A Primer for Debt Funds: Getting Your Valuations Right

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Valuing debt investments is complex, reflecting the growing variety of terms, structures and characteristics in today’s market. Yet it’s a vitally important accounting practice to get right.

Accurate debt valuations help businesses make informed financial decisions, drive investor confidence and maintain regulatory compliance — all critical to long-term success. So how do we make this more effective?

While there is no single solution, we have compiled a set of guidelines that, when implemented together, are designed to yield more accurate valuations of debt investments. In continuation of our previous article, A Primer for Fund Managers: Incorporating Third-Party Pricing Vendors and Valuation Firms into a Robust Valuation Process, which emphasized the role of external pricing vendors and valuation firms, this piece turns its focus to CFOs and managers of debt funds. Here, we outline key criteria to help navigate the complexities of valuing private credit instruments with accuracy and confidence.

Guidelines for Debt Valuations

• Establish and Adhere to Valuation Policy: Funds investing in private debt investments should have a robust valuation policy in place that is adhered to and updated regularly according to asset mix. If a fund invests in a new asset class that did not exist in the prior valuation period, the valuation policy should be updated accordingly to include any new valuation approaches and additional external databases used to value those new asset classes.
• Track the Industry: It’s important to track and review valuation marks of comparable funds that own similar financial instruments. This will instill a market-participant view in the valuation process.
• Review Retrospectively: For valuations performed on a periodic basis, it is crucial to compare models used at inception or prior-period dates if the investment was underwritten several years back. This will help track how key assumptions and expectations compare with actual performance as time elapses. These models should be shared with third-party valuation firms so the comparative performance between expectations and actuals can be factored into the valuation process to accurately recalibrate the models for current conditions.
• Manage Expectations: It’s important to proactively coordinate meetings with external auditors, third-party valuation firms and fund administrators to:
  • Set clear expectations for deadlines known early in the process.
  • Discuss valuation methodologies and key assumptions to be considered (particularly for those that will change from the prior year for new or highly illiquid instruments).
• Understand Structure and Collateral: Given the heterogeneity of debt investments, it is important for fund managers to understand the structure of the various debt investments and types of underlying collateral. From time to time, fund managers must assess the current value of the underlying collateral that is backing the debt investment and compare it to the outstanding debt balance. This will help assess if the debt is well covered with the appropriate loan-to-value ratio at time of valuation, vis-à-vis the inception or prior-valuation date of investment.
• Identify Risk: You should have clear documentation around the important aspects of your funds:
  • Types of risks inherent in each type of debt investment
  • Characterization of the risks (liquidity, credit, market, collateral value)
  • Valuation approaches considered with the models that are appropriate to account for the specific risks via the parameters (e.g., discount, prepay, default and loss-severity rates, loan-to-value ratios, etc.).
• Factor in Non-Performance: Fund managers must consider most likely scenarios for non-performing loans, along with their respective probabilities and percentages of recovery. Once determined, the valuation methodology should be updated accordingly. This will likely be an area of scrutiny with auditors and investors alike.
• Differentiate Esoteric Debt: Consider certain debt instruments separately due to their unique structures and risk-reward profiles, including litigation-finance and merchant cash-advance funds, factoring facilities/receivables financing and asset-backed lenders. Funds should solicit advice from experienced valuation professionals for these highly specialized and esoteric areas of debt valuations.
• Communicate Regularly: Your team should regularly communicate with your borrowers:
  The requirements to complete an audit and issue financials in a timely manner (while being covenant compliant and having the appropriate legal documentation, financial models and valuation policies, if applicable).

Continuous Improvement Required

While the above guidelines shouldn’t be viewed as an exhaustive list, they’re designed to make your firm’s existing valuation process more robust. That said, you should consider this process ongoing — it should be tweaked and expanded to ensure continuous improvement. Having and, more importantly, adhering to a robust valuation framework will not only provide you with a reliable reference point but also facilitate end-of-year financial statement audits and related communications with stakeholders.

Contact Us

Whether your firm needs assistance with internal valuations or external audits of your investment fund, our valuation professionals stand ready to help. We can perform a cost-effective gap analysis of your valuation processes and procedures.

If you have any questions about this article or wish to schedule a conversation with our Valuation team, please contact your PKF O’Connor Davies client service team or:

Noam Hirschberger, CFA, CVA
Partner
Valuation Services
nhirschberger@pkfod.com | 646.449.6363

Victor M. Peña, CPA, CGMA
Audit Partner
Financial Services
vpena@pkfod.com | 646.449.6380

Shalini Chandran, FRM
Director
Valuation Services
schandran@pkfod.com | 646.699.2866