Mark-to-Market in Face of Illiquidity
August 11, 2003
Mark-to-market activities in the loan marketplace, whereby a bank loan fund's book value is adjusted to reflect its current market value, are in a state of transition. Regulatory non-compliance as dictated by the Sarbanes-Oxley Act and risk of investor litigation when funds are discovered to be improperly valued, no longer allows funds to carry all of their loans at par, or original issue value, unless they are in default.
These risks demonstrate the critical need for fair market value loan pricing in the mark-to-market arena. Investors can now offset pricing risks in an illiquid marketplace by using a pricing provider that implements a market approach, along with utilizing financial and credit analysis. Applying this methodology to the valuation of loans facilitates fund pricing that is reflective of current market levels - for even the least liquid loans.
At one time, funds may have neglected to mark their loans with current market values, perhaps under the assumption that no such values existed in the loan marketplace. Although dealer contributor marks are available on a number of loans, they are not available on all facilities outstanding. Neither are they necessarily regarded as reflective of the fair market values. In addition to these shortcomings of dealer contributor marks, these values are the result of arithmetic averages, which can include outliers, be stale and be thin, with few contributors. Current mark services also lack independence, as they rely completely upon the dealer community for their data points. In short, marks alone do not provide the entire loan value picture.
Employing a market approach provides the required breadth of perspective for a loan's value. Market observations - including dealer marks, news, new issues and trades - in conjunction with financial and credit analysis on obligors, and active dialogue with both the buy and sell side of the market, establishes credit and market profiles for illiquid facilities that are then linked to active market comparables.
By incorporating descriptive, market and credit information, this approach is more comprehensive and therefore offers a level of comfort in calculating a fund's true, current net asset value (NAV). This is particularly true for those funds with less liquid names. The result is a truly fair market value price - timely in nature, and reflective of both macro activity on the market level, as well as company credit and financial changes on the micro level.
Investors seeking to reduce risks and obtain accurate prices in an illiquid market should rely on strategic partners that have established methodologies for overcoming the challenges of accurate pricing. The market approach has been time tested and proven highly effective for the evaluation of illiquid or hard-to-price fixed income instruments in other asset classes for decades.
The drive toward transparency in all markets is undeniable. The market approach is a clear indicator of the loan market's efforts to increase transparency. By taking advantage of providers that employ this unique methodology, loan funds can enjoy this level of comfort in their NAVs, and be assured they are meeting mark-to-market regulations with the most accurate prices available. By implementing these prices sooner rather than later, funds reduce investor litigation risks as regulatory requirements become more stringent and exacting.
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