Comment: Illiquid debt – par for the course, or not?

The alternatives industry may be comfortable establishing Fair Value for equity, but for debt products it’s a different story, explain Duff & Phelps executives Ross Hostetter and Ryan McNelley.  

The economic uncertainty across the Eurozone continues to make headlines – some for posing significant challenges for Europe’s policymakers and businesses, and others for creating investing opportunities.  The widely anticipated credit shortage arising from banks’ shrinking balance sheets and tightening of lending standards has created an opening for new entrants in the market to fill the capital void. Not surprisingly, the alternative investment community has stepped in with a flurry of fundraising activity as it rises to the challenge. 

Although investing in European credit securities is hardly new ground for alternative investment fund managers, less than 10 percent of Europe’s corporate lending has historically been provided by non-bank lenders. So there will be challenges along the way as fund managers increase their exposure to this asset class.  Chief among those challenges is determining Fair Value, which, even for performing debt, may not equate to par.

Most alternative investment funds are required to report their investments on a Fair Value basis.  Whether defined under IAS or US GAAP, the task is the same:  to determine “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” (as defined in IFRS 13 and in FASB ASC Topic 820).

The definitional requirement appears straightforward. However, there are many complications in determining the Fair Value of loans in particular.  First, the accounting guidance is essentially silent on the specifics of valuing loans.  IFRS 13 and ASC Topic 820 highlight the importance of “market participant” assumptions, but provide no specific guidance as to sources for the assumptions and only high-level guidance on the appropriateness of standard valuation methodologies. 

While much of the industry guidance on valuing illiquid securities is centered on equity, little has been written on the subject of valuing loans. 

Further, the lack of transparency in the private loan market – the very attribute that often gives rise to the investment opportunity – creates the biggest challenge where the accounting guidance favours observable inputs over managerial discretion. 

Finally, and perhaps most significantly, industry norms are difficult to break.  After all, the lending market was long referred to as “the par loan trading” market for a reason; loans traded at par, so there was no challenge in setting the mark.  Further, the preponderance of traditional bank loans (often cited as the target of new fund raises) are classified as “held to maturity,” so have historically been marked on an amortised cost basis in accordance with IAS 39.  These historical practices, however, are not consistent with a Fair Value standard that requires an assumption of a liquidity event at the measurement date, irrespective of any intent to hold to maturity.  So, before discussing a roadmap for valuing loans, the biggest challenge may be affecting the change in mindset that will be required in marking this asset class to Fair Value.   

Despite these difficulties, fund managers still have to fulfill their fiduciary obligation to determine Fair Value.  Although the debt valuation framework does not always lead to par, it does lead to a robust and defensible Fair Value. In the process, it may also create a differentiated product offering. 

 

This article was co-authored by Ross Hostetter (New York) and Ryan McNelley (London), who are members of the alternative asset advisory practice of Duff & Phelps.