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Complex Financial Instruments

Companies are increasingly using innovative deal structures to optimize the risk-reward metrics in their transactions leading to the growing use of complex instruments. A wide fluctuation in the value of such instruments can have a significant impact on the Company’s future earnings.

How we can help you.

We help clients determine the fair value estimates and lower the risks of compliance costs associated with SEC comment letters or late filings. We bring deep experience valuing a wide range of complex securities, including credit/debt instruments, derivatives, equity, and structured products.

We have a dedicated complex securities team of experienced professionals to provide valuation services for complex securities required for audit, general reporting and tax purposes. Proper fair value estimates require selecting the most appropriate valuation model, a subject which has received increased scrutiny from regulators and investors in recent years.

We assist a wide range of clients with complex securities valuations, including public and private corporations, asset managers, private equity funds, hedge funds, endowments, public and private pension plans, fund administrators, and business development companies.

Widely Used Methodologies for Complex Securities Valuations:

Complex Instruments such as common stock, preferred stock, options, warrants, debt (convertible/callable), and others are valued using complex models, usually involving Monte Carlo simulation, Binomial Lattice models, the option pricing model (OPM), Probability Weighted Expected Return Models, Hybrid Models, Probabilistic models and Scenario-based models.

Binomial Option Pricing Model

The binomial model is an option derivative pricing model which assumes that the asset price follows a defined/discrete process (i.e., discrete-time and discrete value behavior). Since it’s difficult to try and do the mathematics of a variable that changes in a very continuous-time and continuous value, the binomial model steps in and make things simple by making an assumption that- asset price can rise and fall to defined price levels in a given period.

A continuous stochastic process means a variable that changes in continuous time is said to follow a continuous-time stochastic process and which takes any value is said to follow a continuous value stochastic process.
A discrete stochastic process means a variable that changes in discrete time is said to follow a discrete-time stochastic process and which takes limited value is said to follow a discrete value stochastic process.

- Assumptions in Binomial Option Pricing Model

It is better to thoroughly understand the assumptions of the Binomial Option Pricing Model-

The underlying asset has a known outcome i.e., it can take only two possible prices on expiration (i.e., the up-side and the down-side).
The underlying is a non-dividend/non-coupon paying asset.
The risk-free interest rate (periodically continuously compounded) is constant throughout until expiration.
Markets are frictionless (i.e., there are no transaction cost, no taxes, and no regulatory constraints).
Unlimited borrowing and investing funds are available at a risk-free rate.
Investors are risk-neutral.

Monte Carlo Simulation

The Monte Carlo simulation is a computerized algorithmic procedure that outputs a wide range of values – typically unknown probability distribution – by simulating one or multiple input parameters via known probability distributions. This is generally used to value instruments where the payoff may be dependent on the periodic outcomes, or path, of an underlying asset price, metric or feature.

- Engagements often arise from needs relating to:

ASC 718/IRC 409A Stock Compensation:

Tranche Rights

ASC 805 Business Combinations:

ASC 820 Fair Value Measurement:

ASC 815 Derivatives and Hedging:

ASC 842 Leases:

ASC 946 Portfolio Valuations:

Contingent Consideration (Earnouts)

An earnout is a form of contingent consideration that is often included as part of the purchase price of a company in which there is a valuation gap between the buyer and seller. The earnout serves to bridge this gap by rewarding the seller upon achievement of performance metrics, milestones, etc.

ASC 805 allows earnouts to be classified as compensation, liabilities, equity, or even assets. In accordance with GAAP, the acquirer must value the earnout, include it as part of the purchase price, and record the value of the earnout as a contingent liability on the balance sheet. This liability needs to be revalued every period until the earnout period has ended and all changes in the value flow through the income statement.

Rollover Equity

Rollover equity has many benefits to both buyers and sellers when a private equity sponsor acquires a company from existing management. Nuances of the transaction financing and the new capital structure can have important implications for the valuation of the new securities and, ultimately, the fair value of total purchase consideration.

While determining rollover equity value pursuant to ASC 805, it is critical to understand the various factors that may cause simplified value estimates of rollover equity to differ from the fair value of the rollover equity which complies with financial reporting standards. These factors can include Subordination features, Return preferences, Conversion features, Promote structures, Pre-emptive rights, Tag-along rights, Lack of Marketability applications, etc.

Convertible Debt

Convertible notes (or convertible bonds) are hybrid securities with both debt-like and equity-like features. A convertible note may have additional contractual features such as call-ability and put-ability. There could be various conversion features for a convertible note, such as holding periods, market conditions and downward protection resets.

Under ASC 820 requirements, the issuer of the convertible note is required to bifurcate the fair value of the convertible bond into the fair value of the straight debt (liability portion) and the fair value of the conversion feature (equity portion). In some cases, companies are required to perform this bifurcation exercise for all subsequent reporting periods as well.

Incremental Borrowing Rate

The Incremental Borrowing Rate or IBR is the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.

The purpose of ASC 842 (Leases) is to increase disclosure and visibility into the leasing obligations of both public and private organizations. Where previously most leases were not included on the balance sheet, the ASC 842 standard requires companies to report right-of-use (ROU) assets and liabilities for almost all leases.

Hedge Effectiveness Testing

Hedge effectiveness is the extent to which changes in the fair value or cash flows of the hedging instrument offset the changes in the fair value or cash flows of the hedged item.

An organization is required to run a prospective hedge effectiveness test at the inception of the hedge relationship. Thereafter, an organization is required to perform a prospective and a retrospective hedge effectiveness test at least quarterly under U.S. accounting standards and every time financial statements are prepared under international accounting standards.

Embedded Derivatives

When a derivative contract is hidden in a non-derivative host contract (either debt or equity component) which doesn’t pass through profit and loss account known as the embedded derivatives. The most frequent use of the embedded derivative has been seen in leases and insurance contracts. It has also been seen that preferred stocks and convertible bonds also host embedded derivatives.

As per the International Financial Reporting Standards (IFRS), the embedded derivative needs to be separated from the host contract and needs to be accounted for separately.

ASC 815 also provides guidance on how reporting entities determine whether the derivative instrument is indexed to the reporting entity’s own stock and considered to be settled in the reporting entity’s own stock. Such a determination will dictate whether an instrument should be accounted for as debt or equity and the appropriate accounting for the instrument.

Current Expected Credit Loss

The current expected credit loss standard (CECL) is the new methodology for estimating allowances for credit losses issued by the Financial Accounting Standards Board (FASB). It impacts all entities holding loans, debt securities, trade receivables, off-balance-sheet credit exposures, reinsurance receivables, and net investments in leases.

IFRS 9 requires impairments for Trade Receivables to be calculated on an expected credit loss basis.

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Media & Entertainment

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Complex Financial Instruments