoil was especially challenging for New York City, the epicenter of the pandemic and the financial capital of the world. In fact, the world’s stock markets declined over 30% at one point, compared to the previous highs of early Q1 2020; however, stock markets have, since then, largely recovered – effectively reaching within 10% of the highs from earlier this year.
Like many sectors of the economy, private equity firms have been impacted by the pandemic. The initial impacts of COVID-19 on portfolio companies were becoming more known or knowable by Q2 of 2020, as COVID-19 related lockdowns completely ceased business operations in certain industries, such as restaurants and non-essential retail outlets. Stay-at-home orders and social distancing prohibited employees from entering their place of work and forced them to either work remotely or completely stop working, creating a partial or complete shutdown of businesses supporting this corporate infrastructure. Some U.S. states gradually started to reopen non-essential business in late-Q2, however, a significant surge in the new COVID-19 cases has forced them to reconsider.
We have noted a significant difference in certain asset class performance. For example, real estate investments did not show a significant decline in Q1 whereas investments in restaurants and retail stores saw major declines in revenue and profitability. As of Q1, rental incomes were not materially impacted and observed transactions in the real estate sector did not show big declines from prior quarters. However, industry sentiments support downwards adjustments in future quarters due to significant job losses, potentially impacting tenants’ ability to continue paying rents. Reduction in the workforce for many industries could influence commercial occupancy levels in office buildings, as well as future commercial real estate transactions. In addition, according to a forecast by OpenTable1, one in every four U.S. restaurants will go out of business due to the COVID-19 quarantines that have battered the food industry.
Early Q2 data indicates decline in rental prices in key markets. Manhattan rental prices declined 1.8% year-over-year, whereas new leases signed in Manhattan also dropped 63%, compared to a year ago of 2,1892, which represents the lowest number of leases signed in a decade. The number of apartment listings increased by 34%. Similarly, other key markets such as San Francisco bay area, Boston, and San Diego also observed rental price declines due to the pandemic.
Significant challenges for private equity firms exist as they mark-to-market portfolio investments against fair values going forward. The standard of value required for marking investments to market, for financial reporting purposes, is fair value as defined in ASC 820 - Fair Value Measurement.
“Fair Value is 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.” 3
It is important to understand that fair value is based on an orderly transaction and not on a distressed or fire sale scenario. Typically, private equity firms analyze their investments in portfolio companies and mark-to-market their investments to fair value at regular intervals. While firms still need to perform these analyses at regular intervals throughout this pandemic, the current economic environment has caused major uncertainty in the market and, as such, private equity firms are facing many challenges in valuing their investments. A few of these challenges include:
Given the highly leveraged nature of private equity backed businesses, a downward business valuation would potentially be catastrophic for some. In the last couple of months, the pandemic has hammered some private equity owned companies, ill-equipped to handle an economic downturn because of heavy debt obligations. Travel and retail businesses, such as J. Crew, Nieman Marcus, and Hertz, have been especially vulnerable and filed for bankruptcy protection last month. In May, 16 companies backed by private equity were hit hard and filed for bankruptcy. The higher debt obligation can significantly reduce the equity valuations during economic downturn and must be monitored closely.
We expect this to be a challenging time for private equity firms to conduct their mark-to-market valuation exercises. Investors should consider third party independent resources to provide support for management’s values.
3ASC 820 – Fair Value Measurements.