Estimated reading time: 9 minutes

Business Development Company (BDC) professionals are continuing to navigate a complex landscape of accounting and valuation challenges. As the private credit space continues to grow, new entrants and existing players are managing issues such as the recent regulatory focus on valuation calibration, the operational challenges of seeding a new fund with older vintage assets, the treatment of PIK interest, ongoing implementation efforts related to Rule 2a-5, and the complex valuation issues that arise when an asset is held in multiple funds.

These topics and more were covered during the latest Eversheds Sutherland BDC Roundtable, which brought together a panel of experts to address these pressing concerns and provide insights into best practices. The group participants included John Czapla, senior partner at VRC; Jaime Eichen, partner at Ernst & Young; Alex Bradford, partner at RSM US; and Neil Khettry, partner at Citrin Cooperman. Dwaune Dupree and Owen Pinkerton, partners at Eversheds Sutherland (US), co-moderated the event.

The following summarizes key issues that were discussed.

The SEC’s Calibration Focus

Under the FASB’s Accounting Standards Codification 820-10-35-24C, funds are required to calibrate their models at the outset of an investment so that modeled fair values align with the transaction price. Investment calibration procedures for new investment valuations are a crucial component of the accounting and valuation process, as mandated by both the PEVC Guide and GAAP measures. Despite the standards and requirements, many asset managers are falling behind, and panelists noted that regulators are paying attention.

The Securities and Exchange Commission (SEC) recently took enforcement actions for non-compliance related to calibration, highlighting the need for thorough and consistent procedures. The recurring themes in these cases often involve discrepancies between the original investment terms and the ongoing performance metrics, leading to valuation misalignment.

Calibration involves using discounted cash flow (DCF) modeling to calculate the implied yield from the original issue discount (OID) price and contract terms to match the investment’s fundamental credit performance throughout its lifecycle. To comply with GAAP and best practices, valuation models are established at the investment stage to calibrate the OID price with the implied yield and credit spread based on the terms in the underlying credit agreement. In addition, investment-level fundamental credit metrics and market-comparable benchmarks are also established.

Credit metrics at the onset of an investment are continuously compared against current performance metrics to assess the investment’s health and adjust valuations accordingly. Changes to market benchmarks are also considered to further adjust valuations. Adhering to this process ensures that the models reflect the true value of the investments, considering changes in both market conditions and company performance. When a company underperforms and/or logical industry credit benchmarks trade materially differently, and the manager reports marks close to cost, the SEC and investors pay heightened attention.

The Challenges Sown by Seeding

The registration of new public credit funds, often seeded with assets from an existing private fund, comes with specific accounting and reporting requirements. The panel emphasized that it is essential for new entrants to understand how the assets are accounted for and reported, particularly when transitioning from a private to a public fund structure. In many cases, when different sets of Limited Partners (LPs) are affected, it can create the potential for conflicts of interest as General Partners (GPs) often manage both funds. In such cases, obtaining a third-party fairness opinion may be prudent to support the transfer value. Ensuring transparency and fair valuation in these transactions is essential to maintain investor trust and regulatory compliance.

Segment Valuations, Reporting, and Taxes

Credit and equity valuations demand distinct approaches; understanding these differences is crucial to ensure accurate and compliant valuations. While both need to adhere to GAAP and other regulatory guidelines, credit valuations typically focus on discounted cash flow projections and risk assessments, whereas equity valuations may involve different models, considering growth prospects and leaning more on market conditions and comparable publicly traded equity.

The FASB has issued new standards for segment reporting and income taxes. While the intention is to provide more detailed financial information, the panel noted that fund asset managers often run funds more homogenously and do not find the segment reporting meaningful. The new standards may add complexity without significant benefit to investors.

PIK Interest: Treatment and Implications

PIK interest, a feature of distressed companies, was a focal point of the discussion. The panel highlighted that PIK options are often necessary when a company’s liquidity is near zero, indicating stress. New issuances typically carry a premium of 50 to 100 basis points for the PIK option.

In legacy restructured transactions, the PIK option can lead to material discounts in loan values if any added premium for the PIK option is deemed non-compensatory and inadequate market compensation. The valuation impact depends on the negotiation of the amendment, including the all-in rate and the extent of PIKing. The market is seeing a proliferation of PIK toggle options, which can signal opportunistic structures for borrowers.

The panel also discussed the potential for overstating incentive fees due to the treatment of PIK interest, which effectively increases the principal balances on which incentive fees are calculated. Auditors and regulators scrutinize how these fees are calculated and whether they accurately reflect the economic reality of fully realizing the accreted PIK interest. If the company is severely distressed, some managers reasonably do not accrue any of the PIK interest. When the situation is less dire, some managers discount the accreted PIK interest by the same amount as the fair value discount on the underlying loan (e.g., if the loan market is at 80, then only 80% of the accreted PIK interest is accounted for).  Fees are receiving increased scrutiny when calculated on distressed loan balances, evidenced by material sub-par values, and where all accreted PIK interest is fully captured. Ensuring that the accounting treatment aligns with GAAP, best practices, and economic reality is crucial to avoid regulatory issues.

Valuation Differences in the Same Assets Across Funds

Valuation experts on the panel addressed the perennial private market issue of valuation differences for the same asset across differing fund managers.

Recent press has highlighted instances where different public funds hold the same assets but report different valuations. The panel noted that this can occur naturally due to differences in the information available to each fund, the timing of valuations, and the processes used. Generally, the press points out small differences of 1 to 3 points in valuations for performing assets, which the panelists agreed are simply not material given the natural variability in valuations across funds.

Meanwhile, distressed assets can logically lead to significant discrepancies in valuations across fund managers. Differences of 10 to 20 points can be reasonable. Panelists explained that recovery outcomes can vary widely for distressed leveraged assets, contributing to wider valuation ranges and more significant potential differences between funds. Given the nature of distressed investments, this variability is considered reasonable and within natural market parameters.

One panelist emphasized that funds must document the valuation process and the reasons for any differences to ensure auditors can assess the reasonableness of the reported values.

Another related issue that can arise from marking the same asset for different fund managers is conflicts of interest. Conflicts of interest can occur when multiple lending parties are involved, leading to incongruent information and hostile relationships. In such cases, valuation firms may need to split teams or geographies to maintain independence. If the conflict-of-interest risk is more severe, and the valuation firm’s ability to deliver a truly unbiased and confidential opinion for one of the parties is impaired, the firm may need to inform the hiring fund manager and abstain from performing the valuation altogether.

Material differences in reported valuations are more common in distressed investments, where conflicts, differing opinions, differing information rights, and a wider range of outcomes are expected. Auditors must sign off on the accounting treatment of any gains and the valuation treatment that does not use the trade value for fair value reporting.

Impacts and Controversies: Secondary LP Interest Trades

The secondary market for LP interests is seeing a higher incidence of trades at discounts, reflecting slower private equity exits and increased investor liquidity needs. GP-reported Net Asset Values (NAVs) are based on the fair value of individual assets assuming orderly exits, while secondary market prices often reflect opportunistic liquidity premiums for early LP exits. The panel discussed the implications of these discounts, noting that the valuation purpose and underlying assumptions are incongruent. Ultimately, the panelists agreed that the underlying market assumptions are simply different, and valuations are not directly comparable. Therefore, all concluded that secondary market trading prices in a particular fund are not indicative of overvaluation by GP’s valuations of the underlying individual assets. However, auditors and regulators are monitoring the magnitude and rationale of these discounts to ensure fair valuation practices.

Valuation firms and auditors are scrutinizing the reasons for these discounts and the accounting treatment of gains from such secondary LP trades. Fund of fund managers that purchase smaller, fractional fund LP interests at a material discount to the GP-reported fair value are immediately marking up the discounted purchase cost to the higher GP-reported fair value. Under ASC 820, this is permitted if the secondary trade is deemed opportunistic or distressed and thus is not reflective of true market value. The focus is on ensuring that the valuation policies under ASC 820 are followed and that the differences in valuations are well-documented and supported.

Growth of Evergreen, Open-End, Semi-Liquid Fund Structures

The desire by private fund managers to attract retail capital has directly led to material growth of evergreen and open-end fund structures that promise retail investors some level of liquidity, often quarterly, despite the illiquidity of a majority of the underlying assets. These open-ended funds also frequently raise money from these retail sources, often monthly, weekly, or daily. Consequently, asset prices must be determined just as frequently to establish offering and redemption prices for the fund shares.

The panel discussed the methodologies and procedures necessary to handle this high volume and frequency, including more limited valuation procedures, shorter form reports, and new data processing technologies. The panelists also discussed using more portfolio-level dashboarding technologies such as PowerBI or Tableau to focus on large dollar names, large valuation movers, and high-risk investments. More rigorous diligence on procedures and vendor audits are also deemed essential and thus becoming more evident.

Open-ended, semi-liquid evergreen structures are also becoming more evident with fund of fund managers. While relying on GP-supplied NAVs has historically been a practical expedient for closed-ended quarterly fund-of-fund valuations, panelists explained that it sometimes falls short for evergreen or open-ended fund offerings. These structures often require more frequent valuations due to the more-frequent-than-quarterly nature of investor in- and outflows. Therefore, fund-of-funds managers and their valuation agents increasingly use benchmarking and correlation methodologies to bridge the gap between quarterly GP values and the need for more frequent valuation updates. In the case of single-asset funds, more quantitative and mathematical market-based analyses are being employed to handle the scale and frequency of valuations.

Aligning Roles and Responsibilities Under Rule 2a-5

The SEC’s Rule 2a-5 mandate, which became effective on September 8, 2022, and is a regulatory requirement for registered funds, clarified—and some would say expanded—directors’ responsibility for ensuring the accuracy and transparency of fund valuations. The panel discussed the roles of the board of directors, designee, fund manager, and valuation firm.

Most larger funds have assigned a designee, typically the fund manager, who carries out the valuation while working with a middle office portfolio management and valuation team. External valuation firms are often hired to assist in providing independent assessments, adequate documentation around valuation conclusions, and helping to ensure that there are no biases or conflicts of interest.

Despite assigning a designee, boards remain ultimately responsible for overseeing the valuation process. In many cases, compliance with 2a-5 has led to more frequent and detailed valuation procedures, increasing the scope of valuation services. For larger funds that may have 100 or more private investments to value, the panel discussed using newer portfolio monitoring and dashboarding tools to increase efficiency. This includes dashboards showing the assets with the biggest valuation move since the previous valuation, the largest assets in the fund, and a watchlist (usually via the fund manager’s internal risk ranking system) of the most troubled assets.

Considering the Aid of New Technologies

The rapid growth in fund sizes combined with the increased frequency of valuations has driven the exploration and adoption of AI and data management tools in the middle and back office. Panelists agreed that these advancements improve the quality and efficiency of valuations and can help enhance data security and storage, provide better documentation, and create more dynamic portfolio analytics and summaries.

One specific development driven by the embrace of technology and new requirements for high-level board oversight of valuations is the movement toward high-level portfolio monitoring tools and “dashboard” reporting. Dashboards aggregate exposures and focus attention on large positions, positions that moved significantly during the reporting period, and “watchlist” assets—in lieu of overwhelming stakeholders with large packets that contain the detailed modeling behind every name in the portfolio. Ultimately, this allows the fund manager and the board of directors to focus on the riskiest assets versus trying to take a deep dive into every asset.

Auditors are becoming comfortable with the dashboard process, which is particularly useful in managing high data volumes and more frequent valuations. However, detailed reports and individual models remain available for deeper analysis when necessary. The shift towards more portfolio-level analytics and diligence on vendor audits and procedures is critical to ensure auditors can validate the valuation process efficiently and effectively.

Conclusion

The BDC Roundtable event underscored the dynamic and complex nature of the accounting and valuation landscape in the business development company sector. As BDCs and other private security vehicles experience explosive growth, the importance of adherence to new accounting standards, proper calibration procedures, and transparent valuation practices cannot be overstated.

The discussions highlighted the need for robust controls, frequent valuations, and technology integration to manage the increasing demands and potential risks. For professionals in this market space, the event provided valuable insights and best practices to navigate these challenges effectively. The ongoing growth and regulatory scrutiny in the private credit market will continue to drive innovation and improvements in valuation processes, ensuring that the industry remains resilient and transparent.