Note 19 - Fair Value of Financial Instruments

9 Months Ended

Sep. 30, 2021

Notes to Financial Statements

Fair Value Disclosures [Text Block]

NOTE 19 FAIR VALUE OF FINANCIAL INSTRUMENTS

Fair value is the price that would be received upon sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best evidenced by quoted bid or ask price, as appropriate, in an active market. Where bid or ask prices are not available, such as in an illiquid or inactive market, the closing price of the most recent transaction of that instrument subject to appropriate adjustments as required is used. Where quoted market prices are not available, the quoted prices of similar financial instruments or valuation models with observable market-based inputs are used to estimate the fair value. These valuation models may use multiple observable market inputs, including observable interest rates, foreign exchange rates, index levels, credit spreads, equity prices, counterparty credit quality, corresponding market volatility levels and option volatilities. Minimal management judgment is required for fair values calculated using quoted market prices or observable market inputs for models. Greater subjectivity is required when making valuation adjustments for financial instruments in inactive markets or when using models where observable parameters do not exist. Also, the calculation of estimated fair value is based on market conditions at a specific point in time and may not be reflective of future fair values. For the Company's financial instruments carried at cost or amortized cost, the book value is not adjusted to reflect increases or decreases in fair value due to market fluctuations, including those due to interest rate changes, as it is the Company's intention to hold them until there is a recovery of fair value, which may be to maturity.

The Company employs a fair value hierarchy to categorize the inputs it uses in valuation techniques to measure the fair value. The following fair value hierarchy is used in selecting inputs, with the highest priority given to Level 1:

• Level 1 – Quoted prices for identical instruments in active markets.

• Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs are observable in active markets.

• Level 3 – Valuations derived from valuation techniques in which one or more significant inputs are not observable.

The Company classifies its investments in fixed maturities as available-for-sale and reports these investments at fair value. The Company's equity investments, limited liability investments, at fair value, real estate investments, subordinated debt, warrant liability, stock-based compensation liabilities and derivative contracts (interest rate swap) are measured and reported at fair value.

Fixed maturities - Fair values of fixed maturities for which no active market exists are derived from quoted market prices of similar instruments or other third party evidence. All classes of the Company’s fixed maturities, primarily consisting of investments in US. Treasury bills and government bonds; obligations of states, municipalities and political subdivisions; mortgage-backed securities; and corporate securities, are classified as Level 2. Level 2 is applied to valuations based upon quoted prices for similar assets in active markets; quoted prices for identical or similar assets in markets that are inactive; or valuations based on models where the significant inputs are observable or can be corroborated by observable market data.

The Company engages a third-party vendor who utilizes third-party pricing sources and primarily employs a market approach to determine the fair values of our fixed maturities. The market approach includes primarily obtaining prices from independent third-party pricing services as well as, to a lesser extent, quotes from broker-dealers. Our third-party vendor also monitors market indicators, as well as industry and economic events, to ensure pricing is appropriate. All classes of our fixed maturities are valued using this technique. The Company has obtained an understanding of our third-party vendor’s valuation methodologies and inputs. Fair values obtained from our third-party vendor are not adjusted by the Company.

The following is a description of the significant inputs, by asset class, used by the third-party pricing services to determine the fair values of our fixed maturities included in Level 2:

• U.S. government, government agencies and authorities are generally priced using the market approach. Inputs generally consist of trades of identical or similar securities, quoted prices in inactive markets and maturity.

• States, municipalities and political subdivisions are generally priced using the market approach. Inputs generally consist of trades of identical or similar securities, quoted prices in inactive markets, new issuances and credit spreads.

• Mortgage-backed and asset-backed securities are generally priced using the market approach. Inputs generally consist of trades of identical or similar securities, quoted prices in inactive markets, expected prepayments, expected credit default rates, delinquencies and issue specific information including, but not limited to, collateral type, seniority and vintage.

• Corporate securities are generally priced using the market approach using pricing vendors. Inputs generally consist of trades of identical or similar securities, quoted prices in inactive markets, issuer rating, benchmark yields, maturity and credit spreads.

Equity investments - Fair values of equity investments, including warrants, reflect quoted market values based on latest bid prices, where active markets exist, or models based on significant market observable inputs, where no active markets exist.

Limited liability investments, at fair value - Limited liability investments, at fair value include the underlying investments of Net Lease and Argo Holdings. Net Lease owns investments in limited liability companies that hold investment properties. Argo Holdings makes investments in limited liability companies and limited partnerships that hold investments in search funds and private operating companies.

• The fair value of Net Lease's investments in limited liability companies is based upon the net asset values of the underlying investments in companies as a practical expedient to estimate fair value. The Company applies the net asset value practical expedient to Net Lease's limited liability investments on an investment-by-investment basis unless it is probable that the Company will sell a portion of an investment at an amount different from the net asset value of the investment. Investments that are measured at fair value using the net asset value practical expedient are not required to be classified using the fair value hierarchy.

• The fair value of Argo Holdings' limited liability investments that hold investments in search funds is based on the initial investment in the search funds. The fair value of Argo Holdings' limited liability investments that hold investments in private operating companies is valued using a market approach including valuation multiples applied to corresponding performance metrics, such as earnings before interest, tax, depreciation and amortization; revenue; or net earnings. The selected valuation multiples were estimated using multiples provided by the investees and review of those multiples in light of investor updates, performance reports, financial statements and other relevant information. These investments are categorized in Level 3 of the fair value hierarchy.

Real estate investments - The fair value of real estate investments involves a combination of the market and income valuation techniques. Under this approach, a market-based capitalization rate is derived from comparable transactions, adjusted for any unique characteristics of each asset, and applied to the asset under consideration. The cap rates used during underwriting and subsequent valuation incorporate the consideration of risks of vacancy and collection loss, administrative costs of owning net leased assets and possible capital expenditures that could be determined a landlord expense. These investments are categorized in Level 3 of the fair value hierarchy.

Subordinated debt - The fair value of the subordinated debt is calculated using a model based on significant market observable inputs and inputs developed by a third party. These inputs include credit spread assumptions developed by a third party and market observable swap rates. The subordinated debt is categorized in Level 2 of the fair value hierarchy.

Warrant liability - The Company issued the KWH Warrants on March 1, 2019. On December 1, 2020, the Company repurchased the KWH Warrants. The KWH Warrants were measured and reported at fair value. The fair value of the warrant liability was estimated using an internal model without relevant observable market inputs. The significant inputs used in the model include an enterprise value multiple applied to earnings before interest, tax, depreciation and amortization. The implied enterprise value was reduced by the remaining debt associated with the 2019 KWH Loan to determine an implied equity value. The liability classified warrants are categorized in Level 3 of the fair value hierarchy.

Stock-based compensation liabilities- As described in Note 16, "Stock-Based Compensation," certain of the restricted stock awards granted by PWSC are classified as a liability. Liability-classified awards are measured and reported at fair value and are included in accrued expenses and other liabilities in the consolidated balance sheets. The fair value of the restricted stock awards granted by PWSC are estimated using an internal valuation model without relevant observable market inputs. The significant inputs used in the model include a valuation multiple applied to trailing twelve month earnings before interest, tax, depreciation and amortization. Liability-classified restricted stock awards are categorized in Level 3 of the fair value hierarchy.

Derivative contracts- As described in Note 10, "Derivatives," the Company entered into an interest rate swap agreement effective April 1, 2021 to convert the variable interest rate on a portion of the 2020 KWH Loan to a fixed interest rate.  The interest rate swap contract is measured and reported at fair value and is included in accrued expenses and other liabilities in the consolidated balance sheets. The fair value of the interest rate swap contract is estimated using inputs which the Company obtains from the counterparty and is determined using a discounted cash flow analysis on the expected cash flows of the derivative.  The discounted cash flow valuation technique reflects the contractual term of the derivative contract, including the period to maturity, and uses observable market based inputs, including quoted mid-market prices or third-party consensus pricing, interest rate curves and implied volatilities.  The interest rate swap contract is categorized in Level 2 of the fair value hierarchy.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The balances of the Company's financial assets and liabilities measured at fair value on a recurring basis by level within the fair value hierarchy as of September 30, 2021 and December 31, 2020 are as follows. Certain investments in limited liability companies that are measured at fair value using the net asset value practical expedient are not required to be classified using the fair value hierarchy, but are presented in the following tables to permit reconciliation of the fair value hierarchy to the amounts presented in the consolidated balance sheets:

(in thousands)	September 30, 2021
	Fair Value Measurements at the End of the Reporting Period Using
			Quoted Prices in		Significant		Significant
			Active Markets for		Other Observable		Unobservable
			Identical Assets		Inputs		Inputs		Measured at
	Total		(Level 1)		(Level 2)		(Level 3)		Net Asset Value
Recurring fair value measurements:
Assets:
Fixed maturities:
U.S. government, government agencies and authorities	$	15,247	$	—	$	15,247	$	—	$	—
States, municipalities and political subdivisions		1,584		—		1,584		—		—
Mortgage-backed		8,150		—		8,150		—		—
Asset-backed		253		—		253		—		—
Corporate		9,105		—		9,105		—		—
Total fixed maturities		34,339		—		34,339		—		—
Equity investments:
Common stock		187		187		—		—		—
Warrants		—		—		—		—		—
Total equity investments		187		187		—		—		—
Limited liability investments, at fair value		18,180		—		—		3,744		14,436
Real estate investments		10,662		—		—		10,662		—
Total assets	$	63,368	$	187	$	34,339	$	14,406	$	14,436
Liabilities:
Subordinated debt	$	59,601	$	—	$	59,601	$	—	$	—
Stock-based compensation liabilities		1,306		—		—		1,306		—
Derivative contract - interest rate swap		65		—		65		—		—
Total liabilities	$	60,972	$	—	$	59,666	$	1,306	$	—

(in thousands)	December 31, 2020
	Fair Value Measurements at the End of the Reporting Period Using
			Quoted Prices in		Significant		Significant
			Active Markets for		Other Observable		Unobservable
			Identical Assets		Inputs		Inputs		Measured at
	Total		(Level 1)		(Level 2)		(Level 3)		Net Asset Value
Recurring fair value measurements:
Assets:
Fixed maturities:
U.S. government, government agencies and authorities	$	10,104	$	—	$	10,104	$	—	$	—
States municipalities and political subdivisions		1,454		—		1,454		—		—
Mortgage-backed		5,394		—		5,394		—		—
Corporate		3,764		—		3,764		—		—
Total fixed maturities		20,716		—		20,716		—		—
Equity investments:
Common stock		155		155		—		—		—
Warrants		289		17		272		—		—
Total equity investments		444		172		272		—		—
Limited liability investments, at fair value		32,811		—		—		3,263		29,548
Real estate investments		10,662		—		—		10,662		—
Total assets	$	64,633	$	172	$	20,988	$	13,925	$	29,548
Liabilities:
Subordinated debt	$	50,928	$	—	$	50,928	$	—	$	—
Stock-based compensation liabilities		443		—		—		443		—
Total liabilities	$	51,371	$	—	$	50,928	$	443	$	—

The following table provides a reconciliation of the fair value of recurring Level 3 fair value measurements for the three and nine months ended September 30, 2021 and September 30, 2020:

(in thousands)	Three months ended September 30,						Nine months ended September 30,
	2021			2020			2021			2020
Assets:
Limited liability investments, at fair value:
Beginning balance	$	3,302		$	4,290		$	3,263		$	4,392
Distributions received		(80	)		(32	)		(313	)		(109	)
Realized gains included in net (loss) income		80			12			290			98
Change in fair value of limited liability investments, at fair value included in net (loss) income		442			(340	)		504			(451	)
Ending balance	$	3,744		$	3,930		$	3,744		$	3,930
Unrealized gains on limited liability investments, at fair value held at end of period:
Included in net (loss) income	$	442		$	(340	)	$	504		$	(451	)
Included in other comprehensive (loss) income	$	—		$	—		$	—		$	—
Real estate investments:
Beginning balance	$	10,662		$	10,662		$	10,662		$	10,662
Change in fair value of real estate investments included in net (loss) income		—			—			—			—
Ending balance	$	10,662		$	10,662		$	10,662		$	10,662
Unrealized gains recognized on real estate investments held at end of period:
Included in net (loss) income		—			—			—			—
Included in other comprehensive (loss) income		—			—			—			—
Ending balance - assets	$	14,406		$	14,592		$	14,406		$	14,592
Liabilities:
Warrant liability:
Beginning balance	$	—		$	259		$	—		$	249
Change in fair value of warrant liability included in net (loss) income		—			(66	)		—			(56	)
Ending balance	$	—		$	193		$	—		$	193
Unrealized gains recognized on warrant liability held at end of period:
Included in net (loss) income	$	—		$	(66	)	$	—		$	(56	)
Included in other comprehensive (loss) income	$	—		$	—		$	—		$	—
Stock-based compensation liabilities:
Beginning balance	$	1,134		$	—		$	443		$	—
Change in fair value of stock-based compensation liabilities included in net (loss) income		172			—			863			—
Ending balance	$	1,306		$	—		$	1,306		$	—
Ending balance - liabilities	$	1,306		$	193		$	1,306		$	193

The following table summarizes the valuation techniques and significant unobservable inputs utilized in determining fair values for the Company's investments that are categorized as Level 3 at September 30, 2021:

Categories	Fair Value		Valuation Techniques	Unobservable Inputs	Input Value(s)
Limited liability investments, at fair value	$	3,744	Market approach	Valuation multiples	3.1x - 8.0x
Real estate investments	$	10,662	Market and income approach	Cap rates		7.5	%
Stock-based compensation liabilities	$	1,306	Market approach	Valuation multiple	6.0x

The following table summarizes the valuation techniques and significant unobservable inputs utilized in determining fair values for the Company's investments that are categorized as Level 3 at December 31, 2020:

Categories	Fair Value		Valuation Techniques	Unobservable Inputs	Input Value(s)
Limited liability investments, at fair value	$	3,263	Market approach	Valuation multiples	3.1x - 8.0x
Real estate investments	$	10,662	Market and income approach	Cap rates		7.5	%
Stock-based compensation liabilities	$	443	Market approach	Valuation multiple	6.0x

Investments Measured Using the Net Asset Value per Share Practical Expedient

The following table summarizes investments for which fair value is measured using the net asset value per share practical expedient at September 30, 2021:

	Fair Value				Redemption
Category	(in thousands)		Unfunded Commitments	Redemption Frequency	Notice Period
Limited liability investments, at fair value	$	14,436	n/a	n/a	n/a

The following table summarizes investments for which fair value is measured using the net asset value per share practical expedient at December 31, 2020:

	Fair Value				Redemption
Category	(in thousands)		Unfunded Commitments	Redemption Frequency	Notice Period
Limited liability investments, at fair value	$	29,548	n/a	n/a	n/a

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

Certain assets and liabilities are measured at fair value on a nonrecurring basis, including assets that are adjusted for observable price changes or written down to fair value as a result of an impairment. For the three and nine months ended September 30, 2021 and September 30, 2020, the Company did not record any adjustments to the fair value of its investments in private companies for observable price changes.  The Company did not record any impairments related to investments in private companies for the three and nine months ended September 30, 2021 (zero million and $0.7 million for the three and nine months ended September 30, 2020, respectively), which are included in net change in unrealized loss on private company investments in the consolidated statements of operations.  The impairments recorded for the three and nine months ended September 30, 2020 are a result of the impact of COVID-19 on the investments' underlying business. To determine the fair value of investments in these private companies, the Company considered rounds of financing and third-party transactions, discounted cash flow analyses and market-based information, including comparable transactions, trading multiples and changes in market outlook, among other factors. The Company has classified the fair value measurements of these investments in private companies as Level 3 because they involve significant unobservable inputs.

As further discussed in Note 5, "Acquisition," the Company acquired PWI on December 1, 2020 and finalized the related purchase price allocation during the third quarter of 2021. The fair values of intangible assets and deferred service fees associated with the acquisition of PWI were determined to be Level 3 under the fair value hierarchy.

The following table summarizes the valuation techniques and significant unobservable inputs utilized in determining fair values for these Level 3 measurements:

	Fair Value
Categories	(in thousands)		Valuation Techniques	Unobservable Inputs	Input Value(s)
Customer relationships	$	15,000	Multi-period excess earnings	Growth rate		3.0	%
				Attrition rate		12.3	%
				Discount rate		29.5	%
Trade name	$	4,550	Relief from royalty	Royalty rate		4.0	%
				Discount rate		29.5	%
Deferred service fees	$	3,626	Cost build-up	Normal profit margin		17.8%-21.1%
				Discount rate		2.5	%