The Spring of 2012 heralded a new and exciting time for private equity funds considering establishing a Business Development Company (BDC). The Jumpstart Our Business Startups (“JOBS”) Act was enacted into law giving 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. An EGC investment fund desiring to become a BDC may file IPO draft registration statements with the Securities and Exchange Commission (SEC) confidentially and on a non-public basis.
Given the growing popularity of BDCs, 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.
BDCs invest in many different types of investments throughout the capital structure, although the traditional BDC invests in middle market, often mezzanine, securities. BDCs must comply with GAAP and FASB ASC Topic 820 (formerly SFAS 157) “Fair Value Measurements and Disclosures”. The board of directors of a BDC has the ultimate responsibility to ensure the fund’s portfolio represents fair value. There may also be a valuation committee comprised of management.
The fund should establish valuation policies that addresses, among others, some of the following considerations:
• How often will the valuation committee meet?
• Initial categorization and subsequent migration of investments within the fair value hierarchy.
• What is the criteria for flagging which investments to be reviewed and how often?
• What documentation is required?
• Which valuation techniques are appropriate?
• Should valuations be outsourced or performed internally, and if outsourced, at what frequency?
• How should a third-party valuation specialist be selected?
• Does the third-party valuation specialist have a robust valuation process and a dedicated team of knowledgeable employees to the BDC /fund space?
• Should values from an outsourced valuation specialist be expressed as a range of values or a single point estimate?
• What timeline is required for preparation, review and oversight to meet reporting deadlines?
OPERATIONAL BEST PRACTICES
A cornerstone of ASC 820 is the three-level fair value hierarchy. Although types of investments in different BDCs may vary, one thing all public BDCs have in common is that they are required to report quarterly their investments on a fair value basis, and delineate hard-to-value highly illiquid securities (or “level 3” investments within the hierarchy).
Valuations of level 3 investments can be complex and time-consuming and are often 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. BDCs are indeed skilled in capital allocation, however formal valuation skills designed to meet financial reporting challenges and third party review may not represent a core competency. Outsourcing could therefore allow the fund to focus on its core competencies.
The frequency of outsourcing individual investments will vary depending upon internal valuation policies. Some BDCs fully outsource the valuation of their investments, meaning each investment is valued every quarter. At a minimum, best practice will assert that all material, complex and volatile investments be reviewed every quarter. Valuations, whether performed internally or externally, require a consistent valuation process, and an independent valuation specialist should operate under a well-defined valuation process. Industry best practices also dictate that if outsourcing, positive assurance valuations should be used versus negative assurance.
Methodology is critical in generating supportable values. Generally accepted valuation techniques must be used depending on the type of investment and the scope of the work. 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. The entire valuation process is of critical importance, not just separate pieces of it, and proper oversight should generally improve financial reporting quality and reduce the risk of financial misstatement.
Carolyn Bentzien is a managing director at Valuation Research Corporation, a valuation services provider.