In recent years the capital provided to the private credit market has increased exponentially. Private credit investments are a key part of the economic landscape as they provide needed liquidity for early-stage, growth funding and late-stage companies, often financed through private equity investments. Private credit generally has a lower risk/return profile than private equity and as such provides a needed diversification for many investors.
With the private credit market growing to almost $2 trillion, there are increasing questions as to the reliability and rigor of valuation estimates provided by managers to investors. We seek to answer these questions by addressing what valuation rules apply to private credit valuation, highlighting private credit valuation best practices, examining sound private credit valuation procedures, and suggesting ways to improve valuation rigor and transparency.
What Valuation Rules Apply?
Some pundits maintain that there are no rules with respect to valuing private credit. The facts argue differently. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have defined fair value as the amount that would be received in an orderly transaction as of a given valuation date. Investment companies are required to report investments at fair value. Registered Investment Companies in the U.S. are required to follow Securities and Exchange Commission rule 2a-5 which provides specific requirements for estimating value.
Further, the application of such standards is supported by entities such as the International Private Equity and Venture Capital Valuations Board (IPEV), which provides standards for valuing private equity and private debt; the American Institute of Certified Public Accounts (AICPA), which has published a guide for valuing private investments; and the International Valuations Standards Council (IVSC), which has laid out standards for estimating fair value.
The fair value of a private credit investment moves up and down from issuance based on changes in credit quality (underlying company performance), and changes in the market (credit spreads/yields). The fair value framework has been established and applied in its current form for more than 16 years. Virtually all investment managers are required to report private credit investments at fair value. Those who claim that there are no requirements or that requirements vary are promulgating a myth not based on the facts.
What Are Private Credit Valuation Best Practices?
It is logical that greater scrutiny is being focused on the valuation of private credit investments given the growth in the market. To provide investors in private credit funds with the transparency and rigor they require, there are a number of best practices which demonstrate robustness in the valuation process. These include:
- Establishing and following a valuation policy which conforms to FASB and IFRS fair value standards. This means that fair value is estimated each time the manager reports to its investors. Fair value is the amount that a buyer in an orderly transaction would pay for the subject credit given current market conditions, underlying credit performance and risk.
- Consistently utilizing a technology-enabled and systematic valuation process that incorporates benchmarks and pricing data derived directly from private credit markets and informed judgment ensures consistency in information processing, valuation approach, and conclusions.
- As appropriate, utilize the services of an independent third-party valuation specialist to confirm or validate the managers’ fair value judgements to provide additional transparency and support to investors.
Sound Valuation Procedures
The first step in creating sound valuation procedures is to calibrate valuation inputs with the issuance price of the loan. The initial issuance of a loan will contain terms and conditions which are congruent with current market conditions and the expected return profile. Often the yield for a private investment is priced based on a spread over the secured overnight financing rate (SOFR). As the SOFR market moves, the yield moves.
The fair value of a loan will change based on changes in credit quality of the borrower (generally determined by company performance and liquidity), and changes in market conditions (the required spread over SOFR). Often a proxy for changes in market conditions must be used because private credit is not driven by a homogeneous actively traded market such as is the case with publicly traded equities. Therefore, a proxy such as the leveraged loan market or syndicated loan market is used to identify changes in market conditions for private credit.
Market participants have access to similar but not identical data and as such they may reasonably reach different conclusions about changes in market conditions which impact the expected yield for a private credit investment. Obtaining access to data either through proprietary sources or external sources enhances a managers’ judgement in estimating fair value.
Given the nature of private credit investments it should not be expected that different managers invested in the same credit would reach identical conclusions. Managers generally do not share their valuation conclusions with co-investors. If they did, some would argue they were colluding to reach the same conclusion. Their data sources may differ, their outlook on performance, may differ. As such their valuation conclusion will logically differ. From an ultimate investor perspective such differences are not necessarily problematic. They become problematic if valuation estimates vary widely, without supporting analysis.
At times, there may be a wide bid ask spread for certain private credit investments. This can occur when there are limited bids or offers or where there is limited information. Further wide bid ask spreads may occur depending on the overall capital structure and the ability to make contractual payments. Wide bid ask spread does not mean that the valuation conclusion is flawed, it means that significant informed judgment is required to be applied as FASB and the IASB require fair value to be determined as the best answer within the bid ask spread.
When covenants are breached or contractual payments are defaulted upon, fair value is likely to be determined based on an assessment of the timing and extent of cash recoverability, rather than based on a yield approach.
Suggestions for Improving Valuation Rigor
Calibrating valuation inputs with the issuance price, using a robust valuation platform, and obtaining supporting data are key in coming to a rigorous fair value conclusion.
Historically, there have been some biases or practices that some managers have used which are not compliant with FASB or IASB rules and which should be avoided. These include:
- Reporting credit investments at par if there is sufficient enterprise value to repay the loan. Accounting standards have prohibited such an approach for almost 20 years; yet there are some managers who hold on to this outdated practice.
- Reporting credit investments at amortized cost as do many banks. Accounting standards require investment funds (private credit funds meet the definition of investment funds) to report investments at fair value, not amortized cost. Some fund managers who follow International Accounting Standards (IFRS) have interpreted a gray area in IFRS 9 to allow amortized cost. Even if allowed, it is not required, and investors need fair value reporting.
- Reporting credit investments at a “conservative” value. Conservative in today’s world has - in some cases - come to mean purposefully understating. Investors need an objective view of fair value, not an understated view.
- Failing to take into account equity kickers such as options or warrants received as part of the loan package. Some managers fail to report the fair value of such instruments and thereby understate the yield at inception which is derived through calibrating the entire package (loan principle, coupon and equity). Again, investors need fair value of the entire investment package, not just the loan component.
Summary
Reporting the fair value of private credit investments in accordance with FASB and IASB rules is a long-established requirement of private investment funds. Investors need transparent fair value estimates based on robust and validated fair value procedures. Many credit managers seek to do just that.
- They comply with fair value accounting standards
- They utilize best practice guidance from the AICPA, IPEV and other sources
- They document and use observable inputs to augment unobservable inputs in estimating fair value
- They consistently use calibrated inputs in their valuation models/platforms
- They backtest exit prices with interim valuation estimates
- They apply informed judgement utilizing supporting data
- They validate their fair value estimates by utilizing third party valuation specialists as considered appropriate.
