Note Valuations

A recent valuation of a private note maturing in 2044 and with an outstanding balance of $95,000 was valued at $52,000. There’s a silver lining to every cloud. Instead of lamenting about not making your loans AFTER rates shot up, some people are taking advantage of the situation and converting notes made in Traditional IRAs to their Roth. Roth conversions are taxable events based on the fair market value of the assets converted. The timing to have notes appraised for an IRA valuation, and other reasons like estate planning, is better than ever because of the recent sharp runup in interest rates.

The most common method of valuing private loans is the Discounted Cash Flow method (DCF). The general approach is to assess that the note has a “lower value” than the unpaid principal plus accrued interest. The DCF approach measures the value of an asset by the present value of its future economic benefits. When applied to debt instruments, value indications are developed by discounting expected cash flows to their present value at a rate of return that incorporates the current rate environment and the risks associated with the particular debt instrument.

The discount rate used is generally based on rates of return available from alternative investments of similar type and quality. Given that private note transactions are usually not disclosed or publicly available, the initial discount rate search will be sourced from the public markets. Business Development Companies (“BDCs”) comprise a little known segment of the larger, and better known population of investment companies, primarily mutual funds. The investment companies elect to be treated as BDCs for their unique tax treatment. They’re required to invest at least 70% of their assets in illiquid securities of small and medium sized companies, generally debt instruments with equity features or preferred equity. They are publicly traded and provide a published dividend yield used as an acceptable comparison. Currently, the five largest BDCs have an average dividend yield of 11.09% (as of January 5, 2022).

Ares Capital Corp. - 10.18%
SKKR Capital Corp. - 13.48%
Owl Rock Capital Corporation - 10.95%
Blackstone Secured Lending Fund - 10.70%
Prospect Capital Corp. - 10.16%
Average - 11.09%

This gets us into a larger discussion of Fair Market Value (FMV). Note values, secured or unsecured, are presumed to be the amount of unpaid principal, plus accrued interest. Because of FMV, it can be shown with satisfactory evidence that notes are worth less than the unpaid amount. The IRS, and most others, consider FMV using the willing-buyer-willing-seller test. The value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts. Methods for deriving FMV have been tested in numerous Tax Court Cases, mostly in the context of the IRS challenging estate planning techniques pushing for lower values. Because of this, there is great opportunity not for just DCF but for lack of control and lack of marketability in general for assets of all kinds.