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Fair Value Considerations for BDCs filing an IPO under the JOBS Act

By: Carolyn Bentzien, Valuation Research Corporation – The Spring of 2012 heralded a new and exciting time for investment funds considering blossoming into Business Development Companies (“BDC”).

In April 2012, the Jumpstart Our Business Startups (“JOBS”) Act was enacted into law with the intent of giving more private companies the ability to raise capital through Initial Public Offerings (“IPO”). The law allows a BDC to qualify as an Emerging Growth Company (“EGC”), defined as having annual revenues of less than $1 billion. This qualification as an EGC now allows an investment fund desiring to become a BDC to take advantage of a fundamental change to the Securities Act of 1933, allowing an EGC to file IPO draft registration statements with the Securities and Exchange Commission (“SEC”) confidentially and on a non-public basis.

It also eases certain reporting requirements related to accounting and audit, most notably requiring two years, instead of three years, of audited financial statements in the IPO registration statements.

Given the growing popularity of BDCs, the first BDC Index, “WFBDC,” comprised exclusively of BDCs, was recently introduced representing a market capitalization of roughly $18 billion. The BDC population is relatively small, but growing to be sure, helped by fewer restrictions on filing. We have heard some Wall Street analysts predict that the BDC industry may grow four-fold in the next five years. Given that, we wanted to share our experience valuing securities for BDCs going back to 2004 when they first came to fruition.

BDCs invest in many different types of investments representing instruments throughout the capital structure spanning from senior debt all the way through to equity, although the traditional BDC invests in middle market, often mezzanine, securities. BDCs must comply with Generally Accepted Accounting Principles (“GAAP”) and Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 820 (formerly SFAS 157) “Fair Value Measurements and Disclosures. In this context, fair value is defined as the “price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

Valuation Governance

Typically, the Board of Directors of a BDC is comprised of both interested and independent directors and is responsible for the fund’s reported valuations. There will oftentimes be a Valuation Committee comprised of management which reviews the investment valuations before they are presented to the Board. The Board, however, has the ultimate responsibility to ensure that the fund’s portfolio represents fair value.

The fund should establish Valuation Policies from the outset that may address some of the following considerations:

  • How often will the Valuation Committee meet?

  • Proper categorization of investments in the fair value hierarchy, i.e. Levels 1, 2 or 3

  • How will migration occur among the fair value hierarchy?

  • Which investments will be reviewed and how often?

  • Will all investments be reviewed every quarter?

  • If not, what is the criteria for flagging investments for specific review?

  • What level of documentation should be prepared to review valuations?

  • Which valuation techniques are appropriate?

  • Should valuations be outsourced or performed internally?

  • If outsourced, what is the scope and frequency of the outsourcing?

  • Does the third-party specialist have a robust valuation process and a dedicated team of knowledgeable employees to the BDC /fund space?

  • Is positive or negative assurance appropriate if an outside valuation specialist is used?

  • Should values from an outsourced specialist be expressed as a range of values or a single point estimate?

  • What is the timeline required to insure adequate preparation and review and oversight of values to meet reporting deadlines?

  • Changes, and reasons for the changes, to valuation techniques should be documented.

Operational Best Practices

A cornerstone of the ASC 820 pronouncement is the fair value hierarchy consisting of three levels, moving from the most liquid to the most illiquid securities.

 

  • Level 1 investments have available “observable” market inputs to arrive at fair value, e.g. widely traded equity investments traded on an exchange;

  • Level 2 includes investments without direct observable inputs but with similar characteristics to other market securities where prices are available, or instruments which have observable inputs other than quoted prices, (e.g. corporate bonds without direct market prices but with similar characteristics to other market-priced bonds, or bonds where exit market quotes can be obtained from broker-dealers or other market participants); and

  • Level 3 are investments with “unobservable” inputs, i.e. hard-to-value highly illiquid securities with little to no market data available, such as investments in private operating companies.

Although types of investments in different BDCs may vary, one thing all BDCs have in common is that, in accordance with GAAP, all BDCs are required to report their investment portfolios on a fair value basis each and every quarter, and delineate Level 3 investments in the SEC Form 10-K and 10-Q filings including a Schedule of Investments (SOI) of the borrower, rate, maturity, cost and fair value of each investment.

A word on hard-to-value Level 3 investments as the question of outsourcing valuations comes up regularly when addressing the issue of valuing non-traded, hard-to-value investments. Valuations of these investments can be complex and time-consuming and are required in a narrow reporting timeframe. Certainly, industry best practice is to outsource to a qualified independent valuation specialist to provide additional input to the Board, investors, auditors and at times, the SEC, although certain BDCs do successfully perform their own valuations internally. The decision to outsource depends on many factors such as the desire for independence; available internal resources; appropriate knowledge and valuation skill sets; availability of relevant databases; and timing and cost. Although BDCs are skilled in capital allocation, formal valuation skills designed to meet financial reporting challenges and third party review may not represent a core competency. Outsourcing could allow the fund to focus on their core investment and monitoring competencies. All these factors should be weighed objectively.

The frequency of outsourcing individual investments will vary. Some BDCs fully outsource their valuation process which includes outsourcing the valuation for 100% of its portfolio, in other words, every investment every quarter. At a minimum, best practice will assert that all material, complex and volatile investments be reviewed with scrutiny every quarter. Given that premise, some BDCs will outsource these types of investments every quarter, but also ensure that all investments in the portfolio be reviewed at least once per year. It may be, for example, that 60% of the portfolio falls into the critical evaluation criteria, so these investments will be reviewed externally every quarter while the remaining 40% is reviewed once per year, 10% in each of the four quarters, so that 70% of the portfolio is reviewed each quarter. Other BDCs choose a varying version whereby the entire portfolio is valued externally at year-end, so similar to the example above, 60% is valued every quarter, with 100% valued at fiscal year-end. Frequency and timing will depend on internal valuation policies.

Valuations, whether performed internally or externally, require a consistent valuation process. If working with an independent valuation specialist, the fund should ensure that the specialist operates under a well-defined valuation process and procedures. A strong working relationship between the fund and external specialist should facilitate that work gets carried out smoothly and efficiently. Key aspects to consider are communication of key contact points between the fund and specialist, the flow of information and documentation back and forth, and managing and scheduling key dates and deliverables.

Industry best practices also dictate that if outsourcing, positive assurance valuations should be used, which are defined as an opinion of value, versus negative assurance, which is a statement attesting there are no material modifications to the value of the investment reviewed. Investors and auditors will naturally take more comfort from a positive assurance opinion of value. This type of opinion may be expressed as a tight range of values or a single point estimate.

Methodology is also critical is generating ultimate values. Generally accepted valuation techniques must be used and may include proper income and/or market valuation methodologies, depending on the type of investment and the scope of the work. Quantitative, as well as qualitative analyses, should support the valuation. This includes company performance, credit analyses, models, assumptions, sensitivity analyses, capital market information, market comparables, transactions, and indices, as well as relevant industry information. BDCs are also required to disclose for financial reporting purposes significant unobservable inputs used in the determination of fair value. These may include valuation multiples, discount rates, yields, discounts, growth rates, as well as prepayment, default and recovery rate assumptions. Documentation should be concise, yet robust and transparent to meet internal needs and withstand auditor, regulatory and investor scrutiny.

Finally, management oversight of the final marks is critical. Recently, the SEC has made clear that funds must take ownership of fair values and are not to place blind reliance on valuations provided by external specialists. The entire valuation process is of critical importance, not just separate pieces of it. A competent valuation performed by an external valuation specialist is an important input into the process and although it does not eliminate the need for oversight, it will generally improve financial reporting quality and reduce the risk of financial misstatement.

Carolyn Bentzien is Managing Director with Valuation Research Corporation. She works with clients in the financial services industry, including alternative investments and specialty finance: private equity sponsors, BDCs and SBICs, and hedge funds; and the traditional financial community: banks and asset managers.

 

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