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In recent weeks, discussions have been centered around valuation and potential systematic and valuation risks in the private debt markets. As a leading valuation agent for private credit managers, banks, and investors, drawing from over two decades of experience in the private debt market, we find it helpful to offer these insights garnered from our extensive tenure.

Base Rate Impact on Private Credit Market Participants

For much of 2023, as it became clear that inflation was more than transitory and the Federal Reserve embarked on a tightening cycle, we focused on the impact of higher base rates on leveraged middle-market companies in 2023.

Interest coverage and operating cash flow-to-Debt coverage KPIs eroded materially, given the ~50% increase in borrower interest costs due to the rapid rise of SOFR since mid-2022, which also negatively impacted borrower cash flows. Based on our internally compiled data of private borrowers through the fourth quarter of 2023, those deals underwritten prior to Q3 2022 had median interest-to-EBITDA less CAPEX, and operating cash flow-to-debt ratios of 2.37x and 9.6%, respectively, at underwriting.  These KPIs eroded to median ratios of 1.40x and 4.4%, respectively, as of Q4 2023. Although tighter, these stats still represent reasonable cushions, notably as macroeconomic conditions are improving and assuming interest rates are at the peak of the cycle.

Regarding the cycle, the Fed, at its March meeting, indicated that it reached the end of its monetary measures, with the Fed Funds Rate of 5.25%-5.50% likely the peak. Moreover, the Fed is still targeting three 25bps rate cuts this year. This would bring the Fed Funds Rate range down 75bps to 4.50% to 4.75% by year-end 2024.

Similarly, the forward curve for 3-month term SOFR, the private credit market’s preferred base rate benchmark, is still downward sloping and predicts SOFR to decline from 5.33% currently to around 4.50% by year-end 2024, and longer-term (5+ years out), SOFR will level out in the 3.6% to 3.8% range.

Meanwhile, new deals underwritten in the fourth quarter of 2023 had an average interest coverage statistic of 1.89x and an average cash flow coverage statistic of 8.63% based on spot 3-month SOFR rates, which is still tight compared to historical standards (interest coverage closer to 2.5x+). However, borrower risk KPIs and cash flows should improve going forward as base SOFR rates decline thus lowering borrower interest expenses and improving cash flows.

Risk Considerations

Two years since the Fed started aggressively tightening and after more than a year of SOFR rates at 5.0% and above, the spike in private loan defaults that some feared has not materialized. According to KBRA Direct Lending Deals, U.S. direct lending or private loan default rate was 2.3% for all of 2023. Currently, the trailing 12-month March 2024 default rate stands at just 2.1% and is forecasted to rise only modestly by year-end to 2.75%. In the syndicated bank loan market, the default rate was 5.8% for 2023, bumped up to 6.5% as of TTM March 2024, but is forecasted to trend back down to 5.75% for all of 2024, all per KBRA.

B-rated secondary loan prices (a closely watched proxy for direct lending credit risk profiles), on average, are trading close to PAR, so the public market is not pricing for a material market decline inherent of a significant systematic issue in corporate loan markets.

Also, the non-accrual rate as a percentage of total fund assets under management (a proxy for expected defaults) of public business development companies, which primarily hold private loans, as publicly reported as of December 31, 2023, and as compiled by VRC, only amounted to an average of 2.19% of AUM.

Private credit’s relative stability may be attributable to several factors:

• Survivor bias: The pandemic, which aided in triggering inflation and prompted the Fed’s decisive tightening measures, also served to cull the ranks; the surviving middle market companies honed operational efficiencies, trimmed expenses, and often emerged with diminished competition compared to the pre-pandemic market landscape.
• Synthetic fixed rate liabilities: While direct lending is typically viewed as a floating rate market, sponsors often use interest rate swaps and other instruments to hedge anywhere from 30-50% of their portfolios, resulting in effectively lower fixed rates for some securities, according to our clients. They were especially aggressive in locking in lower fixed for pre-mid 2022 deals as base rates skyrocketed.
• Private equity symbiosis: There is a strong relationship between private credit lenders and private equity owners/borrowers. Lenders’ first lien claim on assets coupled with equity holders’ large investment in the same companies (often 50% or greater of capitalization), and considering that lenders and PE borrowers are often a source of each other’s new business, motivates both parties to resolve any issues with minimal disruption to their joint portfolio companies as well as their relationship. Lenders’ general business relationship with private equity borrowers along with the recurring information rights, gives lenders better visibility on the short and medium-term outlook and first-hand knowledge of the big equity holders’ ability to fix any issues. Hence, distressed company resolutions are often handled by private lenders and private equity, constructively and quickly out of court, historically with minimal actual losses (2-3% default rates and 60% average TTM recovery on a par weighted basis per Direct Lending Deals).  Lenders are often comfortable waiving covenants or accepting PIK interest in lieu of cash interest, and private equity owners often infuse additional capital to support businesses in exchange for receiving these private lender leniencies.

Lastly, private credit underwriting has been sound as evidenced by the low default rates to date and the expected modest default rates in 2024, as well as a lower default rate relative to the public bank loan markets, which are reporting 2x the number of defaults as the private lenders.

In the face of recent adversity posed by the COVID financial crisis in mid-2020, the private credit markets experienced much resilience, as many borrower revenues were severely impacted, whereby private lenders along with their private equity partners were able to manage through with modest defaults around 7% of AUM. Now, in a time of one of the fastest and most aggressive monetary policy shifts in our lifetime, it appears that private lenders will manage through with minimal defaults and losses. Systematically, the market is working well and historically has worked well.

Reporting Requirements for Private Credit Funds

Fund directors, chief compliance officers, valuation committee members, and investor relations teams working for private fund managers have several standards that they need to meet for reporting and controls.

Private funds have long been held to standards in determining fair value based on the FASB’s GAAP Accounting Standards Codification 820 (ASC 820) and the International

Financial Reporting Standard 13 (IFRS 13), which are also subject to accounting and SEC audits. Moreover, the SEC has released several new rules affecting the private funds market under the regulated Investment Advisers Act of 1940. The newest rules – Rule 2a-5 and Rule 31a-4 – require additional reporting, recordkeeping, and audit requirements, define how funds should manage potential conflicts of interest, apply and test fair value methodologies, and clarify the role of the board of directors among specifying other material matters fund boards are now required to manage.

Variables Impact Valuations

As a valuation provider for more than ~25,000 private debt and equity securities per year, there are reasons why private debt marks may not appear to move in lockstep with publicly traded debt securities and why different lenders might carry the same private loan at different valuations.

For stressed or distressed credits, valuation analyses rely on assumptions about default probability, equity sponsor behavior, recovery rates (including the present value of future losses), and oftentimes the outcome of bankruptcy proceedings. Under those circumstances, ranges of say, 10 to 20 points, may be considered reasonable.

Even when considering performing loans, variances are possible. However, within the broader context of the market or individual manager portfolios, minor discrepancies of a few points hold little significance. These differences often stem from varying factors such as:

• Varied access to information from the borrower, which could arise from a client’s strict confidentiality policies or pending legal agreements that may require added layers of authorization or clearance; or logistical, operational, or resource-constrained issues that might create or limit communication channels, hindering the timeliness of information provided.
• Timing considerations where an asset is valued at different points in time (or based on differing policies on how and when the information can be reflected after an officially established valuation date).
• Differing fund valuation protocols to determine final valuation estimates by a fund manager’s internal valuation committee and their board of directors.  For example, some fund board of directors simply adopt the mid-point of the valuation providers fair value range, while others may guide to select any value within valuation providers’ range.  A minority of other funds may average the valuation providers midpoint valuation with their own determination.  Accordingly, we could provide the same valuation range for a particular investment to three different fund clients, and they may all have modestly different valuation conclusions.

There are practical reasons why public credit market prices may exhibit greater volatility than those on the private markets, such as:

• Public credit markets expect a certain level of liquidity that is inherently priced in. In times of market dislocation when retail investors flee the markets, debt prices often trade off materially, reflecting a material required liquidity premium for such credits. These trades could be deemed distressed, which is outside of the definition of fair value.
• On the other hand, private credit markets underwrite credits with the assumption of holding them until maturity, which fund investors know. Hence, prices are expected to be more stable in private credit portfolios given the inherent lack of required buyer/seller market forces.
• The potential involvement of private equity sponsors in assisting middle-market borrowers during short-term cashflow crises further contributes to potential stability.

These considerations, coupled with general manager liquidity lines and diversification policies, help mitigate volatility risks that may be associated with the more public, liquid credit markets.

Summary

While the private credit markets may have many differences from public markets, there are many similarities in market diversity and market participant behavior to keep the markets operating efficiently, and standards and rules in place that guide management of the funds, create appropriate oversight, and mandate the reporting of the fair value of their assets, which all help to mitigate systematic risks.