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The opacity of the private credit market has bedeviled investors and market observers for some time, and, to make matters more confusing, the most transparent part of the market may at times give conflicting information.

This segment of the universe is BDCs. There certainly is considerable disclosure for these investment vehicles: each portfolio holding, the pricing for each loan, its maturity 鈥� and, of course, the fair value. It鈥檚 that last metric that sometimes offers differing conclusions.

鈥淚nvestors should be careful to understand the valuation and asset management processes and disclosers thereof between managers to better understand true risks between various BDCs,鈥� said Andrew Winer, managing director and COO of Registered Funds at聽Oak Hill Advisors.

The valuation process is no doubt thorough, and each fund describes its valuation process in its 10-Qs and 10-Ks. Of course, each fund also aims to be extremely precise. But BDCs have undergone significant growth, as many more managers are launching these vehicles to target retail investors.

This new constituency likely will not have the familiarity with private credit as pension funds, insurance companies and other LPs that have been investing in the asset class for years. The retail investors must have a fulsome understanding of private credit鈥檚 risks before making their, most likely, initial allocation.

One instance that has drawn wide media scrutiny is聽Pluralsight, which lenders took control of in August.

Among the BDCs that held the credit, there was a variance of 8 points, as of June 30. The disparity was much starker at the end of Q1 though. On the high end, Golub Capital marked the paper at 97 cents on the dollar; on the low end, Blue Owl Capital recorded a valuation of 83, as of March 31.

But large differences in valuations are also present in other names, such as聽Lithium Technologies.

Among the three BDCs that hold it, Goldman Sachs BDC (GSBD) and Hercules Capital (HTGC) marked it at 50 and 53 cents on the dollar, respectively, as of June 30. These marks fell materially from their Q1 valuations, as of March 31, of 93 for GSBD and 89 for Hercules Capital.

Meanwhile, Sixth Street Specialty Lending (TSLX) held it at 77 as of June 30, versus 91 as of March 31.

GSBD and TSLX both discussed Lithium Technologies on their respective funds鈥� Q2 earnings calls. GSBD Co-CEO and Co-President Alex Chi said that the borrower was one of three investments that, together, made up more than 70% of the fund鈥檚 unrealized losses. It is a recurring revenue loan, he noted.

TSLX CEO Joshua Easterly spoke of Lithium Technologies鈥� performance.

鈥淭he company has not performed as expected. And our fair value mark reflects this assessment,鈥� he said, according to a transcript. In addition, Easterly noted that Lithium Technologies was conducting a strategic process for which there is 鈥渁 range of possible outcomes.鈥�

GSBD and TSLX declined further comment, while Hercules declined to comment.

Diverging marks may offer conflicting views

Another large difference comes from issuer聽Auven Therapeutics聽(issuer A.T. Holdings II), which includes Barings BDC (BBDC) and Oaktree Specialty Lending Corp. (OCSL) as lenders. The Barings fund valued it at 78 cents on the dollar, while the Oaktree fund marked the paper at par, both as of June 30.

At the ends of Q3 and Q4 2023, OCSL held the paper constant at 99; in Q1 the fund moved the investment value up to par and held it there for Q2. Meanwhile, BBDC dropped its marks for the name consistently over that period. At the end of Q3 2023 and going forward, by quarter it declined to 95, 94, 89 and 78 cents on the dollar.

OCSL and BBDC declined to comment on the investment.

鈥淎 vast majority of private credit loans were initially originated at 97% of par or higher. If a loan is valued below this level after origination, it likely signals a decline in the loan鈥檚 credit quality and/or an increase in market spreads,鈥� said Chris Cessna, director at Houlihan Lokey.

As of June 30, an average of 6.0% of BDC portfolios were deemed riskier than at underwriting, while 8.8% were considered less risky, and 85.2% matched the original underwriting risk, according to Houlihan Lokey data.

Another issue can be when a cohort of lenders largely agree on a valuation, but one projects quite a different view.

This is the case with聽Isagenix International. As of June 30, BBDC booked the credit at 86 cents on the dollar, while Crescent Capital BDC (CCAP) and Main Street Capital Corp. (MAIN) each did so at 88. CION Investment Corp. (CION) though remained an outlier, valuing the paper at 98 cents on the dollar.

CCAP referred聽尝贵滨听to its most recent 10-Q for a description of its valuation process.

That process includes an initial valuation by the investment team monitoring that credit, which then goes through an internal pricing and valuation committee and is finally corroborated by a third-party valuation firm.

BBDC also declined to comment on Isagenix, while Main Street and CION did not respond to requests for comment.

Another borrower with conflicting marks is聽Allucent聽(issuer LS Clinical Serves). Two BDCs hold the paper: GSBD and MidCap Financial Investment Corp (MFIC). The former marked it at 88, while the latter valued it at 96, as of June 30.

The marks for each fund over the past four quarters have moved in opposite directions. At the end of Q3 2023 forward, those marks for GSBD were 92, 90, 88, 88; for MFIC those figures were 94, 96, 96, 96.

GSBD also declined to comment on Allucent.

MFIC pointed聽尝贵滨听to its valuation policy disclosure in its most recent 10-Q. The report noted that MidCap BDC鈥檚 valuation process includes getting quotes on a position from multiple brokers or dealers and that it may utilize an independent party.

One source said Allucent is showing signs of 鈥済radual improvement鈥� and that the company has 鈥渟upportive鈥� sponsors. Water Street Healthcare Partners and JLL Partners acquired the company in 2018 when it operated at CATO SMS, later rebranding to Allucent, according to a statement at the time.

鈥淭ypically, what would cause a loan to be deemed riskier than at the time it鈥檚 underwritten is whether the credit metrics of the loan are deteriorating,鈥� Houlihan Lokey鈥檚 Cessna said.

Some of those metrics include a change in leverage, less of an equity cushion as a lender, a financial covenant breach, declining earnings or additional debt taken on by the company.

A source at a private equity firm who asked to be anonymous noted the lack of disclosure about company performance as something to be careful of.

鈥淚f a loan is marked in the 98-100 context, it is viewed as non-impaired, but there is a cohort of assets that don鈥檛 deserve to be marked that high,鈥� the source said. 鈥淧ublic equity stakeholders invested in BDCs have the most to lose. They are not privy to the leverage profile of the borrowers or whether the borrower is growing or declining.鈥�

鈥淭hey trust the marks are valid and legitimate. They are investing capital into a business that is fundamentally overvalued,鈥� the source said.

More frequent valuations and the benefits of third-party valuators

Historically, BDCs used to have third-party valuation firms value at least 25% of their portfolio each quarter but that has been changing, according to Proskauer Partner John Mahon.

Now, with the rise of non-traded BDCs, which are offered through RIA platforms and other distribution channels, the shift is to have third-party valuation firms value investments more frequently.

鈥淎s a result of that, we’ve seen a move towards even 100% third-party valuations on a quarterly basis, and even some moving to 100% third-party valuations more frequently than that, even on a monthly basis,鈥� he said. 鈥淏y that I mean third-party valuation firms coming in and kicking the tires as far as what those valuations are.鈥�

One result of more rigorous valuation processes is it gives future investors even more assurance in the managers鈥� investments.

鈥淟Ps investing in future funds get more confidence in the positions that they’re investing in,鈥� King & Spalding Partner Todd Holleman said. 鈥淪o really, the ability to raise future funds is reliant upon people’s confidence in the process around valuation.鈥�

It鈥檚 a 鈥渉uge discussion topic鈥� for both a firm鈥檚 existing and future LPs, he added.

During the process of valuing their investments, some BDC managers conduct their own valuations solely internally, while some also hire a third party for 鈥減ositive assurance.鈥�

Other BDCs rely mainly on third-party valuation firms, which typically provide the fund manager with a range of values rather than one definitive value. For managers that use third-party valuation firms, they may mark positions in the midpoint of that range.

No matter the case, the BDC manager ultimately decides the value of the investment. Engaging an independent party though is viewed positively though.

鈥淲e talk to each BDC about their valuation process and view involvement from a third-party firm as favorable,鈥� said Chelsea Richardson, a Fitch Ratings senior director who focuses on BDCs.

The process for those third-party firms is part quantitative and part qualitative, according to a source at an independent valuation firm who described the process. The numbers include EBITDA, cashflow, leverage and liquidity, to name a few. But the valuation considers subjective factors too, including the company鈥檚 outlook.

鈥淚f the numbers are really strong today but the outlook isn’t, who cares what you’re doing right now if your outlook is poor?鈥� the valuator said. 鈥淚f the numbers are poor today, but you’re about to win several big contracts, that’s a whole different story. Numbers can give you a part of the story but don’t give you the whole story.鈥�

Third-party valuation firms may talk to the BDC鈥檚 deal team for a given credit, who are generally straightforward, the valuator said. 鈥淚 have seen deal teams flat out say to us, 鈥榶ou need to write this down substantially as things are just deteriorating,鈥欌�� the source said.

Houlihan Lokey鈥檚 Cessna said that each independent valuation firm鈥檚 process might vary slightly.

鈥淭hird-party valuation firms may differ in their approaches to loan pricing and the depth of their analyses,鈥� Cessna said. 鈥淲e are engaged to offer an independent valuation perspective, backed by comprehensive and rigorous analysis. However, the final decision on loan valuation ultimately rests with the individual BDC.鈥�

Lack of information, distress may lead to valuation differences

One factor contributing to diverging valuations is access to information. Two BDCs that hold the same loan may have different entitlements and access to information that not all debt investors may be privy to.

Some of this can depend on what role the lender holds in the transaction. Administrative agents and lead arrangers will sometimes have greater access to information than those solely participating in the lender syndicate.

鈥淲hat we’re trying to do from a valuation point of view is take the market participant perspective,鈥� said Lincoln International鈥檚 Brian Garfield, managing director and the firm鈥檚 US portfolio valuation practice.

He continued: 鈥淥n information that would be disposable to a market participant in the same instrument that I’m valuing, what would a willing buyer pay me for this, and what would a willing seller be willing to sell out of it. That’s essentially what you’re trying to figure out at the end of the day.鈥�

If a BDC has additional information through extra rights, that too should be considered, Garfield said. An example could be board representation through which a lender has learned about the company winning a big contract.

Stressed or distressed assets can lead to wider valuation differences.

鈥淢ore meaningful differences in valuations generally occur in underperforming assets,鈥� Fitch鈥檚 Richardson said. 鈥淭here might be something about a company鈥檚 financials, the overall market, or there may be a restructuring or sale process that makes it difficult to predict an ultimate outcome or recovery that could drive variation.鈥�

Still, most loans 鈥� 84.5% 鈥� were priced above 97% of par as of the end of Q2 2024, reflecting the strength of the underlying assets in BDCs. Only 3.9% of loans were priced below 80% of par, according to Houlihan Lokey. This data is consistent with historical norms.

One cautionary point: BDCs must show only how many loans are on non-accrual 鈥� meaning how many loans are not paying interest 鈥� rather than how many loans have been modified or amended.

How much liquidity has been extended to a borrower or whether a loan has gone through a modification is not required to be disclosed.

BDCs may show which names are performing above, at or below expectations, but they may not necessarily specify which loans were underperforming from when the investment was originated.

Discrepancies in BDC valuations have not initiated ratings changes, according to Richardson.

鈥淚f we saw a BDC consistently different from others that might be a flag to dig further into it,鈥� she said. 鈥淲e do see discrepancies in non-accrual category status. Generally, if there are elevated non-accruals it may indicate that losses are coming but ratings actions are driven based on realized losses.鈥�

With market volatility sure to ebb and flow, and individual assets susceptible to idiosyncratic moves, there is no doubt that some assets will be subject to discrepancies, no matter how thorough and rigorous the valuation procedures in place. Barring special situations, valuations are largely in line from one BDC to another.

鈥淐ritics of BDC marks don鈥檛 understand the work that goes into it,鈥� Houlihan Lokey鈥檚 Cessna. 鈥淓ach valuation is the work of three to four weeks in determining each mark, each quarter. We have a team of hundreds of people who do that.鈥�

Andrew Hedlund
andrew.hedlund@levfininsights.com
+1聽480 313 1334

Krista Giovacco
krista.giovacco@levfininsights.com
+1 917 757 6399