On Wednesday the US Securities and Exchange Commission (SEC) charged three senior executives from New York-based publicly-traded fund KCAP Financial, regulated as a business development company (BDC), for not taking into account certain market-based activity in determining the fair value of its debt securities and certain CLOs.
KCAP Financial chief executive Dayl Pearson, chief investment officer Jonathan Corless and chief financial officer Michael Wirth have settled charges they had overstated the value of fund assets and failed to disclose that the fund had valued its two largest CLO investments at cost.
The charges are a reminder of fund managers’ duty to calculate assets at fair value – defined as the exit price that would be received to sell an asset in an orderly transaction at the time of measurement – in accordance with US Generally Accepted Accounting Principles (GAAP).
For private debt fund managers – a growing class of GPs as banks continue to restrict lending – the charges should be particularly noteworthy. KCAP used an enterprise value (“EV”) methodology to determine the fair value for those debt securities that it determined were illiquid. The calculation was run to reveal whether, in the event of a default or liquidation of the issuer, KCAP would receive full repayment of its loan. However, this methodology didn’t show what the actual exit price was for the debt securities, the SEC said in its filing. “Instead, the EV methodology provided KCAP an assessment of whether the entire principal balance owed to it was likely to be repaid by the debt.”
The SEC noted that KCAP’s internal controls over financial reporting did not adequately take into account certain market inputs and other data during the thick of the financial crisis in late 2008. “When market conditions change, funds and other entities must properly take into account those changed conditions in fair valuing their assets,” Antonia Chion, associate director in the SEC’s Division of Enforcement, said in a statement.