Value and the Virus
The Covid 19 pandemic and the reactions of markets and governments is creating a huge challenge for valuers. While the virus may not be exactly unprecedented as is often claimed, the other “U word”, uncertainty, definitely is appropriate. The IVSC has issued a statement that acknowledges that this uncertainty will inevitably lead to challenges, not just determining value, but also in the reporting of those values in a way that is both helpful and informative to users.
Unfortunately, the IVSC statement offers no solutions or advice for valuers on how they should address this challenge, other than to refer them to their relevant professional bodies.(1) At a time when global sharing of solutions is needed more than ever this is an odd omission. However, relevant advice for valuers is actually closer than acknowledged by the statement because the IVSC has been here before.
While global market tumult following unexpected events is fortunately unusual, it is not unprecedented. Indeed, the financial crisis of 2008 provides a comparatively recent example. Misplaced confidence in valuations, especially of complex derivatives, leading up to the crisis was identified as a significant contributor to the crisis and led to the Financial Stability Board to call for improved disclosure of valuation uncertainty. This was endorsed and included along with other actions that had been identified to protect the financial system in the Communique issued by the G20 following its meeting in April 2009.
While the G20 had addressed the request to the accounting standard setters, the IVSC at the time was working closely with both the IASB and FASB in the USA on issues arising from their coordinated Fair Value projects. Since valuation uncertainty was seen as a valuation rather than accounting issue the ball was quickly passed to the IVSC. Over the next three years the IVSC consulted widely and deeply with valuers and various actors in the financial markets on when and how valuation uncertainty should be highlighted.
Most agreed that market risk had to be distinguished from valuation uncertainty. Market risk is inherent in every transaction. Sellers are taking the risk that prices may rise in the future and buyers taking the risk that they may fall. When a deal is struck the price represents a numerical coincidence of those views. Valuation methods and models reflect this iteration between risk and reward either implicitly, for example by direct comparison with market prices, or explicitly, for example by adjusting discount rates in a DCF. There is obviously uncertainty that this value will still be valid at any future date but this is expected by market participants and baked into their calculations of the price they are currently willing to pay or accept. This process should be reflected by any appropriate valuation technique.
In contrast, valuation uncertainty refers to uncertainty about the valuation process itself. All valuations are estimates and therefore will represent the valuer’s estimate of the most probable of a range of possible figures. The confidence that the valuer has in this estimate will depend on the quality and availability of the data. What was troubling the politicians and regulators in 2009 was those relying on valuations were not being told when the valuations were estimates based on limited or suspect data and therefore could not distinguish them from valuations that were supported by a stack of sound and objective evidence.
While there was a wide consensus that valuation uncertainty needed to be disclosed there were many more
diverse views as to when and how such disclosures should be made. Many were concerned that tagging valuations as being uncertain in all but the most unusual circumstances would undermine confidence in all valuations, and also risked situations where there was a real problem being overlooked by investors - the valuation equivalent of the boy who cried “wolf” in Aesop’s fable. It was eventually agreed that uncertainty disclosures should only be required when the uncertainty was “material.”
Some advocated using a statistical approach, using a calculation of the “confidence interval” for any valuation to determine the threshold for materiality. However, others pointed out that for such calculations to be meaningful a significant number of comparable data points would be needed. While in deep and liquid markets these might be available, the problems highlighted arose where assets had proved to be illiquid, resulting in situations where there was little or no transaction evidence which could be analysed. Looked at from the other end of the telescope, if there was enough data to calculate a confidence interval then the valuation would probably be sufficiently robust not to be declared “uncertain”.
After a process that involved seeking views on an initial Discussion Paper and two Exposure Drafts the IVSC finally settled on an information paper (2) aimed at helping valuers understand how to comply with the requirement in IVS 103 to disclose any material uncertainty when reporting valuations. This paper defines what is meant by valuation uncertainty, gives examples of when it might arise, how it can be determined as being material (and therefore requiring an appropriate disclosure) and appropriate forms of disclosure. With regard to the latter point the paper strongly advises that a qualitative explanation of material uncertainty is nearly always preferable to a quantitative expression, and even if the latter can be provided, an explanation is needed to avoid giving a false impression of either the reliability of the valuation reported or any numerical adjustment made to it.
The disruption that is now occurring in many markets around the world certainly make this the biggest potential trigger for valuation uncertainty disclosures in many valuation reports since the 2008 financial crisis. While the IVSC information paper provides a sound starting point for determining if material valuation uncertainty exists and principles for the type of disclosure that should be made, for good reason it does not attempt to suggest wording for those disclosures. This is due to the extreme range of circumstances that might cause material valuation uncertainty, many of which will be unforeseeable.
While the Covid 19 virus is the common cause, the impact on markets is far more diverse. In many cases it is actions taken by governments to combat the spread of the virus that has the greater impact on markets than the anticipated human toll. To take real estate as an example, it can be reasonably anticipated that the value of many retail, leisure, and hospitality properties is likely to fall. However, the impact on logistics property is likely to be less severe. The residential situation is likewise mixed. In the last few days I have seen statistics that indicate that, ignoring new builds, residential sales in Hong Kong were 5% up in February compared with the same month last year, but I have been told by an agent in the UK that nearly all their unsold stock has been withdrawn by their vendor clients which will result in a dearth of sales in coming weeks.
I give these examples to illustrate that just in one sector the potential impact will vary significantly. However, I again stress that it is not uncertainty about what will happen tomorrow that determines whether a material uncertainty disclosure is required but the availability, quality and relevance of the data used to produce the valuation.
So what steps should a valuer be taking before including a caveat that their valuation is subject to material valuation uncertainty because of the disruption caused by the pandemic? The first is to look at the evidence needed to produce a valuation, whether this be direct price comparisons or individual data inputs such as cashflow forecasts, discount rates, yields etc. Does this predate the pandemic and the reactions to it in the relevant market? If so, it must be suspect. If there is nothing more recent that can be used to reasonably indicate the effect on prices then the valuer may have to use their judgement as to the adjustment that may be appropriate. However skilled the valuer this inevitably introduces a much greater element of subjectivity into the valuation.
The valuer may conclude that any valuation in the current climate is so unreliable that the assignment must be declined. However, this creates obvious problems where the entity requiring the valuation needs a figure as at a given date for statutory or regulatory purposes. Where this is the case they may produce a valuation to the best of their ability but communicate their concern at the relevance and reliability of the available data, so that those making decisions based on the reported value appreciate that less reliance can be based on the figure than would normally be the case.
The other key point that valuers must bear in mind is that there can be no such thing as a standard disclosure. Events following any crisis tend to move more quickly that in in more stable times. The reasons for any material valuation uncertainty disclosure must be relevant to the facts of each case and these can, and often do, change quickly. As soon as there is enough post event data to reasonably measure the impact on prices in a particular market, the caveat should be removed, otherwise it is suggesting that the valuer is ignoring the reality of the market.
An unfortunate side effect of automated report templates is that once text is introduced to react to an event it tends to become established and is not removed when it is no longer appropriate. I saw reports issued as late as 2015 containing caveats that the financial crisis made real estate valuations materially uncertain, even though every piece of evidence relied on was from post crisis transactions. In the UK, the result of the referendum to leave the EU in 2016 surprised the markets in the short term, and RICS suggested that valuers might consider including an uncertainty caveat. Within a few weeks the impact on prices in different sectors had become clear but this did not stop many RICS valuers continuing to warn that their valuations were less reliable than they might have been for two or more years, which risked undermining their credibility more than the credibility of the valuations they had provided.
My key message is that valuers need to mindful of the dates of key events that have impacted the market in which they are dealing and critically assess the relevance of available evidence to the situation as it existed on the valuation date. Because the pandemic has been known as a growing threat since January 2020, in some markets the potential consequences may have been reflected in recent deals done but have subsequent events proved these expectations to be optimistic or unduly pessimistic? There is therefore much to think about, but it is quite probable that valuers will properly place question marks over the relevance of transactions that until recently would have been seen as “copper bottomed”. If this is the case then is appropriate to include an explanation that there is material uncertainty in the valuation, but remember to stay agile, as it may not be long before the impact of the changes will become the new normal, at which stage the caveat should be removed.
After publication of this blog, IVSC issued a "Letter from the IVSC Technical Standards Boards" that effectively repeats most of the 2014 TIP with updated references to other parts of the IVS.
TIP4 Valuation Uncertainty ISBN: 978-0-9569313-8-2 Available from IVSC Bookstore.