The private debt market continues to grow with more fund managers active every year and a steadily increasing total of outstanding loan notional values.
As institutional or high net worth investors seek to diversify their portfolios the private debt market has proven attractive to many for a variety of reasons. These include having low correlations with mainstream equity markets while providing a fixed income like asset with a much higher yield than government or high grade corporate bonds.
Comparison with other asset classes
Compared with other alternative asset classes such as hedge funds, private debt has a simplicity of positioning that all investors can relate to. Choosing solid companies (or finding a quality fund manager to do the job for you) is the key driver to high risk-adjusted returns. Doing this successfully however is a highly skilled task. The sector also has much lower risk than its sister asset class of private equity and has demonstrated much higher increase in volume over recent years.
However private debt is not a way to earn risk-free money. Because of its increased popularity, spreads have compressed to the point where investors are asking if the market is offering enough yield to justify the risk taken on. This is also not a market with infinite depth – as the number of investors increase and previous loans are taken up there is a danger that future opportunities are simply not as good as those that have gone before. The skill of being able to lend wisely amongst companies seeking loans has been valuable for centuries.
2008 financial crisis and regulation
While investors need to be extremely discerning there is also the reality of the burden of compliance in today’s world. The effect of the financial crisis in 2008 is still being felt today in many parts of the global economy.
One profound and long term consequence was the advent of regulations crafted in the wake of this crisis. MIFID II and PRIIPs both came into effect in 2018 and have been up to ten years in the making. Much speedier on the scene in regulatory terms was the introduction of the Alternative Investment Fund Managers Directive (AIFMD) in mid 2013. There are reasons for the quicker arrival of this regulation. It has a relatively limited scope by asset classes and because some of the biggest investment disasters were related to complex and illiquid instruments this was an area of the market needing urgent attention.
Thankfully the financial community has for the most part moved on to a more sensible array of investment options. Investors have demanded simpler and more transparent investments in every market and regulatory pressures have accelerated this process.
The private debt market has also benefited indirectly from regulatory developments. Banks are much less able or willing to lend money and therefore smaller companies that have to raise money do so by tapping into direct lending.
AIFMD quite rightly demands a robust valuations framework for all alternative asset classes and this includes private debt. Before the financial crisis and this directive it might have been acceptable to value such loans at par or with a simple discounting technique, but not in today’s world. Parties are still struggling with reconciling traditional practices of assessment into a proper valuation process.
Valuation levels and techniques
The valuation of private debt falls into the category that the international accounting boards (IASB and FASB) term “Level 3” valuations. This is the most complex and subjective end of the valuation spectrum and is fundamentally different to directly traded instruments with screen prices (Level 1 – including listed equities and bonds) and those that can be computed via market inputs and accepted models (Level 2 – including derivatives).
At FVC our newly developed private debt valuation service is strongly built around a concept of bringing Level 2 discipline and techniques into the Level 3 world. These techniques have three main components to measure and account for core credit quality, illiquidity effects and covenant conditions.
It is of course impossible to conjure up liquidity or transparency where none exists but valuable insights can be made which increase the accuracy and meaning of the valuation process for investors. One of the most important axioms of finance is that no investment sits in a vacuum and therefore comparisons can always be made.
At the heart of our valuation methodology is use of our proprietary and sophisticated credit assessment algorithm. This was first developed this in 2007 for assessing issuing bank credit spreads and these techniques have been extended for private companies.
There is a wealth of theory and data on this subject but it is important to take an approach that can be combined with other properties and components of the contract. This is an important point - the assessment of credit is not the same as for a larger liquid company where credit spread directly translates into bond prices.
Once core credit quality has been assessed the effect of the lack of the liquidity on the loan yields also needs to be addressed. It is possible to account for the increase in yield in a way that can be calibrated and used consistently. In illiquid markets such as private debt, the illiquidity is a permanent intrinsic property of the market and its presence provides much of the yield premium. It is there to be embraced by investors rather than feared in the way that temporary illiquidity can grip mainstream markets in distressed times.
Theory and analysis of the interplay of debt, equity and options produced over the last 40 years as used extensively in Level 2 valuations can also be used as part of the process of valuations of illiquid instruments with great effect.
Finally the third issue that occurs frequently in private debt is measuring the effects of covenants (any restrictions on the company taking the loan). This can also be modelled in various ways borrowing from well known techniques in financial theory.
This combined approach yields many benefits and provides a more solid valuation framework with much greater transparency and detail. We see the valuations process as not merely providing a snapshot price of a certain instrument on a certain day, but an ongoing value added service which aids understanding and reporting. These ingredients make for successful long term risk management and with that a sound compliance framework.