In a recent example, Carlyle Group Inc.’s direct-lending arm helped provide a “second lien” junior loan to a U.S. lawn-treatment specialist, TruGreen, marking the debt at 95 cents on the dollar in its filing at the end of September. The debt, which is publicly traded, was priced at about 70 cents by a mutual fund at the time. Most private credit portfolios “remain above their public market peers,” the BoE’s Foulger noted in his speech on “nonbank” lenders.
And it’s not just the comparison with public prices that’s sometimes out of whack. As with Magenta Buyer and HDT there are eye-catching cases of separate private credit firms seeing the same debt differently. Thrasio is an e-commerce business whose loan valuations have been almost as varied as the panoply of product brands that it sells on Amazon, which runs from insect traps and pillows to cocktail shakers and radio-controlled monster trucks.
As the company has struggled lately, its lenders have been divided on its prospects. Bain Capital and Oaktree Capital Management priced its loans at 65 cents and 79 cents respectively at the close of September. Two BlackRock Inc. funds didn’t even agree: One valuing its loan at 71 cents, the other at 75 cents. Monroe Capital was chief optimist, marking the debt at 84 cents. Goldman Sachs Group Inc.’s asset management arm had it at 59 cents.
The Wall Street bank seems to have made the shrewder call on looming distress. Thrasio has been weighing a debt restructuring and today one of its public loans is quoted well below 50 cents, according to market participants. Oaktree lowered its mark to 60 cents in December.
“Dispersions widen when a company is falling into distress as well as when a lot of funds are marking the same asset,” says Bloomberg Intelligence analyst Ethan Kaye. “When a company is either stressed or distressed, it becomes less certain as to what future cash flows might look like.”
In an analysis of Pitchbook data from the end of September, Kaye found that in one in 10 cases where the same debt was held by two or more funds, the price gap was at least 3%. When three of four funds own the same loan, something that’s common in this industry, the differences get starker still.
Distressed companies do throw up some especially surprising values. Progrexion, a credit-services provider, filed for bankruptcy in June after losing a long-running lawsuit against the U.S. Consumer Financial Protection Bureau. Its bankruptcy court filing estimated that creditors at the front of the queue would get back 89% of their money. Later that month its New York-based lender Prospect Capital Corp. marked the senior debt at 100 cents.
In data pulled together by Solve on the widest gaps between how a lender marks its loans versus other parties’ valuations, Prospect’s name appears more regularly than most. BI finds that smaller firms in general appear to mark their loans more aggressively.
“There are big differences in how managers approach valuations, and a lack of transparency and comparability between them,” says Florian Hofer, director for private debt at Golding Capital Partners, an alternative investment firm.
Private Fans
For private credit’s many champions, the criticism’s overblown. Fund managers argue that they don’t need to be as brutal on marking down prices because direct loans usually involve only one or a handful of lenders, giving them much more control during tough times. In their eyes, the beauty of this asset class is that they don’t have to jump every time there’s a bump in the road.
Some investors point as well to the shortcomings of the leveraged-loan market, private credit’s biggest rival as a source of corporate finance, where Wall Street banks gather large syndicates of mainstream lenders to fund companies.
“There are a lot of technicals that influence the broadly syndicated loan market, like sales encouraged by ratings downgrades or investors getting out of certain sectors,” says Karen Simeone, managing director at private markets investor HarbourVest Partners. “You don't get this in private credit and so I do think it makes sense that these valuations are less volatile.”
Direct lenders also use far less borrowed money than bank rivals, giving regulators some comfort that any market blowup could be contained. They typically lock in cash they get from investors for much longer periods than banks, and they don’t tap customer deposits to pay for their risky lending. They tend to have better creditor protections, too.
Third-party advisers such as Houlihan Lokey and Lincoln International are increasingly assessing loan marks, adding scrutiny, though it’s paid for by the funds and is no panacea. “We don't always get unfettered access to credits,” says Timothy Kang, co-lead of Houlihan’s private credit valuation practice. “Some managers have access to more information than others.”
In the U.S., direct lenders often set up as publicly listed “business development companies,” requiring them to update their investors every quarter. BDCs do give better visibility on their loan prices but their fund managers are paid according to the portfolio’s worth so there’s an incentive to mark debt high.
“Part of the problem stems from the decision makers for portfolio marks, which include the third-party valuation firms and the BDC boards, who have a lot to lose if they decide not to play along,” says Finian O’Shea of Wells Fargo Securities, a BDC analyst.
For Hecht at AQR the real fear isn’t so much the wilder cases of value gaps, more that the very purpose of private credit is lending to risky businesses and that isn’t shown in overall asset values, echoing the UBS chairman’s lament.
“The part I’m also worried about is for normal credit risk environments where they mark nearly all assets at 100,” he says. “Most of the time, people are looking at these asset valuations and thinking they have no risk.”
This article was provided by Bloomberg News.