Private Asset Valuations

The Credit Strategist Blog

The following is excerpted from the August issue of The Credit Strategist for paying and non-paying subscribers.

As President Trump prepares to sign an executive order allowing Americans to buy private investments in retirement accounts, a Wall Street Journal story about the collapse of a high yield municipal bond fund should serve as a warning that private investments may not be all they’re cracked up to be by their proponents.

The collapse of that fund also suggests that owners of private assets - including endowments, sovereign wealth funds, and pension funds - should question their funding levels to the extent they are based on significant holdings of private assets because the valuations of those assets are probably overstated. Recently, Apollo Management’s highly respected economist Torsten Slok reported that the 100 largest corporate defined pension plans sponsored by U.S. public companies were fully funded. To the extent those plans own private assets, that statement may not be true. As the increasingly active secondary market for private equity stakes shows, these assets are not worth where they are marked by their managers. Discounts of 10-20% are not uncommon. Public markets values have rallied strongly (in my view they are in a bubble) which certainly boosted pension fund valuations, but private asset values are lagging since many assets were purchased at high prices during ZIRP/QE. Timely, accurate valuations of these assets as the quantum of private assets grows into the trillions is more important than ever.

Shares of the fund in question, Easterly Asset Management’s high yield municipal bond fund, were trading at around $6 in June based on Easterly’s valuation of the bonds in the fund. Many of those bonds, however, hadn’t traded in years. When Easterly started selling some of the bonds in June, it turned out that the bonds were worth far less than what Easterly had been reporting and the fund’s shares collapsed by 50% to around $3. According to the Journal, Easterly’s explanation was that “true price discovery is only possible when bonds trade in the market.” The truth is that Easterly was not marking its assets to market properly. In fact, they were not marking them to market at all.

The high yield municipal bond market is about $400 billion in size and expanded rapidly from 2016 to 21 when massive liquidity fueled a pre-pandemic borrowing frenzy. Municipal bond managers funded all types of dubious one-off projects. Traditional municipal bonds are backed by taxes and monitored by rating agencies, which is not true of many high yield municipal bonds. These bonds frequently fund individual projects designed to repay the bonds out of the project itself and tend to be sold to small groups of asset managers, which means they rarely trade. For that reason, the valuations provided to investors by managers are meaningless until tested by the market unless managers conduct serious independent valuations of those assets (which they tend not to do).

This is important not just for the high yield municipal market but for other illiquid markets. Publicly-traded business development companies (BDCs) and private credit funds are filled with trillions of dollars of private high yield loans that rarely if ever trade, leaving their managers to report the values of these loans to investors based on their best estimates. Private equity portfolios are also filled with trillions of dollars of non-publicly traded equity investments valued in similar ways. Unless managers conduct serious, independent valuations of these positions on a regular basis, they are reporting inaccurate valuations to their investors. And if they don’t conduct such valuations, their valuations are highly unreliable until these assets meet the test of the market.

Among the most serious problems posed by unreliable valuations is that managers are charging high fees based on these unreliable valuations (because fees are based on the value of assets under management (AUM)). Perhaps this issue is best resolved between the managers and their investors who, after all, are generally large institutions and/or wealthy individuals capable of defending their own interests. The securities laws that govern this area are honored more in the breach than anything else. But if that’s the case, then the laws should be changed rather than remain on the books to be invoked selectively at the discretion of regulators. Instead, the situation today involves managers of private assets fudging valuations and disguising losses by raising more capital that absorbs the losses buried in their portfolios. This approach lowers returns but avoids or limits the type of catastrophic losses experienced by the Easterly fund, though there will no doubt be more situations like that. As I wrote last month, the lowest quality assets in a portfolio are always the most difficult to sell and many of those assets end up dumped at losses or written off, which is why investors want to be the first rather than the last one out the door when they sense trouble.

Rep. Elise Stefanik (R., N.Y.) is asking the Securities and Exchange Commission (SEC) to investigate Harvard University’s financial disclosures to bondholders with respect to the valuations of the university’s endowment’s investments in private equity funds that “are often overvalued due to reliance on internal estimates and outdated transaction data.” She argues that “the real, realizable value of these assets is likely far below stated values,” because of higher interest rates than when the assets were purchased and declining private market valuations. Harvard alum Bill Ackman warned that Harvard would suffer losses on pending sales of private equity positions a few months ago. Harvard doesn’t value these assets itself; it generally relies on its private equity managers to provide them. If the SEC were to oblige Rep. Stefanik and initiate an investigation, it would effectively have to investigate the private equity firms themselves. The New York Times’ Jonathan Weil thinks this could be helpful because, “With a full-court press under way in Washington to get private-market funds, like private equity, into Americans’ 401(k) retirement plans, it’s more urgent than ever that alternative investments reflect market realities, not wishful thinking.”

Such an investigation under in the current political environment is a long shot, however. As you can imagine, many of Rep Stefanik’s Republican (and Democratic) colleagues privately oppose such an investigation because the private equity industry and Wall Street are major sources of campaign contributions whose worst nightmare is exposure of their valuation practices. The Big Beautiful Bill protected the unjustifiable carried interest tax break again that has become a third rail even for Democrats like Senate Minority Leader Chuck Schumer. Whether the current SEC will act remains to be seen; it seems to have other priorities though someone should ask Gary Gensler why he left the multi-trillion dollar valuation issue alone while bringing many other unjustified enforcement actions.

Accounting rules on this issue are toothless, saying that investors “shall consider whether an adjustment [in value] is necessary” without requiring investors to do anything more than “consider” it. There is no outright prohibition on using valuations provided by managers even if those valuations are obviously unreasonable. Some argue, however, that forcing institutions like Harvard to value these assets could lead them to avoid making such investments because of the incremental cost involved. I seriously doubt they will do so unless they are pressured by donors and alumni. And investing less money in illiquid assets that produce poor risk-adjusted returns would be a good thing. But by and large private asset investors enjoy the opacity provided by an industry that allows them to hide losses. The industry thrives on opacity just like our politics.

There is nothing inherently wrong with private assets. There is no reason why every asset must be publicly traded. There are good reasons to keep assets private. Public ownership imposes heavy burdens on fiduciaries. But that doesn’t mean managers of private assets can avoid their own fiduciary obligations that include fairly and accurately and independently valuing their clients’ assets. Private loans, for example, are no different in kind than the types of loans traditionally extended by banks (the market for syndicated loans resembles the market for corporate bonds in terms of relatively limited liquidity and price discovery). The difference is that the private credit firms or funds are not banks and are not subject to the same types of regulation as banks. They are supposed to be subject to regulation as securities firms but there is a generally acknowledged hole (more like a Black Hole) in that regulation regarding how they value and charge fees on their assets. The dilemma lies in the business model of basing fees on assets under management (AUM) with respect to assets whose values are imprecise and subjective (and therefore able to be manipulated and inflated). Expecting Wall Street to police itself is asking foxes to guard henhouses, however. One alternative would be replacing the AUM fee model with a different fee model. For example, it doesn’t take more work to manage a $100 million loan than a $1 billion loan so why should a manager be paid ten times as much for the latter than the former? So perhaps an overall fee should be charged for an investment fund, or perhaps a fee based on the number of different investment positions, rather than AUM? This is not meant as a dispositive suggestion to a complex problem but as an effort to initiate discussion to solve a problem that is only growing worse as private assets come to dominate the market (my suggestion applies equally to private credit, venture capital, and any other non-public assets). As for situations like Easterly’s high yield municipal bond nuclear waste site fund, I suggest those types of assets should not be publicly traded or packaged into publicly-traded vehicles because the highly illiquid, one-off nature of those types of assets invites the outcome that occurred there. And there will be more Easterly’s before the current credit bubble runs its course.