Private: Blog

SUMMARY

• Real assets as a long-term investment with stable cash flow
• Continuous development of valuation standards and corresponding benchmarks
• Peer groups or clustering techniques help with the selection of financial instruments
• A well-founded data basis leads to the best validation

TEASER: The valuation of complex financial instruments is becoming more and more important not least due to the increasing requirements of regulators. For this reason clear rules have to be drawn up, in particular also for alternative financial instruments linked to real assets. As there are generally no tradable prices in these cases, the valuation must be derived. This can be solved with comparison instruments or with peergrouping.

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BACKGROUNDINFORMATION

Due to the current interest rate situation, more and more investors are in a dilemma. With conventional asset classes, it is becoming increasingly difficult to achieve risk-adequate returns. How do we deal with this situation? Are real assets in this case a real alternative and how could the implementation look in practice?

1. A first variant is simply to bear the “suffering” of an underperformance. This may not be so dramatic at first sight. But think only of the whole retirement plans.
2. The second solution is a diversification of the portfolios. In addition to shares and bonds, this should also include “alternative investments or real assets”.

Real assets are assets that can be viewed and touched, such as, Real estate or long-term infrastructure investments. These types of investments generate long-term, stable cash flows, which also provide at least a partial protection against inflation. The requirements on financial instruments linked to real assets are usually return, volatility, risk and liquidity. Infrastructure investments, in particular, have a further positive aspect for the portfolio: sustainability, which is becoming increasingly important for institutional investors.

How can you invest in real assets?

• Equity vs. Debt
• unlisted Real Assets vs. listed Real Assets
• direct vs. indirect
• Single transaction vs. Pooling vs. Operating Company

At high volatilities and low interest rates, interest in real assets increases.

• Diversified Returns
• Exposure to global economic growth
• Low correlation
• Inflation protection

Assessment parameters and valuation models. However, the decisive factor for any investor is that he also needs to understand his investments and possible developments, also on the pressure of the regulators. In addition to understanding, the issue of the ongoing valuation of such financial instruments is becoming increasingly important. According to a recent survey by the EDHEC Infrastructure Institute – Singapore among investors in infrastructure investments, nearly half of respondents do not trust the valuations they receive from the asset managers. In addition to the internal valuation, more and more external service providers are also establishing themselves who are able to evaluate financial instruments with regard to real assets. Not least, the standards for the valuation of these financial instruments are constantly being further developed.
The following points are important for the valuation of such financial instruments, which may be either equity or debt.

• Definition of instruments
• Development and implementation of a cash flow model
• Availability of transaction documents
• Derivation of the relevant discount factor
• Availability of sufficient data
• Development of benchmarks
• Periodicity of evaluation and reporting

Definition. In a first step, instruments are to be defined with regard to the underlying assets (real estate, infrastructure, etc.), whereby, of course, a distinction must also be made between equity and debt instruments. A key distinguishing point, which is relevant for the selection of the valuation method, is the subdivision into private and listed financial instruments (unlisted vs. listed instruments).

The payment flows that flow into a robust model should usually be derived from the transaction documents. For example, these can be the following documents, which are to be processed in the cash flow model (discounted cash flow (DCF) approach).

• Documentation of origination
• Annual accounts of any special purpose entities
• Current Reports, Investor Reports
• Existing or current valuations of the real assets
• Rating information or other relevant documentation

The relevant discount factor usually reflects the risks of the financial instrument. This should be decomposed into its sub-parts, e.g. can be defined as follows.

• Issuer-specific parameters
• Illiquidity premium
• Risk of default
• Other economic risks from the underlying real asset
• Definition of a risk-free interest rate

In order to derive the discount factor, other economic risks from the project should also be taken into account. These can be derived directly from the Real Asset as part of a project financing analysis. These are key figures, e.g. Equity service cover ratio (ESCR), debt service cover ratio (DSCR), loan to value ratio (LTV) or amortization profile.

The basis for a statistically robust validation of the above parameters should be a comprehensive data pool. This is made up of sufficiently available, observable data points for the respective underlying real assets. In my view, the availability of such data is generally the greatest uncertainty in the valuation of complex financial instruments. The question of the data base will remain the biggest challenge in the valuation of illiquid financial instruments. A next step in the evolution of the valuation of such financial instruments is the development of appropriate benchmarks that will lead to increasing accuracy in portfolio construction and risk / return ratios.

Since the underlying projects in the area of Real Assets can constantly change, a certain periodicity or regularity should also be introduced in the valuation process. In practice, a monthly valuation frequency has been found to be useful, regardless of any regulatory requirements. However, this requires that transaction documents mentioned above be provided at this frequency. An ongoing reporting, combined with a comprehensive documentation of the evaluation routine, round off the requirements.

For financial instruments related to real assets, peergrouping or clustering techniques are usually used …

The following valuation approaches can now be derived from the above evaluation parameters. As a rule, this is done in different steps.

1. Is there a quota / tradable price for the financial instrument?
2. Do quotes / tradable prices exist for comparable financial instruments?
3. If the above steps do not lead to the goal, peergroups are created or clustered techniques applied.

Essential for the efficient operation of financial instruments linked to real assets is a statistically sufficient definition of comparable instruments, which can usually only be achieved using peergroups or clustering techniques. In this case, according to different criteria, e.g. Regions, industries, types of use, contractual components, currencies, financing structures, etc.

The financial market regulators have also taken account of this development and have set up key requirements for the valuation of alternative investments within the scope of the Europe-wide introduction of the AIFMD. The coupling of these requirements to the ever-deepening practice will bring the desired success in the medium term in the form of more transparency for capital market investors.

About the author, Heinz Hofstaetter – Over 20 years of international experience in senior management positions in the areas of consulting, banking, finance, asset management, valuation and Real Assets.

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