Hidden values: Special report on private market valuations

Is the private credit sector overvalued? As regulators circle, Kathryn Gaw reports on the hidden side of private market valuations…

Depending on who you ask, the private credit sector is worth between $1.7tn (£1.34tn) and $40tn. These figures are based on the assumed cumulative values of all private credit funds – values which have been meticulously calculated and independently verified. But in a persistently high interest rate environment, with ongoing economic instability on both sides of the pond, questions have been raised about the reliability of private credit valuations.

Leading these questions are the regulators. In the UK, the Financial Conduct Authority (FCA) has confirmed that it plans to undertake a review of private market valuations. Last year, the US Securities and Exchange Commission (SEC) introduced new rules to improve the transparency of private market funds. These rules require all registered private fund advisers to “obtain and distribute to investors an annual financial statement audit of each private fund it advises and, in connection with an adviser-led secondary transaction, a fairness opinion or valuation opinion.”

Meanwhile, a report from the International Organization of Securities Commissions has warned that the global private capital sector is too complacent about possible risks, including interest rate risk. Higher rates can cause stress for borrowers, and could lead to higher defaults further down the line, which could then impact on investor returns.

To the untrained eye, the valuation process for unlisted assets is far less transparent and therefore far more risky than public funds. However, industry insiders are adamant that their existing valuations processes are every bit as detailed and reliable as their public counterparts. They are simply carried out behind closed doors.

“We compare the valuation of the private credit market to the public markets, and how credit risks should be priced based on the economic cycle and underlying credit issues along all the borrowers,” says Tim Warrick, head of alternative credit at Principal Asset Management.

“We still think private credit is appropriately priced, and there’s a premium in the private credit market compared to the public market.”

In the UK and the EU currently, the valuation of assets does not have to be carried out independently for UK and EU alternative investment funds. Most private credit managers carry out their own valuations. However, for some private credit offers, the type of analysis required can vary considerably and requires a high degree of expertise, which is typically provided by the likes of S&P or Moody’s.

“Illiquid valuations are opinion-based with subjective inputs and assumptions,” explains Laura Erwin, executive director, private asset valuations at S&P Global Market Intelligence.

“Valuations of the same security may vary between investors based on valuation policy, investment insights and information rights. This valuation uncertainty is frequently captured through a valuation range provided for each position.”

Read more: Blackstone boss cites 0.3pc default rate on private credit

S&P’s credit risk assessments might involve scenario analysis and stress testing for more material positions. Valuations are also assessed through an annual audit cycle to ensure they have been performed in accordance with best practice standards, such as the International Private Equity and Venture Capital Valuation (IPEV) guidelines, and those set by the American Institute of Certified Public Accountants (AICPA).

“Any changes in credit health should be documented and appropriate adjustments made to the discount rate,” says Erwin.

Key risk factors include the quality of the borrower, the spread duration, and the overall spreads in the market at any given time. However, private credit managers are quick to point out that these risks are not new, and in many cases have already been priced into valuations.

“We still think there’s strong value when you consider not only valuations, but consider the structure with covenants on the deals we’re looking at anyway, and lower leverage, which I think is maybe the most important thing in this consideration of risk-adjusted returns of valuation,” says Warrick.

Warrick believes that the leverage profile of these companies is much more attractive than it would have been two years ago in a lower rate environment. This means that companies will be in a better position to withstand uncertainty in economic conditions going ahead, even if the rate environment remains elevated for some time, given the lower leverage attachment and the fact that there is more equity in these transactions.

“Market risk is a vital component of the valuations process and is typically captured using an appropriate market benchmark,” explains Erwin.

However, market risks are evolving rapidly. The rising rates environment has started to test global credit fundamentals, and average leverage has been creeping upwards while interest coverage is compressing, limiting downside headroom. This makes valuation testing even more important across private credit portfolios which may be disproportionately exposed to higher-risk sectors such as consumer credit and real estate debt.

Read more: Private credit set for largest target allocation growth among alternatives

“I think we’re starting to see an environment change, and we’ve started to see dispersion in performance as a consequence,” says Christina Padgett, associate managing director and head of leveraged finance research and analytics at Moody’s Investors Service.

“And so I think it will be easier to see who’s been complacent and who hasn’t, who has created the right protections or the right structures.”

Moody’s’ expectation is that rates will come down this year. However, Jeanine Arnold, senior vice president, leverage finance EMEA for Moody’s Ratings, believes that a more significant risk could be related to spreads.

“Spreads are very tight,” says Arnold. “And what is more of a risk is that the banks are now providing financing where spreads are exceptionally tight and private credit is having to react to that and having to bring their overall yield down, because the interest rate might be the same, but the spread has to come down in order for them to be competitive on a basis.”

Private credit managers have begun to talk more openly about the possibility of rising defaults this year as a result of these challenges. Yet defaults are still expected to remain below four per cent, even after all of these various risk factors have been accounted for.

“We expect some demand destruction,” says Warrick. “Some industries will experience flatter growth or potentially some contraction in certain industries, and that will put some pressure on the underlying borrowers.”

There will always be valuation uncertainty associated with private credit investments, as the value of the underlying assets will inevitably be affected by macroeconomic issues. Quarterly valuation updates are now the industry standard, but there has been a recent push to increase the frequency of valuation updates. Alternative Credit Investor is aware of one private credit manager which is currently planning to launch a fund with daily valuations. This fund will have a high level of exposure to middle market direct lending loans, and will be aimed at both institutional and high-net-worth individual (HNWI) investors.

Read more: IMF warns on ‘retailisation’ of private credit

Over the past couple of years, private credit funds have been increasingly targeting HNWIs in an effort to tap into the lucrative retail market. Retail investors are used to a certain level of transparency in their public market investments, and there is a growing sense that incoming regulation may be influenced by this new investor demographic.

One private markets expert, who asked to remain anonymous, told Alternative Credit Investor that valuation regulations are seen as a way of protecting retail investors and educating them on the risks of private credit, ahead of an expected influx of retail cash in the coming years. They noted that the IPEV guidelines have been regulating private credit valuations for years. Therefore, if new regulation is introduced, it must be an education issue rather than a cause for concern.

“Private markets have been growing rapidly over the last several years,” notes Erwin. “With that level of growth comes increased scrutiny from investors and regulators globally.”

Unsurprisingly, this level of oversight is not always welcome.

“We already have a lot of scrutiny and oversight from external auditors,” says Warrick.

“We don’t believe there’s any need for additional regulation. But we do believe it will become more and more transparent through time as more and more investors gain access to the asset class.”

Regulation appears inevitable, and it is likely to have an immediate impact on the private credit industry. For example, more compliance professionals may be required to deliver the data that is requested by the regulators.

“If there are more compliance roles coming then there will be more data scientists required,” predicts Karen Sands, chief operating officer, private equity at Federated Hermes.

“The demands that we’re going to put on individuals mean that they’ll need to be multi-skilled.”

The higher cost of regulation could also impact investor yields.

“Regulation may have more of a purview as to ensuring that transparency is provided and consistency across managers,” says Warrick.

Read more: Direct lending returns will “more than offset” higher defaults this year

“But I don’t think it’s going to be burdensome or overly impactful. Right now the market is already evolving. Managers are already delivering what clients and investors are requesting and wanting to see. And that just naturally raises the game for all of our peers to provide the same level of transparency that we’re providing.”

Incoming retail investors may request a higher level of transparency in private credit valuations, but the institutional investors who fund the majority of these deals do not appear to be too concerned about hidden risks. Over the past year, multiple institutions have either carved out new allocations for private debt or increased their existing allocations, in a vote of confidence which has seen private market investment values soar.

Regulation may create a few headaches for compliance departments, but as long as demand for private credit is booming, the value of the sector is likely to remain robust.