By Stephen L. Nesbitt – Chief Executive Officer, Chief Investment Officer of Cliffwater.
Contrary to concerns expressed in a recent Bloomberg article1 and republished in P&I Daily, private loan valuation is not a threat to the growth of the private debt asset class.
Investors, retail and institutional alike, are drawn to private debt because of their comparatively high current yields and safety.
Since the Financial Crisis, yields on senior private debt have averaged 7.2 percentage points over cash yields and 3.4 percentage points over comparable publicly traded bank loans.2 An investor in senior private debt would have seen twice the income investing in private debt compared to equivalent publicly traded debt.
Most investors view private debt, particularly senior direct loans, as safe. Loan losses from private debt defaults have averaged 0.9 percentage points per annum, slightly higher than the 0.7 percentage points for publicly traded bank loans. Losses at these levels would qualify as non-investment-grade by the ratings agencies but low enough to qualify as safe from a risk management perspective.
For most investors, the valuation of private debt is not an issue.
Valuation of private debt is straightforward, combining (1) the discounted value of promised principal at maturity minus and (2) the discounted value of possible losses from default.
Part (1) is a no-brainer. Floating reference rates found in private debt are closely tied to the risk-free rate. That means $100 in future principal will always have a $100 value regardless of the movement in interest rates.
Part (2) is more challenging, but manageable. It involves forecasting (a) the probability of future default at maturity, (b) the loss given default, (c) the present value of any future losses.3 Option pricing theory helps a lot in finding an answer but like most financial models, inputs matter.
The good news is that for senior direct loans, which comprise the growth in private debt, the inputs for (2) favor consensus on valuation. First, maturities are short by debt standards with effective maturities around 3 years. You don’t need to look far into the future to assess default risk. Second, senior direct loans are first-priority with loan-to-value ratios that provide significant equity protection, particularly given the short maturities. Third, most senior direct loans, unlike publicly traded bank loans, have covenant protections that mitigate inputs that give rise to losses in Part (2).
Diversification dramatically deflates valuation risk.
Pricing differences across lenders participating in the same private loan should be expected due to differences in lender or valuation firm inputs described in Part (2). Those differences should be greater for loans under financial stress. With no public market mechanism to determine a consensus loan price, individual loan price discrepancies will exist.
The further good news for investors is that loan diversification can quickly minimize or eliminate these estimation errors in loan pricing. Our research shows that investors should expect any individual loan to have a valuation estimation error of plus or minus 3 percentage points. For a portfolio of 30 loans, the valuation error drops to 0.5 percentage points at the portfolio level. And at one-thousand loans, valuation errors basically disappear.4
Private loans are not systemically overvalued.
The quantification of pricing errors and impact of diversification identified above might be compromised if valuations were systematically overpriced, as hinted at in the Bloomberg article. We also find no evidence of such behavior. While the median post-GFC price for private debt equals $98, or $2 above the median $96 price for public debt, that positive difference is largely explained by the amortization of original issue discount (OID) in private direct loans that is not present in public loans.5
Claims that private loan valuations are “smoothed” or “laundered,” thus understating risk, are not supported by the data.
We have written extensively on using statistical techniques to detect serial correlation in private debt valuations, a symptom of smoothing, and find that no such evidence exists for private debt.6,7 Real estate valuations are a different matter, where pricing remains sticky.
Why are public loan valuations so much more volatile compared to private loans?
This is an easy one, though not directly observable by investors. The two-step valuation process described above for private loans excludes a third component when public loans are considered. That third component is the cost of liquidity. Unlike private loans, public loans can be sold at any time, providing a benefit to investors. This liquidity option has a cost, generally estimated at 2 to 3 percentage points, that explains a good deal of the private-public loan yield spread. However, as most investors know, in times of financial stress, the cost of liquidity can rise dramatically. This cost increase materializes in a drop in public loan prices. Given that most public broadly syndicated loans are held and traded in highly levered CLO structures, it should not be surprising that there exists the potential for a blow-out in demand for liquidity, causing accelerated and deep price declines in these public loans, the consequence of which is high price volatility.
Private direct loans do not offer the same liquidity option to investors, and consequently the market volatility in the cost of liquidity is not determinative to private debt pricing.
Three valuation lessons for private debt investors.
1. Diversify loan exposure as much as practically possible to minimize valuation errors.
2. Select high quality lenders that follow best practices in loan valuation, including using independent valuation agents.
3. Choose investment vehicles offering liquidity consistent with confidence in asset valuation. For example, distressed debt might not be appropriate for evergreen vehicles.
Footnotes:
1 “Flawed Valuations Threaten $1.7 Trillion Private Credit Boom”, Bloomberg, February 27, 2024.
2 Yields are based upon the Cliffwater Direct Lending Index-Senior, 3-Month T-bills (FRED), and the Morningstar LSTA US Leveraged Loan Index.
3 See a full discussion of loan valuation and the application of option pricing in Private Debt: Yield, Safety and the Emergence of Alternative Lending, by Stephen L. Nesbitt (Wiley & Sons, 2023), Chapter 10.
4 Ibid. Chapter 18, page 160.
5 Ibid.
6 Ibid.
7 “Forecasting Risk for Illiquid Asset Classes”, Cliffwater Research, October 2019.
All posts are the opinion of the contributing author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CAIA Association or the author’s employer.
About the Author:
Steve Nesbitt is Chief Executive Officer and Chief Investment Officer of Cliffwater, and is primarily responsible for the day-to-day management of Cliffwater Corporate Lending Fund (CCLFX) and the Cliffwater Enhanced Lending Fund (CELFX), an SEC registered credit interval fund focused on the US corporate middle market.
Steve is recognized for a broad range of investment research. His papers have appeared in the Financial Analysts Journal, The Journal of Portfolio Management, The Journal of Applied Corporate Finance, and The Journal of Alternative Investments. His private debt research led to the creation of the Cliffwater BDC Index, measuring historical BDC performance, and the Cliffwater Direct Lending Index, measuring historical performance for direct middle market loans. Steve authored the book, Private Debt: Opportunities in Corporate Direct Lending, Wiley Finance (2019) which provides the analytical and empirical underpinnings of the private debt market.
Stephen L. Nesbitt snesbitt@cliffwater.com