Asset valuation is the process of determining the current worth of an asset or portfolio, often expressed as the net asset value (NAV). This valuation is typically required when an asset or portfolio of assets is being sold, or when investors want to enter or exit an existing investment fund or pool. In such cases, the portfolio's value ultimately determines the investment or redemption price.
Depending on the asset class, there may be different approaches to valuing an asset or pool of assets. For assets with a public liquid secondary market, such as stocks, bonds, or most fungible crypto tokens, values are usually approximated through available market prices.
Determining the value of illiquid assets common in private credit, which are mostly financed through the Centrifuge protocol, is more difficult because, by definition, there isn't a liquid secondary market to determine the value.
In such cases, the valuation methodology is often based on a fair value approach utilizing a financial model ("marked to model"). This can involve valuing the present value of future cash flows expected to be received based on these financings, using the discounted cash flow (DCF) method. Another approach may be "marking at par," in which the value of the outstanding debt is simply based on the amount owed.
The Centrifuge Protocol is asset class-agnostic and can handle different kinds of asset valuation methodologies. The valuation method chosen can be configured on a pool level based on the underlying asset class. Currently implemented and used are DCF-based approaches and "marking at par". For example, legacy Ethereum-based Tinlake pools predominantly apply a simplified one cash-flow approach for financing invoices or trade finance with a simple bullet loan (one borrow, one repayment). Pools financing longer-term assets with regular interest payments may opt for a classic DCF approach with multiple cash flows.
The valuation on Centrifuge Protocols is implemented on a per-asset level. That means whatever valuation methodology is chosen is applied on each individual asset. The sum of the asset values of all individual assets adds up to the portfolio value and together the pool reserve then equals the pool value.
The pool value mainly drives the price of the most junior tranche of a pool. As long as a junior tranche exists, changes in the pool value will not impact more senior tokens. These tokens accrue value at the determined fixed rate on "deployed capital", so adjusted only by the pool's cash drag. The junior tranche thus captures both, excess returns of the pool reflected through NAV increases beyond the senior rate as well as losses through defaults reflected through write-offs or write-downs of asset values.
Centrifuge allows for a flexible treatment of defaults implented as write-offs and write-downs on the valuation of an asset. If the repayment of an asset is overdue the valuation can be writte-down to a certain percentage after a defined number of days following pre-determined criteria (e.g. a grace period and collection period). The final step of this cascade of write-downs would be to fully write-off the asset. Note, that write-offs and write-downs only impact the most junior tranche of a pool.
The most common valuation methodology currently applied for pools on Centrifuge is a simple simplified "discounted cash flow" (DCF) model with one expected cash flow. This is often used for simple bullet loan structures (one borrow, one repayment) which are common particularly in invoice financing and trade finance. We will describe this methodology in more detail below. The same concept can also be applied to DCF valuation with several cash flows.
The DCF valuation process can be summarized as follows:
Derive expected cash flow
For every outstanding financing of an asset, the
Expected repayment amount is derived based on (i) the expected repayment dates and (ii) the expected repayment amounts.
Expected repayment date is derived on contractual obligations associated with the financing, e.g. the due date of the underlying invoice. This is provided through an Oracle based on the documents underlying the NFT minted on Centrifuge's P2P Protocol.
Expected repayment amount is projected based on the outstanding Tinlake financing by applying the financing fee on the current debt until the repayment date.
Risk-adjust expected cash flows
Expected repayment amount is risk-adjusted for credit risk by the
Expected loss. Every financing is allocated a risk class that has a
Probability of Default (PD) and
Loss Given Default (LGD) assigned to it. The
Expected Loss is calculated as
Expected loss = Expected repayment amount * PD * LGD and substracted from the expected repayment amount to adjust for credit risk. Note that PDs are often defined per anno and may need to be adjusted to the maturity of the underlying asset.
Discount risk-adjusted expected cash flows
Expected repayment amount are discounted with an appropriate discount rate (this depends on asset class and pool) to derive the present value of a financing. The discount rate usually reflects the rate of return an investor could earn in the marketplace on an investment of comparable size, tenor and risk. The discount rate is usually the same for every financing of a pool.
The standard formula to calculate the PV of a cash flow is:
r = discount rate and
t = period of cash flows. As we deal with intra-year cash flows, the formula becomes
number of discounting periods per year (e.g. 360 days for a financial year).
The portfolio value plus the liquidity currently in the Reserve of the Pool gives the Pool Value.
Please find a visual overview of this process below:
This example describes calculating the present value of a one cash-flow
Assumed Asset Parameters: Financing date = 01.01.2020 Financing amount (P) = 100 DAI Financing fee (i) = 10% APR Expected repayment date = 29.06.2020, Expected loan duration = 180 days
Valuation assumptions Discount rate (r) = 5.00% (Annual) PD = 4.00% LGD = 50.00%
General Assumptions: Days per year: 360, Seconds per year: 31104000
Remember, the textbook compounding formula is:
P = Principal in DAI [=100],
i = Interest rate (decimal [0.1]),
t = Time --> Loan duration in years [180/360 days = 0.5],
n = Number of times interest is compounded per unit
t [31104000 seconds per year]
Applying this to our financing assuming compounding per second gives
The Expected Loss with the risk parameters given is
as the PD expresses the annual probability of default we further adjust the expected loss for the term of the asset (assuming a uniform distribution of defaults):
This is substracted from the Expected CF to calculate the risk-adjusted expected CF: 105.13 DAI - 1.05 DAI ~ 104.08 DAI
r = 0.05, t = 90 / 360 = 0.25 = remaining asset duration in years, n = 31104000 seconds per year, gives:
Please also find the underlying calculations as well as other examples here.