SEC Requires Third-Party Fairness Opinion Certificate for BDCs

Fairness Opinion Certificate Required Before Issuance of Senior Securities Issued Using the New BDC Asset Coverage Ratio Exemption

By: John Czapla | Chad Rucker

(Estimated reading time: 3 minutes)

On April 8, the Securities and Exchange Commission (SEC), as a response to COVID-19, provided temporary exemptions to BDCs to issue and sell senior securities if they are “unable to satisfy the asset coverage requirement under the Investment Company Act of 1940 (the Act) due to temporary mark-downs in the value of the loans to such portfolio companies.” This SEC order is in effect until 12/31/2020.

The Act requires BDCs to meet asset coverage tests (total assets/debt) of 200 percent, or 150 percent if the Small Business Credit Availability Act election is made by the BDC. The goal of the temporary exemption is to allow BDC’s headroom in its Asset Coverage Test to raise additional debt capital to provide needed liquidity to its portfolio companies that were negatively impacted by COVID-19.

If the BDC, their board of directors, and their investment advisor determine that issuing senior debt securities is in the best interest of the BDC and their shareholders, the BDC can elect to use the Adjusted Asset Coverage Test and issue senior debt securities if:

    1. The board approves reliance upon the order, and
    2. The board receives advice and a certificate from an independent evaluator as to whether the terms and conditions of the proposed issuance or sale of the senior securities “are fair and reasonable compared to similar issuances.”

Also, before issuing any securities, the BDC must publicly announce that it has made an election to do so on SEC Form 8-K. Also, a BDC that elects to rely on the order cannot, for 90 days from the date of selection, make an initial investment in a portfolio company with the BDC was not already invested as of the date of the order. Effectively, any money raised is intended to provide funds to existing portfolio companies.

In the exemption, the BDC may use an Adjusted Asset Coverage Ratio, based on an Adjusted Portfolio Value, with respect to portfolio company holdings that meet the following criteria:

(i) The BDC held the security at December 31, 2019,

(ii) The BDC continues to hold the security at the time of such issuance or sale, and

(iii) The BDC is not recognizing a realized loss on such securities.

Effectively, the fair value of the BDCs securities held at 12/31/2019 that meet criteria (i), (ii) and (iii) serve as the basis for the Adjusted Portfolio Value. The Adjusted Asset Coverage Ratio is equal to 25 percent of the difference between the asset coverage ratio using the Adjusted Portfolio Value and the unadjusted asset coverage ratio. This effectively gives ~25% weight to year-end 2019 portfolio fair values, pre-COVID-19, in the current asset coverage ratio calculation.

An example of the Adjusted Asset Coverage Ratio is as follows:

    1. At 12/31/2019, the BDC reported an asset coverage ratio of 220% based on the fair value of assets and the original guidance under the Act.
    2. At the time of the issuance of a covered senior security, e.g., 3/31/2020, the BDC estimates the Adjusted Portfolio Value using criteria (i) through (iii) from above at 12/31/2019, and then calculates the Adjusted Asset Coverage Ratio, which it determines is 200%.
    3. The BDC calculates the unadjusted Asset Coverage Ratio at 3/31/2020, under the original guidelines, which it determines is 160%.
    4. The Adjusted Asset Coverage Ratio at 3/31/2020 is equal to 25% of the difference between the asset coverage ratio using the Adjusted Portfolio Value (200%) and the asset coverage ratio assuming no portfolio value adjustment (160%). Therefore, the BDC would have an Adjusted Asset Coverage Ratio of 190% (200% minus 10% (25% of the difference between 200% and 160%)), which would make it compliant with 10% headroom to issue debt securities.

VRC believes that it is prudent for BDCs, their boards, and investment advisors to be cognizant of any potential risks from shareholder litigation in relying upon the exemption and selection of the independent evaluator. The SEC clearly is placing the responsibility on the board and adviser to determine if such senior security issuance is in the best interest of BDC and its shareholders.

VRC recommends that if a BDC makes the exemption, that their board and investment advisor hire an independent evaluator that performs an in-depth and thorough analysis when making a determination that an issuance is “fair and reasonable.”

VRC is one of the largest providers of valuation services to BDCs. We also have significant experience in preparing and defending fairness opinions in highly complex situations. These are uncertain times, and COVID-19 has taught us all to prepare for the unexpected, including potential litigation.


Source: Valuation Research Corporation and SEC Investment Company Act of 1940 Release No. 33837/April 8, 2020 “ORDER UNDER SECTIONS 6(c), 17(d), 38(a), AND 57(i) OF THE INVESTMENT COMPANY ACT OF 1940 AND RULE 17d-1 THEREUNDER GRANTING EXEMPTIONS FROM SPECIFIED PROVISIONS OF THE INVESTMENT COMPANY ACT AND CERTAIN RULES THEREUNDER”