The valuations shoe that no longer fits

European private debt firms are trying to measure portfolio performance based on a private equity template. No longer will that suffice.

It was back in June 2005 that two national private equity associations and one regional association – France’s AFIC, the UK’s BVCA and Europe’s EVCA – proudly announced their joint formation of the IPEV Board to govern (and, if necessary, make changes to) the newly developed International Private Equity and Venture Capital Valuation Guidelines.

The valuation guidelines, based around the principle of fair value, were a welcome step in the application of objectivity, consistency and transparency to the tricky task of arriving at a current valuation of stakes in portfolio companies that would satisfy both fund managers and investors.

At the time, there was little problem in private debt applying the same guidelines. It was a stretch to describe it as an asset class and, indeed, many saw it simply as a subset of the private equity universe. Mezzanine was dominant – an equity-like strategy characterised by minority stakes featuring equity kickers and warrants which would often be opportunistically sold before reaching maturity.

From 2005 to the present, private debt has grown beyond all recognition – last year accounting for well north of $200 billion in global fundraising. While it now boasts a myriad of different strategies, the most popular these days is direct lending – a buy-and-hold approach that bears very little resemblance to private equity.

Industry professionals tell us that while direct lending valuations should factor in credit risk, and perhaps currency risk, market risk has much less relevance than for private equity valuations. Rarely are positions sold to a third party on a secondary market – the type of transaction which underpins estimations of fair value.

Because of this, forcing private equity valuation methodologies onto direct lending brings to mind square pegs and round holes. Despite this, private debt fund managers are still widely expected to reference the IPEV guidelines in their reporting to investors. We are told that sophisticated investors and managers have collaborated on tailored models that pay a kind of lip service to IPEV while incorporating some common-sense flexibility.

But while it is possible to tiptoe around the issue, wouldn’t it be better to simply confront it head on? A swathe of firms has launched private debt operations in recent years – many of them with their roots in private equity – and they find themselves stumbling unwittingly into a valuation minefield. It would not take much collective effort to mobilise and try to precipitate changes to the guidelines.

They may not experience much resistance. Sources we sought views from were quick to stress that those who implement and govern the guidelines are good listeners, open to the idea of making changes that will go down well with industry association members. Expect proposals for change to be submitted soon.

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