16 Feb Mark To Marketing (Q3-24)
Valuation has become a major area of concern for investors in private debt due to the asset class’s opacity, illiquidity, and susceptibility to economic and market uncertainties. Stale valuations, conflicts of interest, and the lack of standardized practices further amplify these concerns, particularly as the sector attracts more retail investors and faces heightened regulatory scrutiny.
Stale valuations, or delayed adjustments to asset prices, are an inherent characteristic of private credit due to the market’s illiquidity. Unlike publicly traded debt instruments, private credit loans do not benefit from regular price discovery, making it difficult to gauge their true market value. This creates several systemic risks. For instance, in evergreen or open-end funds, where investors can request redemptions at periodic intervals, stale valuations can create a first-mover advantage for better informed investors. Those with insights into a fund’s overvalued assets may choose to redeem their investments early, leaving remaining investors to bear the brunt of eventual markdowns. This dynamic increases the risk of “runs” on evergreen private credit funds, which are popular with retail high-net-worth investors, potentially destabilizing the segment. Such a risk is minimized in closed-end funds, the preferred vehicle for institutional investors, since limited partners do not have the option to redeem at will. Any attempt to exit would require a secondary market transaction, which inherently involves price negotiation, limiting the ability to exploit stale valuations.
The combination of illiquidity and infrequent valuation updates makes it challenging for external stakeholders to assess potential losses in a timely manner. This lack of transparency can undermine trust in private credit markets, particularly during periods of stress when accurate information is most critical. In such moments, market conditions shift rapidly, borrower creditworthiness deteriorates, and valuations need to reflect these realities to provide a true picture of portfolio risks. However, the lack of real-time price discovery and limited transparency leaves investors reliant on fund managers’ reporting, which is often delayed or incomplete. This lag can obscure risks, leading to poor decision-making and an inability to act swiftly to protect capital.
This challenge is further exacerbated by the incentives fund managers have to maintain high valuations, especially during fundraising periods. Strong historical returns are one of the most persuasive marketing devices managers can leverage to attract new commitments, and valuations play a critical role in shaping the narrative of a fund’s performance. By keeping valuations elevated, managers can enhance reported metrics, projecting a sense of stability and profitability that appeals to prospective investors. For institutional investors wary of the inherent opacity in private credit, such performance metrics can be reassuring, even if they are not entirely reflective of underlying realities.
The reliance on historically higher returns to market funds also aligns with the financial incentives of fund managers. Most evergreen private credit funds structure management fees as a percentage of the net asset value (“NAV”) of the fund. This creates a direct economic benefit for managers who maintain elevated valuations, as higher NAV translates to higher fees. In cases where valuations are closely tied to perceived fund size, delaying markdowns or impairments becomes not just a defensive strategy but a financial one.
This approach, however, creates a dangerous misalignment between the interests of fund managers and those of investors. Inflated valuations, while advantageous in the short term for raising capital and maintaining fees, can mask underlying risks. When economic conditions worsen or borrower performance declines, these risks can become suddenly visible, leading to a rapid deterioration in trust. Investors who relied on optimistic valuations may feel misled, particularly if losses materialize without sufficient warning. This erosion of trust damages not only the specific fund in question but the broader credibility of private credit as an asset class.
During periods of financial stress, the impact of delayed or inflated valuations becomes particularly acute. Accurate valuations are critical for investors to evaluate portfolio health, rebalance exposure, and make informed decisions about future commitments. If valuations are consistently slow to reflect impairments, investors may begin to suspect that managers are prioritizing their own interests over those of the fund’s stakeholders. This perception can lead to reduced confidence in the market and, in the case of open-end funds, redemption pressures that exacerbate liquidity challenges.
When high valuations attract new commitments, managers may be incentivized to continue delaying impairments, creating a cycle where reported performance diverges increasingly from actual portfolio health. Eventually, the delayed recognition of losses can no longer be sustained, leading to sudden markdowns that damage investor confidence and destabilize funds.
This dynamic highlights the need for private credit managers to adopt more transparent and consistent valuation practices. While accounting standards such as GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) provide general guidance, they stop short of prescribing specific techniques for asset valuation, leaving managers with substantial discretion in how valuations are determined.
Business Development Companies (BDCs) in the U.S. offer a unique window into otherwise opaque private credit valuation practices due to their granular reporting requirements such as position-by-position accounting fair value marks. BDCs are specific investment funds created in the United States to encourage the flow of capital, primarily in the form of secured loans, to smaller companies.
A benchmarking analysis by the International Monetary Fund (IMF), which focuses on promoting global financial stability, assessed BDC valuation practices.¹ The study revealed that private credit prices tend to be less responsive to credit shocks compared to high-yield or leveraged loans, despite the higher risk profile of BDC loan portfolios. This reduced sensitivity in valuation adjustments is offset by a significant discount applied to the market prices of BDC shares (relative to their NAV). Notably, the discount tends to widen during stress periods, driven by the general market repricing of credit risk, as reflected by traded proxies for loans such as the LSTA US Leveraged Loan Index.
Evidence suggests that adjustments to private credit loan valuations are not only smaller but also slower than those observed in public markets. Such deviations often persist for several quarters, during which time share prices and net asset values gradually converge. This lag in valuation adjustments highlights the inherent challenges of assessing private credit assets, particularly in volatile market conditions. As private credit attracts more retail investors, concerns about valuation have grown. Retail participants often lack the sophistication and access to information that institutional investors possess, making them more vulnerable to the risks posed by inaccurate or inconsistent valuations. This has led to increased regulatory scrutiny and calls for enhanced disclosure and governance practices.
The regulatory framework for private credit funds has historically been light, focusing on policy documentation, governance standards, and investor disclosures, without prescribing specific valuation methodologies. This leniency reflects the assumption that institutional investors, such as insurance companies and pension funds, possess the sophistication and resources to independently assess valuation practices and make informed decisions. However, these same investors often prioritize portfolio stability and may lack the incentive to rigorously challenge fund managers’ valuations, even in cases where discretion leads to significant discrepancies in asset pricing across funds.
In response to growing concerns about valuation risks, regulators have begun intensifying oversight. The U.S. Securities and Exchange Commission (SEC), the UK Financial Conduct Authority (FCA), and the European Securities and Markets Authority (ESMA) have all taken steps to tighten governance and enhance transparency in private fund valuations. Measures include stricter requirements for independent audits, more frequent supervisory inspections, and greater scrutiny of valuation practices. Regulators are also emphasizing the importance of timely and accurate loss recognition, particularly for semiliquid funds or those approaching the end of their lock-up periods. Where valuation risks are deemed high, policymakers are considering mandates for independent external audits and more rigorous internal governance frameworks to improve valuation reliability and investor confidence.
The increasing trend of retail participation in private credit has raised concerns about herd behavior during stress periods, where redemption pressures could destabilize the market. To mitigate these risks, securities regulators are recommending measures such as longer settlement periods, closed-end fund structures, and the adoption of liquidity management tools. Under the Alternative Investment Fund Managers Directive II (AIFMD II) in Europe, which went into force in April 2024, funds that substantially engage in the granting of loans must adopt a closed-end structure. Clear and comprehensive 10 International Monetary Fund, Global Financial Stability Report: The Last Mile: Financial Vulnerabilities and Risks. April 2024 disclosures on redemption limitations and potential risks are also being emphasized by regulators worldwide to ensure retail investors are adequately informed.
These developments underscore a broader shift toward enhanced regulatory scrutiny and governance practices in private credit. As the market continues to grow and evolve, aligning valuation and liquidity practices with heightened transparency standards will be essential to maintaining trust and resilience in the asset class.
[1] International Monetary Fund, Global Financial Stability Report: The Last Mile: Financial Vulnerabilities and Risks. April 2024