Private Debt Investor, October 2018

Time to confront the valuations dilemma

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IPEV guidelines were brought in with private equity in mind and have an increasingly questionable application to private debt. Laurent Capolaghi of EY says changes may be made

What is the issue facing private debt firms when it comes to valuation? 

There is pressure from some institutional LPs, including supranational investors, to include a reference to the IPEV [International Private Equity Valuation] guidelines even if the fund pursues a ‘buy and hold’ strategy. But the problem is that these excellent guidelines were designed for private equity firms. If you hold private debt assets in isolation the standard requires you to value debt instruments based on a DCF [discounted cashflow] model, i.e. calculating the present value of contractual cashflows using the expected market yield relevant as of the measurement date.

IPEV methodology has dramatically evolved and the level of subjectivity has drastically gone down for private equity but, when it comes to private debt, it actually does nothing to change the element of subjectivity. Ascertaining the present value of contractual cashflows is a very difficult thing to do – collateral and terms and conditions, for example, are very different and there are no obvious comparators to come up with a reliable expected market yield.

When the IPEV guidelines were first written 10 years ago, there was a segment within private equity which was mezzanine, and that type of loan was very different. Mezzanine is much more opportunistic in terms of selling the asset before maturity and you typically have minority stakes, equity kickers and warrants. Therefore, it works very well with IPEV as it’s an equity-like approach. The market has changed a lot since then and private debt is no longer synonymous with mezzanine.

The current trend in private debt is in favour of direct lending strategies. These funds are all about yield and stability and distributions to investors and are not supposed to be subject to volatility in the P&L. But in valuation terms, you currently have the worst of both worlds – you have subjectivity and specific cost to comply with the standard. It is therefore not well aligned with the value creation objectives of the fund.

There is a good point to raise this with IPEV and the private debt community can take the initiative.

In direct lending situations the LPs are financing the real economy, applying a ‘buy and hold’ approach focusing on stable yield and balanced risk. As a result, the most appropriate valuation should only factor in credit risk and currency risk when applicable. But not market risk, because the seller is not seeking to dispose to a third party on a secondary market.

Such an approach would be very similar to what IFRS currently foresees: depending on the economic approach and provided that certain conditions are met debt instruments could be measured at amortized cost. This would align with current LPs’ expectations.

Do you think the situation is likely to change? 

I am very optimistic that Invest Europe [the industry body and overseer of the guidelines] will consider making changes. They have refreshed the guidelines frequently – normally every two years, which is very sensible. They recognise that the guidelines need to reflect LP and market expectation. 

Private debt has gained a lot of momentum over the last five years and it needs to be understood that it covers different strategies and more of them are of a ‘buy and hold’ nature. IPEV and Invest Europe have always been very open to pragmatic solutions.

From a Luxembourg perspective we have discussions about this very often as private debt funds have increasingly relocated to Luxembourg. Many GPs see the need for change. In terms of LPs’ due diligence processes, they need a reference to international standards but they also realise the standards are not appropriate for the strategy. These adjustments will bring greater transparency to the private debt universe.

What is the level of awareness of the valuation issue? 

It is actually very disparate. From an investor’s perspective, some institutional investors are well aware of the issue and have agreed not to refer to IPEV. From a private debt firm’s perspective, the largest houses have built the relevant models and have devised methodologies which have a better grip on the market yield. At the same time, lots of houses are also currently launching credit funds having not necessarily been in the debt industry for a long time. These players are therefore less aware of this issue and tend not to anticipate this item in the negotiation of the terms and conditions of the LPA. 

So, what happens next? 

Invest Europe listens carefully to its members and the industry, especially if there are direct calls from the members for change. I would expect the national associations to go to Invest Europe and raise these points. They could be endorsed by each national association and there could be a high-level paper that describes the situation. It would outline the expectations from LPs and GPs and propose amendments to focus on the risk that matters. It would then be added to the agenda of the committee that implements the guidelines, and I’m positive they would be happy to slightly amend the guidelines.  
 

CHALLENGES IN TRIPLICATE

Laurent Capolaghi summarises three other issues facing private debt: strategic diversification, lack of clarity around origination and the need for experience

The challenges in relation to the debt fund market are naturally following the same pace as the development of the industry. A first element is certainly that, under the current market environment, capital deployment will remain a challenge and may ultimately impact the overall appetite of investors for the asset class. We have seen several players over the last months considering further diversification of the strategies proposed to their investors. These strategies tend to address the low yield environment and related current expectations from investors in that regard.

Also, the uncertainties over loan origination in certain EU countries very much remain. While Luxembourg or Ireland have now clarified their position and welcome origination as long as the vehicle qualifies as an Alternative Investment Fund as per the Directive, several state members still restrict or do not have clear guidance when it comes to direct lending. Lastly, the consistent and continuous growth of private debt over years in combination with several operational relocations that occurred in the context of Brexit contingency plans have seen the need for seasoned professionals familiar with the asset class strongly increasing. It therefore seems crucial for the industry to keep attracting, training and retaining relevant professionals to serve the asset class both at the level of the manager and the service providers.