The ABCs of BDCs: Private Debt and SEC Concerns

Business development companies, or BDCs, represent a growing class of relatively large, closed-end, SEC-registered funds. Most are publicly traded. BDCs supply capital, primarily debt but also equity, to the middle market space. They are a valuable addition to other available financing options as traditional banking industry sources have been facing other headwinds and capital demands. Larger BDCs have well over $1 billion of assets under management, with the ability to raise and disburse additional capital. Unlike private equity funds, BDCs are generally designed to have an unlimited life. Leverage of up to one-to-one debt-to-equity is allowed, and their status as a Regulated Investment Company (RIC), much like mutual funds, allows pass-through tax treatment of income.

BDCs may be considered as generally public vehicles for making private investments. There are many BDCs now in the development stage with the goal of a near-term IPO. BDCs generally invest in the debt and equity securities of “traditional” middle-market companies ($10mm to $50mm of EBITDA), but they may also invest in larger-cap (to ~$300mm EBITDA) and small-cap middle-market companies. Most BDCs are generally credit-focused with investments in senior secured debt, including 1st and 2nd lien loans, and subordinated debt, including mezzanine debt and distressed debt. Investments may also include equity securities (with control positions allowed), including warrants. The holdings are often considered “Level 3” illiquid (and untraded) assets under ASC 820.

With this growth of BDCs comes a real and growing need to responsibly value the illiquid investments. As registered companies with quarterly reporting requirements, their valuation need is also quarterly. Hedge funds and private equity groups may also have this need on a regular basis.

VRC provides valuation opinions and support to many of the leading BDCs, as well as hedge funds, private equity groups, and other asset managers:

  • Our valuations are used primarily for financial reporting and investor reporting purposes.
  • Our support is also used to facilitate interfund transfer requirements, and for lender reporting needs (i.e. collateral).
  • Our services are most commonly for the independent valuation of Level 3 illiquid investments, on a quarterly basis.
  • VRC also provides price verification for Level 1 investments, and input verification for Level 2 investments.
  • Securities commonly valued include the following:
    1. Credit Securities: Floating and fixed rate 1st lien and 2nd lien loans, secured or unsecured mezzanine debt and convertible bonds
    2. Equity Securities: Convertible preferred, straight preferred and common
    3. Structured Products: Collateralized loan obligations (CLOs), collateralized debt obligations (CDOs), and bespokes. VRC may value highly complex asset-backed or mortgage-backed securities with the assistance of its affiliates.
    4. Derivatives: Options, warrants and credit default swaps (CDSs)

VRC has experience valuing investments in nearly all industries. As credentialed analysts, we are able to determine and analyze key industry-specific value drivers on a timely basis. Our work with large-cap, middle-market and small-cap capital providers helps keep us abreast of current capital market conditions, capital structures and required rates of return.

Positive valuations represent the overwhelming majority of the valuations provided by VRC. This is a valuation which provides the client with an independent opinion of value, with visibility as to inputs and assumptions. Our valuations may or may not be developed with access to the client’s own valuation models. From time to time, clients may have a special need for a negative assurance opinion, such as in situations when a complex proprietary model is managed by the client. In these situations, VRC will provide assurance as to the reasonableness of the model inputs driving the client’s valuation conclusion. VRC may also provide an opinion letter verifying a client’s internal model in terms of functionality and accuracy.

SEC Concern on the Valuations of Illiquid Investments

The SEC has voiced concerns on the quality and content of third party valuations. As reported by Emily Chasan, Senior Hedge Fund Correspondent for Reuters:

“At issue [for the SEC] are disclosures for complex measurements used when companies have to establish the fair value of certain assets, such as thinly-traded corporate bonds, asset-backed securities or structured products. Many companies use pricing services or valuation consultants to come up with these numbers, but may not be asking enough questions about the numbers.”

“There may have been significant judgments taken by that pricing service and the company may simply record and disclose the measurement and not understand the judgments that have been made behind it,” said Brian Croteau, the SEC’s deputy chief accountant, on Dec. 1, 2011 at an accounting conference at Baruch College in New York. “How does management in fact know that they are complying with GAAP? The SEC’s Division of Corporation Finance has been focusing on the issue in its reviews of corporate disclosures this year, and the Public Company Accounting Oversight Board has also been pressing auditors to make sure that managers are getting enough information about inputs used in fair value measurements.”

VRC can add value to companies in that we can provide a more in-depth fundamental and technical analysis with verifiable and documented support in a professional format. We are not a pricing service, and our valuations are never “black box.” Our reports are developed with the express purpose of being transparent, supportable and audit friendly. In addition to our client, others who may review our work include boards of directors, valuation or audit committees, external auditors, lenders, and perhaps even external investors. And, as many of our clients are public, ultimately the SEC. Supportability and transparency of values, inputs, and assumptions, are critical. For more information, contact your VRC representative.