TAKE two private credit portfolios run by the same firm for different investors: Should managers be allowed to trade unlisted assets between them?
It sounds like a practice mired in conflicts of interest and ripe for abuse – and yet lobbyists for big funds are asking US watchdogs to lift the ban on such transactions.
The push by the Alternative Investment Management Association (AIMA), reported recently by Bloomberg, comes with the caveat that so-called cross-trades between affiliated funds use independent, third-party valuations.
That sounds reasonable, but it places an awfully big responsibility on those pricing firms. They will live or die on their reputations for robust work, just as auditors or credit-ratings companies do – and that hasn’t always worked out well.
If the Securities and Exchange Commission (SEC) agrees to loosen its rules, it must ensure tight guardrails around how private asset prices are calculated and used and pursue strict oversight of valuation firms, too.
The proposal comes at a time when big investors are already concerned about growing conflicts in the private equity industry selling assets to itself through so-called continuation funds.
Also, the effort to lift the ban aims to make it easier for private credit funds to open to more retail investors, just as the industry is going through its first big test of individuals demanding their cash back.
The SEC’s ban on cross-trading applies to registered funds, which are those that can be sold to ordinary people, including exchange-traded funds and the newer evergreen, open-ended funds that the private asset industry is marketing to wealthy individuals.
It also applies to business development companies, or BDCs, which have been the focus of recent waves of withdrawal demands from some investors.
Big alternative managers want to be able to trade private assets between registered funds, BDCs and their traditional closed-end institutional funds.
The point is to help them better manage retail inflows and outflows where they are allowed, or to make it easier to switch some credits out if borrowers get into trouble, for example.
“Liquidity needs in an individual fund, or the change in status of an asset might mean you need to trade out,” AIMA deputy chief executive officer Jiri Krol told me.
“The best buyer then is likely to be an affiliated fund where the manager knows the asset well already.”
My main argument about private credit is that illiquidity is a feature, not a bug: Institutional funds that don’t allow redemptions are a safer and more stable structure for longer-term loans, especially those to highly indebted buyout companies, which is what most people mean when they talk about this market.
But if retail money in private loan funds is inevitable, let’s deal with the standards that should apply.
That’s where the practices of valuation matter. It’s a live issue because third-party estimates are used already to set quarterly net asset values in BDCs, for example.
As Krol points out, investors are already reliant on them to make real economic decisions. So how robust are they?
There are different approaches. Some funds do all their own valuation work and then turn to a third party for a stamp of approval – or a positive assurance, in the lingo of the industry.
That’s a lot like an auditor’s opinion on company accounts – the work isn’t redone, it’s just assessed.
Other funds ask an agent to do an independent cashflow-based valuation and provide a range of prices so that the manager can pick a level within those.
Investors ought to be worried if any manager always picks near the top or bottom of the ranges they get.
Sometimes a manager will ask for a point estimate – a specific price – from a third party.
That’s the most independent version of the exercise, but there’s no guarantee that the valuation is correct.
Then there’s the question of frequency.
To save costs, the most common practice is to get 25% of a portfolio of private credits assessed every quarter, meaning each loan is priced once a year.
That works in a stable economy when most companies are trundling along fine, but it can mean very stale marks if turbulence arrives.
In my view, the SEC shouldn’t lift its ban, instead maintaining the standard that market prices must be readily available for any trades between affiliates.
But if the watchdog is pressured into making a change, it must insist that all aspects of off-market valuation be very tightly controlled – and that ordinary, non-finance people can understand and trust them. — Bloomberg
Paul J. Davies is a Bloomberg Opinion columnist. The views expressed here are the writer’s own.
