Considerations for Alternative Investment Managers During COVID-19: Valuations

A Q&A with Gunes Kulaligil, Co-Founder, Methodical Management

Methodical Management provides valuation and advisory services with a focus on secured and unsecured consumer and business loans, structured products and servicing rights. EisnerAmper sat down with Co-Founder Gunes Kulaligil who shared his outlook on valuations of structured products during COVID-19 compared to the 2008 global financial crisis. He also imparted his outlook on how valuations might return to pre-COVID-19 levels and finally, shared the industry’s biggest concerns regarding valuations during the current pandemic.

EisnerAmper:

Can you please tell us about your clients and what they engage you for?

Kulaligil:

We service a diverse client base representing financial institutions who are involved at different touch points throughout the lifecycle of a loan. Structured products are often relatively illiquid, esoteric and hard to value, as are whole loans and servicing rights. Our clients hire us to perform valuations for purposes including periodic fair value for NAV calculations and transactions where the client may need an opinion of value. On the advisory side, we assist clients with asset management best practices, transaction advisory and portfolio surveillance, all geared towards increasing transparency and decreasing the complexity of managing these assets.  

EisnerAmper:

What trends are you currently seeing regarding valuations of structured products during COVID-19? How does this compare to shortly before the pandemic?

Kulaligil:

Prior to the pandemic, many market participants saw a dearth of investment opportunities at attractive risk-adjusted levels, and in fact, it’s the same issue now that the immediate panic caused by the pandemic in the financial markets has subsided. Starting in mid-March, we saw spreads creep up for structured products in sympathy with other sectors but it was not until March 22 when the metaphorical wheels came off as distressed sellers and repo sellers tried to offload bonds into a very illiquid market with bids substantially lower than just a few weeks prior.

While the distressed trading largely ceased by a week or so into April, spreads are still significantly higher than February for many assets, especially those exposed to travel (aircraft ABS), transportation (container ABS), non-prime unsecured consumer credit (e.g., marketplace lending) and non-standard mortgage credit (e.g. non-qualified mortgages).

Now that the Q1 is behind us, the entire industry is in the process of updating their processes and models. Originators are re-thinking their funding models. Investors are updating their loan performance models’ assumptions about delinquencies and defaults. This has led to a disconnect between sellers and buyers. In some cases, sellers are holding out on the hope that the Fed will step in with further support for their sector of the market.

Many market participants continue to feel that there is too much capital chasing too few good opportunities, as several large distressed credit funds have raised many billions in additional dry powder to put to work in the coming months. However, the crisis facing corporate credit and structured products may take a while to clean up so there may be ample investment opportunities through the end of 2020 – in other words, there is no rush to deploy right now since the acute stress has already largely dissipated.

EisnerAmper:

How do valuation issues today compare to the issues faced during the global financial crisis of 2008?

Kulaligil:  

Some of the similarities are the lack of orderly transactions by willing buyers and sellers to provide benchmark clearing levels, but the biggest valuation issue right now is the lack of performance data (since we are barely a month into the economic impact of the pandemic and reporting timelines are often longer than that) and a lack of consensus of what future loan performance will be.

The speed and the destructive force of the first round of sell offs we see this time around seems to be faster and stronger than anything we saw in 2008. The subprime crisis built up and played out over a two-year period starting in early 2007 before finally bottoming out in March 2009. This meant market participants were able to update their models as unemployment, delinquencies and charge offs built up over time compared to our current situation. Weekly unemployment claims have already reached a level ten times higher than their 2009 peak. Additionally, in the 2008 crisis there were periodic liquidation sales that provided some price discovery. In the current crisis, trading is still quite slow which leaves investors in the dark as to how much values may have recovered since the initial distress.  

EisnerAmper:

What will it take for valuations to return to pre-COVID 19 levels, or will they ever?

Kulaligil:

We have already seen asset classes supported by the government recover to pre-pandemic levels, or even surpass them (such as agency MBS) as interest rates have collapsed given the strong policy response. While such interest-rate-sensitive assets have already recovered or will recover relatively shortly (as long as there is leverage available, either directly from the Fed or as a knock-on effect as banks’ balance sheets are freed up), credit-sensitive assets will continue to languish at lower levels as it will take some time before buyers and sellers can agree on expected loan performance and execute a substantial volume of trades. This lack of trading particularly impacts matrix pricing and other Level 1 or Level 2 approaches, meaning more assets than ever must be marked to model as Level 3 assets.  

EisnerAmper:  

What have been industry participants’ main concerns?

Kulaligil:

Concerns revolve around a few familiar themes: access to liquidity, access to leverage (or other funding) and consensus on loan performance assumptions.

Being able to project loan performance and consumer behavior is a challenge for all institutions. Many originators of non-standard loans completely shut off production due to the funding pressure caused by secondary market turbulence, and are still in the process of recalibrating their performance models and restarting production. Whether they succeed in convincing their secondary market counterparts that these new performance assumptions are accurate remains to be seen. Many loan or bond holders balked at the low bids made in the past month and preferred to sit tight, but most of them can only sit tight for so long; the process of meeting in the middle is still in process, and whether that “middle” is more often biased towards the perspective of the sellers or the buyers remains to be seen.

An additional concern relates to servicers, who process borrowers’ payments and are part of the glue holding the system together. Some had shorted TBAs in anticipation of new origination and were short squeezed as an unintended consequence of the Fed’s support for Agency MBS prices. Servicers will continue to face liquidity and capitalization stress as they advance four months’ worth of payments on behalf of delinquent or forborne borrowers. Many servicers do not have the liquidity to advance in a crisis of this magnitude. They have some bright spots such as the widening primary-secondary mortgage market spread increasing their gain on sale, but overall they face a difficult few months.

EisnerAmper:

What have the various stimulus packages done to valuations?

Kulaligil:

The quick response of the Federal Reserve has injected leverage back into the system and taken away the technical selling pressures. Newly issued structured products (primary issuance) are the most prominent benchmarks for the market as a whole, and their absence has exacerbated the uncertainty. As such, the rebirth of the Term Asset Loan Facility (TALF), which supports primary issuance, should be a boon to pricing transparency for the entire market.

The impact of stimulus packages passed by Congress has less direct impact on valuations. While the changes to unemployment benefits, the Paycheck Protection Program, and cash sent directly to taxpayers will strengthen consumer balance sheets, the pandemic‘s long-term effects are still very much unknown. Federal support for state and local governments is also uncertain. While the stimulus provides support to expected future cash flows and thus valuations of structured products and loans, the market is pricing in the assumption that stimulus will fall substantially short of completely offsetting the impacts of the pandemic.

EisnerAmper:

Are there any final thoughts or takeaways you would like to share?

Kulaligil:

As SEC Chairman Jay Clayton put it, “the way a fund values its investments is critical to our Main Street investors … It affects the fees they pay, the returns they receive, and the value of the fund shares they hold” so there is no doubt valuations will be heavily scrutinized. Furthermore, with the dearth of active trading, there will be more reliance on third-party valuation providers. It is often said that valuation is both an art and a science. Given the current market conditions, valuations will have to lean more heavily on the expertise of valuation providers represented in the “art” part of the process. The onus is on fund boards to ensure third-party valuation firms they select have this expertise and their funds’ NAVs hold up to scrutiny.

EisnerAmper:

“Gunes recognizes the challenges brought on by the abrupt market displacement that will result in the need to develop significant changes to critical valuation model assumptions,” said Michael Aronow, Partner, EisnerAmper’s Corporate Finance Group.  “Many assumptions based on historical performance will need to be revised to reflect the impact of the pandemic over an extended period, and that may take some time be understood and appropriately quantified.”