There are two methods of valuing an asset:
Mark-to-Model: You (or a third party you’ve hired) does an analysis. Some modeling and benchmarking. Plenty of spreadsheets. There is a range of sophistication that can be employed here. Once you’ve completed the modeling and benchmarking you reach a conclusion: “this asset is worth $xx.”
Mark-to-Market: You tell the world it’s for sale and see what interested buyers offer.
Most have their first experience with asset valuation in residential real estate. There are two ways to value a house:
- Have someone perform an analysis. Type in the address in Zillow and see what Zillow’s algorithm says. Or hire a real estate agent and get their opinion. Mark-to-model.
- List the home for sale and see what people offer. Mark-to-market.
The housing market today is living in the tension of mark-to-model and mark-to-market pricing producing very different numbers. Sellers are pricing homes based on mark-to-model. They’re anchored to 2021’s 3% mortgage housing market. Buyers armed with 6% mortgage financing have no interest in houses priced as if borrowing was still historically cheap. That is a simple explanation for the present slowdown in the housing market.
Mark-to-model has legitimate uses. Sometimes you must value an asset that is not for sale. Perhaps you’re using a home’s value to secure a loan. The bank must value your home without listing it. Or perhaps a private company is issuing stock to employees. The stock isn’t traded on the public markets, but it requires a fair valuation. Third-party appraisers and accountants assign a fair value to the stock. Mark-to-model. Very reasonable.
But if you are in a position where you can list the asset for sale; that is, you can determine the value via marking it to market as well as mark-to-model… obviously mark-to-market indicates the real value of the asset. I can demand my home is worth $1M until I’m blue in the face, but if I need to sell it and no one offers over $750K then it is presently worth $750K, my protestations notwithstanding.
Anyway…
Blue Owl is an alternative asset manager that recently offered an interesting case study of the discrepancy in the aforementioned valuation methods. At issue are two of its funds – OBDC and OBDC II. These are both private credit funds: that is, the assets in the funds are private loans made to businesses outside the traditional banking system. The underlying portfolios of OBDC and OBDC II are nearly identical, as you can see on Blue Owls’ website:
There is one critical difference between the two funds: OBDC is publicly traded while OBDC II is not. You can buy and trade OBDC at the click of a button in your brokerage account at the current marked-to-market price. If the market suspects some of the loans in the underlying portfolio may go bad, the fund will trade at a discount to its net asset value. If the market reads the 10-Q filings and notices much of the portfolio is made up of loans to software companies at risk of being automated out of existence by Claude, the fund may trade at a substantial discount. On the other hand, if the market believes the managers of the fund are exceptionally skilled at allocating capital and managing risk, the fund may trade at a premium. OBDC II on the other hand – though it holds 98% of the same investments as OBDC – is not subject to market pricing. It is a non-listed business development company. It is marked to model on a quarterly basis by Blue Owl itself and the 3rd party appraisers it hires. It is sold largely by wealth advisors to retail clients.
Given a choice of two nearly identical assets, one of which offers a realistic market price and the other offers a mark-to-model price, why would you choose the latter? Well… think about it from a financial advisor’s perspective. Imagine how easy it is to make the following pitch to a prospective client who just wants stability and good returns from their portfolio:
Mr. and Mrs. Prospect, you’ve worked hard to build this nest egg and now it’s time to create income to fund your retirement. How should we allocate your hard-earned dollars? Stocks are scary – they’ve suffered 20+% drawdowns three different times already in the 2020s alone. That’s one every other year! The benchmark public bond index has been in a drawdown since August of 2020 – nearly six years! On top of that, in 2022 bonds – the asset meant to serve as a buffer against stock volatility – were down 17%. What if I told you we could allocate your capital to an asset class currently paying an annual yield of 10% that didn’t suffer any drawdown in 2022 while bonds had their worst year in history?
Countless advisors made that pitch the last three years. Clients ate it up. My email inbox is testament to the full court press private credit managers have applied to wealth managers seeking an allocation to their client’s capital. I receive multiple inquiries a day from the private credit folks. On a hunch as I typed that last sentence, I checked my junk email inbox (I have ruthless filters for these people) and what do you know – an email from a private credit manager arrived 30 minutes ago. Our fund pays 10% and showed a positive total return in 2022.
Remember OBDC and OBDC II are public and private wrappers for the same pool of assets. Mark-to-model (OBDC II) works just fine until the privately valued fund continues to be marked at net asset value (“no problems here!”) while the publicly traded fund (OBDC) is in a 21% drawdown. When investors in OBDC II see the publicly traded version of their portfolio trading at a 20% discount they all have the same thought:
While my portfolio still shows a positive return, I want out.
This is one of those scenarios where the oft-pilloried base economic assumption that all humans act rationally is vindicated. If the asset manager running your private credit portfolio says it’s worth $100 and the market says it’s worth $79, you will certainly tell the asset manager you would like to redeem your shares for $100 right now.
Most of these non-listed business development companies - the vehicle of choice for private credit managers peddling their funds to wealth manager’s clients - have an option to redeem 5% of total outstanding shares per quarter. You can get your money back at mark-to-model pricing any given quarter as long as no more than 5% of all outstanding shares are requested to be redeemed. If aggregate redemption requests from all investors exceed 5% of the fund, the fund runs into problems. Back to homo economicus:
If the economy is strong, sentiment is optimistic, and the mark-to-market wrapper is trading at or at a premium to net asset value, why would anyone want to redeem their mark-to-model holding that is seemingly immune to drawdowns and paying them 8+% annually? Very few investors submit redemption requests in these conditions.
If the economy feels less strong, sentiment is plagued by fears of AI-related job-less and bankruptcies, and the mark-to-market wrapper is trading a substantial discount to net asset value, investors in the mark-to-model wrapper are going to submit redemption requests. Yes, please pay me a substantial premium to what these assets are currently trading for in the public markets.
Gradually, then suddenly. Here’s what happened with the aforementioned Blue Owl funds:
- Through 2025, OBDC II was marked-to-model at net asset value (for simplicity, let’s say NAV was $100/share).
- The public markets began sniffing out issues in the loans making up OBDC/OBDC II’s portfolios. By November, OBDC was trading in the public markets at a 21% discount ($79/share).
- OBDC II’s investors rushed for the exits and asked Blue Owl to redeem their shares at $100 (the mark-to-model value according to Blue Owl). Redemption requests far exceeded the 5% quarterly cap.
- On February 18th, Blue Owl announced it will no longer be repurchasing shares from investors and will instead begin the process of winding down the fund and returning all capital to shareholders.
Of course, to return capital to shareholders, it must sell the fund’s assets that it has been marking-to-model.
Do you think the price it (and, by extension, its investors) gets for those assets will be closer to the mark-to-model or mark-to-market values?
Sean Cawley, CFP®
Sources:
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