Cliffwater: Realized and Unrealized Gains or Losses
Accounting For Realized and
Unrealized Gains (Losses)
Net gains (losses) are defined as the periodic change in loan valuation. It is the equivalent of price change for traded securities. We divide net gains (losses) into two components, realized and unrealized.
Realized gains (losses) represent the component of valuation change for completed transactions. In the case of a portfolio of loans, such as the Cliffwater Direct Lending Index (CDLI), realized gains (losses) mostly come in the form of realized losses generated by write-downs of loan principal that result from borrower default. The amount of the write-down depends upon the value of the post-default collateral or new principal amount.
Unrealized gains (losses) represent the component of valuation change that is sourced by a change in market price or, in the case of a portfolio of loans, such as the Cliffwater Direct Lending Index, a change in “fair value” not attributable to a transaction.
It is instructive to review the mechanisms by which gains and losses for direct loans are typically generated, as well as the link between realized and unrealized gains and losses.
Loan values are established quarterly based upon a fair value assessment as to what the loan is worth. Fair value takes account of the probability and size of future loan impairments based upon individual loan circumstances.
Price changes in the broader traded credit markets, including high yield bonds and bank loans, help guide expectations for future loan impairments and fair values.
Quarterly changes in fair value create unrealized net gains (losses) which cause fair value to differ from cost (par) value. Most likely, fair value will be below cost value to reflect some probability of impairment.
Unrealized losses from reductions in fair value usually occur in advance of actual loan impairments as the certainty of loss increases as default approaches.
A subsequent default event triggers a realized loss which is a permanent reduction in the cost value of the loan.
The realized loss (from a default or restructuring) replaces the existing unrealized loss through an offsetting unrealized gain. The new unrealized gain equals the prior unrealized loan loss if the default event and realized loss was correctly anticipated
Over time, investors observe a build-up in net realized losses, as defaults accumulate. These realized losses are similar in construct to loss rates reported by rating agencies and banks for high yield bonds and bank loans.
Unrealized losses generally build in the early stages of a credit downturn and reverse in later stages as realized losses from defaults replace them.
Stephen Nesbitt, CEO & CIO
Steve is the CEO of Cliffwater, an investment advisory firm specializing in alternative investments, including private equity, private debt, hedge funds, real assets, and real estate.
Important Disclosure Information
There is no guarantee that private debt will perform favorably under all market conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
Investments in alternative funds are speculative and entail substantial risks.
References to any particular entity should not be considered as a recommendation or endorsement by Cliffwater.
The Cliffwater Direct Lending Index (the “CDLI”) seeks to measure the unlevered, gross of fees performance of U.S. middle market corporate loans, as represented by the underlying assets of Business Development Companies (“BDCs”), including both exchange-traded and unlisted BDCs, subject to certain eligibility requirements. The CDLI is an asset-weighted index that is calculated on a quarterly basis using financial statements and other information contained in the U.S. Securities and Exchange Commission (“SEC”) filings of all eligible BDCs. Cliffwater believes that the CDLI is representative of the direct lending asset class. The CDLI is owned exclusively by Cliffwater, and is protected by law including, but not limited to, United States copyright, trade secret, and trademark law, as well as other state, national, and international laws and regulations. Cliffwater provides this information on an “as is” and “as available” basis, without any warranty of any kind, whether express or implied.