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Finding the value of BDCs
By CAROLyn BENTZIEN
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 fourfold in the next five years. Given that, we wanted to share
our experience valuing securities for BDCs.
VALUATION GOVERNANCE
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?
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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-tovalue highly illiquid securities (or “level 3” investments
within the hierarchy).
Valuations of level 3 investments can be complex and timeconsuming 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 (VRC).
This article appeared in PE Manager.