Among the attractions of an investment in an unlisted private credit fund is avoiding the volatility associated with public markets. However there is a downside to being forced to mark-to-market, with the risk a fund holds assets at a Book Value well in excess of Market Value.
A topical example is the impact of recent interest rate rises, with higher rates driving falling asset valuations. Yet the market has not observed wholesale revaluations in the private credit sector. While it may be argued that a loan not in default should not be subject to a negative revaluation, the illustration below indicates otherwise.
First, we establish the two basic building blocks of a headline interest rate:
- Base Rate | Reflects current funding environment (e.g. bank bill swap rate)
- Margin | Interest rate premium to reflect risk factors
Next, we consider a hypothetical private credit fund holding $100m of loans written in March 2022 at a fixed rate of 10.0% p.a. – fixed rates prominent in pre-1H CY22 portfolios – implying:
- 0.1% | Base Rate
- 9.9% | Margin
Fast forward 12-months and we observe the impact of the RBA Cash Rate rises and corresponding higher bank bill swap rate on the same loan portfolio.
- 3.5% | Base Rate
- 9.9% | Margin
The market now requires a return of 13.4% from the same portfolio, with no change in risk driven by a higher Base Rate.
Should the fund seek to trade this $100m portfolio, no fully-informed acquirer would pay 100c on the dollar as the 10.0% return is below Market Value.
Utilising the Yield-to-Maturity calculator below, we see that a Market Value return of 13.4% can only be achieved if the loan is revalued to $95m or a 5% discount to Book Value.
This reflects several concerns for investors, chiefly:
- New investors acquiring units in the fund risk overpaying by 5%
- Exiting investors have their units redeemed at a premium (100c vs 95c) at the expense of investors who remain
This Market Value challenge is not only driven by the impact of higher interest rates on the Base Rate.
Equally, loans that were sized utilising valuation reports drafted in early 2022 risk reflecting higher LVRs in 2023 and may be a refinance risk. Consider how the valuation of a property development site will have moved over the last 12 months.
A $35m loan on a project valued in 2022 at $50m reflects a bankable 70% LVR. However a 12% fall in valuation to $40m will result in an 80% LVR – a 15% increase in risk for not additional compensation to investors.
The key message to investors is to understand the composition of a private credit fund loan book, as this illustration shows how an attractive headline return and stable valuation may hide meaningful challenges.
The author’s advice to prospective and existing private credit fund investors is to read documents in full, ask questions, and seek professional advice.