With the Explosive Growth of Private Credit, These Are Interesting Times for Valuation Professionals

By John Czapla and Parag Patel, Valuation Research Corporation

A recurring theme at a series of events featuring senior members of the VRC private portfolio group is that, while the private credit markets continue an explosive growth trajectory and fund structures evolve to address the needs of a widening investor base, valuation processes and technology solutions are struggling to keep up.

Valuation groups and the broader operational support functions at large funds need to adapt to policies and procedures on the fly to keep pace with the growing demands for reporting and valuation transparency and accuracy for bigger and bigger portfolios while still operating on an already tight timeline. Often, that means band-aid solutions such as bolting legacy technology onto new platforms and trying to get them to talk to each other effectively to keep pace. Accordingly, all market participants, fund managers, and service providers are hyper-focused on technology solutions to keep up with “bigger, more, and faster.”

$5 Trillion or Bust?

There is an emerging consensus that the global private credit market will nearly double in the next five years, from $1.7 trillion to $5 trillion or more, as new entrants get involved in direct lending and incumbent managers launch new vehicles. A majority of the traditional institutions that have long-driven funding of the private credit market – pension funds, foundations, and endowments – say they aren’t done allocating yet. Further fueling growth are new groups of investors, such as insurers and high-net-worth retail accounts, as well as new regions like Asia-Pacific, or APAC.

These new participants are driving new fund structures, with risk-averse insurance companies seeking exposure to the safer parts of the capital structure and the intermediary channel demanding open-ended funds with regular liquidity windows on behalf of their retail clients.

All the capital flowing into private credit has clear implications for loan pricing and underwriting – tighter credit spreads and lower risk tolerance via low coverage ratios. As they look to deploy all the capital, market participants are looking to a growing array of loan structures, including more cash flow loans and asset-based lending (i.e., infrastructure, renewable energy, real estate, structured products).  Many believe asset-based lending is the new frontier as banks will be forced to withdraw from riskier parts of this segment due to pending Basel III: the Final Solution regulations. The new regulations will mandate or at least incentivize regulated banks to move to only the safest structures, leaving an opportunity for private credit to fill the void.

Balancing Valuation Opinions

With the proliferation of funds and a greater variety of instruments in those funds, valuation teams spend a lot of time thinking about how they partner with third-party valuation providers. How many should they use, and how should they divide the work across different asset classes and different funds?

Some market participants believe that different methodological and operational approaches for different assets are entirely acceptable. They might, for example, get a valuation range for debt positions from one provider and then seek positive assurance on their private equity marks from a rotating group of different providers.

There is a clear tension regarding the number of valuation providers that review any one position. While longtime valuation professionals – who understand that illiquid security valuation is part art and part science that requires sound judgment – know intuitively that getting an array of opinions from different valuation providers is expected, which invites board members, auditors, LPs, and other constituencies to ask questions when there is a valuation delta between providers. The issue has some sponsors adopting a policy of selecting a single vendor to cover a given asset class. Limiting the number of vendors looking at the portfolio also saves costs and reduces administrative burdens.

Valuation teams also face the challenge of handling positions held in multiple funds with different reporting periods and liquidity provisions. In some cases, that means setting up new valuation committees to meet more frequently than quarterly, such as monthly or on an ad hoc basis, to review big moves that might impact a daily net asset value requirement. With new fund structures launching quickly, some funds must update their written valuation policies to cover the latest procedures.

Sponsoring multiple vehicles that may have cross holdings also raises the question of how to reflect new information about borrowers. Some set up monthly or daily valuation committees to handle changes while others set up materiality thresholds.

Technology: Plus ça Change … (The more things change …)

The more technology solutions for private credit solutions change, the more the perennial challenges of capturing and normalizing data from disparate sources and deploying it across various portfolios and fund structures stay the same. With the market’s explosive growth, the cost of falling behind keeps growing. Moreover, with the growth in systems and a general desire to migrate data to the cloud, market participants are losing sleep over data security concerns.

New technology vendors spring up every year to serve the operational and valuation needs of the growing private credit market; participants remain frustrated that current systems are not up to the task. There’s long been broad recognition that the individual Excel investment models that still form the core of many sponsors’ middle offices are not efficient for ample data storage and processing yet normalizing them – and the information coming in from portfolio companies – remains a significant challenge, with most sponsors hardcoding data all along the chain to hold the systems together. However, despite the challenges, all agree that moving data from individual Excel models to cloud-based storage mediums and new-age software to organize and process the data is the way of the future.

There is general excitement in the market about AI’s potential to help solve the growing tech challenges by scraping and normalizing data from financials, credit agreements, and other sources. Some participants even express optimism that the benefits could go beyond enabling operational scale by generating insights from portfolio data that lead to better investment, risk management, and valuation decisions. But the AI magic bullet still seems, at best, a few years away from hitting those targets.

Summary

As key players in arguably the fastest-growing segment of the financial market, valuation professionals are being challenged like never before: more capital, more fund structures with more frequent reporting demands, more instruments, and more technological complexity to knit together. Interesting times, indeed.

John Czapla is senior managing director at Valuation Research Corporation, head of VRC’s portfolio valuation securities practice, and chairman of the board of directors. Czapla has more than 25 years of valuation experience. He can be reached at jczapla@valuationresearch.com or 609-243-7016.

Parag Patel is managing director of business development at VRC, focusing his support on the alternative investments community. He can be reached at paragpatel@valuationresearch.com or 917-338-5618.

The views and opinions expressed in the preceding article are those of the authors and do not necessarily reflect the views of The DI Wire.