Private Credit: Public Challenges

Valuation is a critical component of the private credit market - it underpins the analysis of returns, risk, the cost and availability of capital and is especially relevant when considering the average credit quality of the borrowers that typically seek out private credit over commercial bank lending. For this reason, combined with the continued growth of the sector and interconnectedness with other financial institutions (which we explore further below), there is a relationship between valuation trends and the stability and transparency of the financial system. The valuation of assets into which private credit may be invested is not straightforward – different methodologies may generate vastly different valuations. In general terms, the two most common approaches are (1) Discounted Cash Flow (DCF) and (2) the Market Approach.

The Market Approach determines the value of an asset based on the market price of comparable assets. The Market Approach requires identifying a set of comparable assets that have similar characteristics and risk profiles to the asset being valued such as industry, size, yield to maturity, price to book value, credit rating, debt to EBITDA multiples and collateral. The concept is that the market price of the comparable assets reflects fair value, but this can be challenging as private credit is relatively illiquid compared to public credit.

Effects on liquidity

Credit funds therefore ensure that there are significant parameters set in valuation methodologies proposed by borrowers, to protect against the risk of asset overvaluation. 

A significant driver of overvaluation concerns in the current cycle has been the marked increase in interest rates borne by portfolio companies, as exacerbated by private credit borrowers typically carrying more debt on a floating rate basis and being smaller in comparison to borrowers of syndicated leveraged loans or bonds. Credit funds therefore need to ensure that valuation methodologies factor in amendments and extensions and recalibrations to the proportion of PIK to cash pay interest.

Where overvaluation does occur, it can lead to reduced liquidity as loans are less likely to be redeemed at their valuation figure and therefore prudent fund managers need to manage valuation methodologies to optimise the attractiveness of that fund so that it can successfully fundraise from those same limited partners for successor funds.

Leverage across the fund and portfolio structure

In a stagnant exit environment, many credit funds bridge their maturity-liquidity gap and facilitate earlier investor returns by utilising either:

• NAV facilities, a fund finance product often used in a manner akin to a dividend recap, where the credit base is the portfolio of loans and the funding is used to make early distributions to limited partners; and/or 
• continuation funds, which allow the harvest period of an investment to be refreshed in a separate fund vehicle and effectively creating a secondary market for the same assets within the same fund. 

Continuation funds typically have a different composition of limited partners, depending on the limited partners seeking an exit at the end of the original fund’s term and the entry of new limited partners looking to benefit from historic performance of the underlying assets. Certain commentators consider that continuation funds mask the true liquidity of the fund assets, as these are assets that the fund originally intended to, but did not, divest at the end of the fund’s term.

Concern with such fund finance solutions is also elevated where financing has been raised against the value of a fund’s underlying assets and such assets are at risk of having been overvalued. Broadly speaking, the funds themselves may end up holding debt instruments across the fund and portfolio structure which potentially sees them over-leveraged and under-collateralised. Whilst individually this may not cause concern, repeated and widespread occurrences of defaults may jeopardize the stability and sustainability of the private credit market. Thankfully, we have not seen any instances of notable defaults across fund and portfolio structures. This is attributable to the prudence of reputable fund managers and efforts of financial stability regulators. 

Market Stability

Regulators in multiple jurisdictions have been considering the arguments for greater regulation of the private credit industry. Whilst losses incurred by experienced private investors (and indeed banks in commercial lending markets) are a naturally occurring feature of the financial system and markets can regulate themselves to a degree, the distinction between credit funds and banks is that many credit funds’ investor bases feature pension funds, insurers and other traditionally regulated institutions. 

There is therefore a balancing act in a fund manager’s mandate on the one hand to deploy capital but also to invest in creditworthy assets. As banks regain their appetite for lending and compete with private credit, credit funds will invariably consider more ways in which to maintain their market dominance, potentially leading to looser covenants and more generally permissive documentation. It is not yet clear how this evolution of terms will impact valuations, noting historically valuations have generally increased in more competitive markets, but it is important to be aware of the potential impact. 

Conclusion

The issues of market cyclicality, information asymmetry, valuation uncertainty outlined above have come to the fore as a result of the more challenging economy experienced at its unprecedented size of the market, estimates pitch the value of assets under management in private credit at over $800 billion in Europe alone. Whilst it is arguable the market is self-regulating, regulators will be conscious of any distress in private credit markets spilling over into the wider financial system, and such regulatory supervision may be welcome to investors looking for greater stability in credit performance and consistency in valuations.