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Global rules on foreign direct investment (FDI)
Cross-border acquisitions and investments increasingly trigger foreign direct investment (FDI) screening requirements.
Global | Publication | juillet 2024
The private credit market and direct lending have grown and diversified immensely in the past decade, offering alternative sources and terms of debt compared to those historically provided by the syndicated leveraged loan and public issuance markets. Consequently, they are fast becoming pivotal components in the capital ecosystem, so much so that the Bank of England consider that the private credit market is currently responsible for approximately $1.8 trillion of debt issuance, which is four times its size in 2015. This growth has been particularly pronounced in Europe and the US but there has also been significant activity in Asia.
Notwithstanding private credit’s continued robust performance and popularity in the recent macroeconomic environment (particularly, higher-for-longer interest rates), there are some structural considerations related to the valuation of private assets that must be kept in mind when considering the medium-term prognosis for this part of the debt market. We examine these considerations below.
DCF is one of the most widely used methods – it involves estimating the value of an investment based on its expected future cash flows (such as principal repayments, interest payments and fees) and risk-adjusting this for the time value of money using a discount rate.
Valuations are typically conducted on a quarterly basis, so credit funds recognise that the latest reported data may not reflect the current, up to date market conditions and the performance of the underlying assets, although this is no different from valuation methodologies for other private capital classes (such as private equity, real estate and infrastructure).
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.
In a stagnant exit environment, many credit funds bridge their maturity-liquidity gap and facilitate earlier investor returns by utilising either:
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.
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.
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.
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