IFRS 13 in Private Credit: Navigating Level 2 and Level 3 Fair Value

The hierarchy problem in private credit

IFRS 13 organises fair value measurements into three levels based on the observability of the inputs used to derive them. For listed equities and vanilla interest rate swaps the classification is rarely contentious. For a bilaterally-negotiated unitranche loan — with an idiosyncratic covenant package, a PIK toggle, and an equity cushion provided by a middle-market sponsor — the classification is the single most consequential disclosure an asset manager makes.

The stakes are not academic. A Level 3 classification triggers expanded quantitative disclosures under IFRS 13.93, including the sensitivity of the fair value measurement to changes in unobservable inputs. It increases auditor scrutiny, invites regulatory questions, and frequently drives LP governance discussions. Managers therefore have a structural incentive to argue for Level 2 whenever defensible — and auditors have a corresponding incentive to push back.

When does a private credit position clear to Level 2?

The paragraph IFRS 13.81 defines Level 2 inputs as those other than quoted prices included within Level 1 that are observable, either directly or indirectly. In a direct lending context, the relevant question is whether the valuation is predominantly driven by observable market data — typically through a proxy.

A senior secured term loan originated at S+550 to a B2 / B rated borrower, where comparable broadly syndicated loans (BSLs) in the same industry, size bracket and rating cohort trade at an observable spread of S+475–S+525, may reasonably be marked using the observed BSL spread plus an illiquidity premium. If the illiquidity adjustment is modest and supportable, Level 2 is typically defensible.

• Observable spreads on comparable BSL or high-yield bonds from issuers in the same rating bucket and sector
• Credit default swap indices (CDX.HY, iTraxx Crossover) used as directional inputs
• Rating transition matrices published by Moody's and S&P Global
• Quoted prices from pricing services where a secondary transaction has occurred in the same or a similar tranche

Why most directly-originated loans remain Level 3

In practice, the population of private credit assets that clear to Level 2 is small. The majority of positions held in direct lending, mezzanine and unitranche funds are Level 3 because the inputs that most materially influence value are unobservable and entity-specific.

These include bespoke covenant packages (springing maintenance tests, incurrence-only structures, equity-cure mechanics), PIK toggles and their activation triggers, the quality and quantum of sponsor equity cushion, anti-layering protections, and deal-specific workout assumptions. Each of these materially affects expected loss and is not observable from market data.

Documentation standards for Level 3 marks

IOSCO's Thematic Analysis: Emerging Risks in Private Finance — Final Report (September 2023) raised the bar on what constitutes adequate valuation support. The report flagged the inherent opacity of private markets, valuation challenges where no observable market exists, and weaknesses in the documentation of valuation inputs across the private finance sector.

A contemporary valuation support file for a Level 3 private credit position should contain: the contractual cashflow projection with day-count and schedule methodology; the discount curve used (typically OIS plus a credit spread), with evidence for each component; hazard rate term structure (typically calibrated to a CCC or B3 benchmark and adjusted); LGD assumption with collateral and enterprise value analysis; sensitivity tables structured as a three-by-three grid of ±50bps on discount spread, ±10 percent on LTM EBITDA, and ±25 percent on recovery rate.

The exit price principle and the transaction price presumption

IFRS 13 sets out the relationship between transaction price and fair value at initial recognition (see paragraphs 57–60 and the related guidance in IFRS 13.B4). Whether the transaction price equates to fair value is a matter of judgement that depends on the facts and circumstances. For directly-originated loans the assessment is frequently nuanced — an origination fee, an upfront OID, or a structuring premium captured by the lender can mean the transaction price is not a clean exit price.

The general direction of IFRS 9 / IFRS 13 guidance, and of IFRS Interpretations Committee discussion of similar fact patterns, is that Day 1 gains supported only by an entity's own unobservable model inputs are typically deferred and released over time, while gains supported by observable market evidence may be recognised at inception. The specific accounting outcome will depend on the entity's policy, the instrument's classification, and the auditor's view — managers should treat this as a matter for their accounting policy and external auditor rather than a settled rule.

Practical takeaways

The gravitational pull of the hierarchy is towards Level 3 for private credit — and the analytical work the platform must support is at the Level 3 end: calibration, sensitivity, transfer disclosure, and reproducible evidence of inputs. Managers who have invested in systematic valuation infrastructure over the past two years are visibly differentiated during audit and regulatory inspections.