Private debt valuation has become a major topic among alternative credit managers as the effects of COVID-19 reverberate through the market.
In partnership with the Alternative Investment Management Association’s (AIMA) Alternative Credit Council (ACC), we hosted a BNY Mellon virtual roundtable on May 5, 2020 to discuss current practices for valuing private credit strategies in the midst of unprecedented economic and market uncertainty brought on by the pandemic.
Joining us and our clients at the roundtable were members of the ACC and industry experts Murray Grenville from Sterling Valuation Group, Ryan McNelley from Duff & Phelps and Jiří Król from the ACC.
Below are the key takeaways from the session.
This Time It’s Different
This crisis is unique and valuation questions are front and center at private credit firms, particularly those active in illiquid, hard-to-value markets. The openness of the session showed how fund managers are keen to compare notes to endeavor to be in line with the market when determining fair value in these unprecedented times.
But Some Things Never Change
When it comes to core valuation principles, nothing has changed. Policies should be designed with enough flexibility to withstand market volatility and credit cycles. The fundamental question of what fair value is and where to look for fair value guidance has remained the same. However, some methodologies changed to reflect the uniqueness of the current situation.
Any approach to fair value should also be agnostic about whether the fund is open or closed-ended. However, the necessity to treat incoming and out-coming investors fairly raises the stakes for open-ended funds given the fact that money comes in and out at the NAV. Open-ended funds may require some extra care and disclosures around methodologies to ensure adequate transparency for investors and avoid surprises. The relatively stable environment for subscriptions and redemptions over the past decade is likely to change and this was marked out as an area where asset managers should expect greater scrutiny.
Preparing for a Second Quarter of COVID
So how do you value an investment in a COVID world? Many potentially relevant inputs – ranging from government liquidity support and timing on a vaccine to reduction in social distancing – are hard to quantify or forecast. Layering multiple uncertain variables means a greater chance of errors being compounded across the analysis. Therefore, many have preferred a simpler model based on yield adjustments, using current and historical objective inputs where possible.
Given the level of uncertainty as of March 31, fundamental credit analysis at the end of Q1 was extremely difficult. From a valuation perspective, investors sought to calculate an appropriate discount rate adjustment given the issuer, sector and level of COVID exposure.
Q2 is expected to be very different. Of course, a vast number of uncertainties remain, yet businesses are publishing 2020 re-forecasts. Therefore, the Q2 valuation process is expected to be quite labor intensive as fund managers review their portfolio borrower by borrower. Attention must be paid to the risk of double counting – one cannot simply layer credit analysis on top of broad discount rate adjustments as some of these factors will be already be taken into account.
Another area where people are reflecting on current approaches was the use of amortized costs as a proxy for impairment. This practice might be seen as a “shortcut” that is often unnoticed in a stable environment, but not necessarily in a COVID world. Here, the main question is whether it’s better to make adjustments or use disclosures and whether investors will be welcoming of either.
The pandemic also brought into question how fund managers can or should best use liquid assets and broker quotes to inform valuation in private credit. The initial stage of the crisis is showing some level of disconnect between public and private markets and a reduction in available data to compare. Discrepancies between public and private markets are manifesting in both timing and volatility levels. In March, there was a lot of data in public markets pointing downwards and an absence of data points for private markets. Since then, public markets have improved and private market data points are starting to become more available. Some managers reported widening yield prices in public and/or liquid loan markets being accompanied with concurrent tighter spreads in certain private market originations. What was known and knowable on March 31 will be very different by June 30.
Learn by Example
Other regions and prior crises may be instructive in valuing portfolios. Broadly, Asia is a few weeks ahead of North America and Europe in terms of the crisis timeline. The region may provide a preview of what may come to pass. Initial data suggests we are seeing some amendments to payment schedules, loans paid down to improve LTV coverage or the addition of more collateral.
Roundtable participants also reiterated how going back to 2008 and finding sector comparable companies was the most useful proxy at this stage for some firms. Looking at how comparables have contracted/expanded since 2008 could provide a gauge of their cyclicality at a time when robust data points are harder to source. Some were cooler on the wide use of historical or modelled EBITDA and LTM figures in forward-looking scenarios with the view that these factors are too hard to substantiate.
Another source of transparency is the Business Development Company (BDC) sector. BDCs must disclose a great deal of data in their filings and Q1 results are now being published. Interestingly, there is some clustering with NAV adjustments coming in around the 10-15% range whereas equity prices showed much greater dispersion. The transparency around BDCs might therefore be a useful window into how mid-market lenders are approaching valuation more generally as well as how credibly those valuations are perceived by the market.
Investors are increasingly sophisticated and are requesting more information. They are even engaging independent valuation agents to provide shadow valuation. Fund managers should strive to engage with their investors in a fulsome and transparent manner. Fund directors have also been focusing on valuation practices and disclosures at board meetings.
Our thanks to the ACC team for developing this roundtable with us, inviting its members to participate and sharing these takeaways.