Time Will Tell: Diverging Perspectives on BDC Portfolio Values

We observed last spring that 2015 would likely mark a turning point in portfolio valuations with the degree of difficulty likely to increase during the year. With Q4 earnings season beginning, we take an opportunity to check in on portfolio marks and market sentiment over the year. The key takeaway from the year is that the valuation perspectives of investors and portfolio managers began to diverge.

Are You GIPS-Compliant?

The Global Investment Performance Standards (GIPS®) were adopted by the CFA Institute in 1999 and are widely accepted among the international investment management industry. GIPS are a set of ethical principles based on a standardized, industry-wide approach that apply to investment management firms and are intended to serve prospective and existing clients of investment firms. While compliance by investment firms is voluntary, many investors consider GIPS compliance to be a requirement for doing business with an investment manager. Alternative managers have lagged behind the industry in claiming compliance with GIPS, but changes in the industry suggest GIPS compliance is becomingly increasingly important.

Updated: Valuation Best Practices for Venture Capital and Private Equity Funds

The International Private Equity and Venture Capital Valuation (IPEV) Guidelines were developed in 2005 to set out recommendations on best practices in the valuation of private equity investments. The IPEV Board is made up of leading industry associations from around the world, including the National Venture Capital Association (NVCA) and the Private Equity Growth Capital Council (PEGCC) in the United States. In October 2015, the IPEV Board published draft amendments to the existing guidelines that, if approved, will go into effect at the beginning of 2016.

Valuation concerns mark Southern Capital Forum: Are VC trends the canary in the RIA coal mine?

Mercer Capital had a great time sponsoring the Southern Capital Forum on Lake Oconee last week. The annual gathering of the venture community is a favorite to check in with many of our clients and get a read on capital markets from some intentional listening. Beautiful weather and the bucolic surroundings of Reynolds Plantation helped, and on the second day of the conference, Janet Yellen kept her foot on the cost of capital. So what’s not to like? Despite the generally upbeat attitude of the sponsor community, and plenty of planned fund raisings, we heard one theme repeated over and over again that threatens the broader asset management world: stretched valuations.

In the Eye of the Beholder: Increasing SEC Scrutiny of Public Company Fair Value Marks

In an article published in August 2015, NERA Economic Consulting examined some of the effects of the SEC’s increasing use of quantitative analysis to identify potential problematic valuations in public company filings. Although the SEC previously used its tools in the private fund advisor sphere, the agency is beginning to turn its gaze to publicly traded companies. Thus far, the SEC’s focus has been on two main points, valuation policies that differ from actual valuation practices (including valuation methods and approaches, as well as the inputs used) and the incorporation of market conditions (or lack thereof).

Unicorn Valuations: What’s Obvious Isn’t Real, and What’s Real Isn’t Obvious

In the two short years since Aileen Lee introduced the term “unicorn” into the VC parlance, the number of such companies has steadily increased from the 39 identified by Lee’s team at Cowboy Ventures to nearly 150 (and growing weekly) by most current estimates. Pundits and analysts have offered a variety of explanations for the phenomenon, with some identifying unicorns as the sign that the tech bubble of the late 1990s has returned under a different guise, others attributing the existence of such companies to structural changes in how innovation is funded in the economy, and the most intrepid of the group suggesting that the previously undreamt valuations are fully supported by the underlying fundamentals given the maturity and ubiquity of the internet, smart phones, tablets, and related technologies.

Yes, Virginia, the Cost of Capital Really Is Low

Because of the wide availability of low-cost debt, even a “hefty” purchase multiple does not necessarily obliterate prospective equity returns. Berkshire Hathaway’s purchase of Precision Castparts provides a timely illustration of the practical effect of the Fed’s accommodative monetary policy on corporate costs of capital and valuation multiples.

Rules for the Modern Investment Manager

On May 20, 2015, the Securities and Exchange Commission proposed new rules and amendments to modernize and enhance information reported by investment companies and investment advisers. The proposed rules would be applicable to most investment companies registered under the Investment Company Act of 1940 and all investment advisers registered under the Investment Advisers Act of 1940.

Portfolio Marks: 2Q15 Outlook

With the second quarter drawing to a close, private equity managers can look forward to a fresh round of portfolio valuation marks. We recently pulled some historical gains and losses reported by publicly-traded BDCs to help provide some context as we look to the upcoming valuation marks.

A Capital Raise in Acquisition Clothing?

M&A has not been a common occurrence among BDCs. Under the external management model, the opportunity for material cost savings is limited, and prices at or near NAV indicate that investors assign little “franchise” value to the lending and origination platforms. The recently announced acquisition of MCG Capital (MCGC) by PennantPark Floating Rate Capital Ltd. (PFLT) is likely the exception that proves the rule. In the conference call describing the transaction, PFLT’s chairman Arthur Penn aptly described the acquisition as a “synthetic equity” raise for PFLT.

How to Value Venture Capital Portfolio Investments

In this post we describe our process when providing periodic fair value marks for venture capital fund investments in pre-public companies. This process includes examining the most recent financing round economics, adjusting valuation inputs the measurement date, measuring fair value, and reconciling and testing for reasonableness.

Second Fairness Opinions

The fairness opinion states that a transaction is fair from a financial point of view of the subject company’s shareholders. The opinion does not express a view about where a security may trade in the future; nor does it offer a view as to why a board elected to take a certain action. Valuation is at the heart of a fairness opinion, though valuation typically is a range concept that may (or may not) encompass the contemplated transaction value.

If Valuation Were An Olympic Sport

If valuation were an Olympic sport, fund managers and valuation specialists would expect to lose some points for the low “degree of difficulty” in their exercises over the past couple years. Buoyant equity markets, broad credit availability, historically low fixed income yields, and benign credit experience each contributed to ideal valuation conditions for private equity managers in 2013 and 2014. A reversal – or even slowing – of this trend would likely increase the scrutiny on fair value measurement for fund managers. In short, portfolio valuation marks are likely to get trickier in 2015.

Credit Spread Blues & Portfolio Valuation Marks

After being bloodied by widening spreads in the second half of 2014, any hopes that credit investors may have cherished for relief in 2015 remain unfulfilled through the end of January. Time will tell whether wider spreads are here to stay, or if fund flows to high-yield credit and leveraged loan funds will turn positive again, increasing the supply of capital to borrowers. In the meantime, managers responsible for setting fair value marks will need to carefully consider how best to take account of current market conditions.

Credit spreads, not fed funds basis points, are the key for 2015

While rising rates should support higher net interest margins and EPS for a broad swath of commercial banks that have a sizable amount of non-interest bearing deposits and loans that reprice with 30-day LIBOR, we should focus on credit. If credit spreads are widening (or narrowing), NIM discussions, like much of what the Street chatters about, are just noise.

SNC Exam Nuggets

My theory on markets, like much of life, is that things are never as bad as they seem when events are going south and never as good as they seem when all appears to be headed higher. One standard deviation on either side of the mean is where most of the action occurs. The 2014 Shared National Credit exam, I think, falls within the two standard deviations confidence interval. I did not see any big surprises in the examiners’ comments, which for the second consecutive year focused on leveraged lending commitments ($767 billion) within the context of the overall SNC exam ($3.4 trillion of commitments). That said there were some instructive comments that may point to how the market will evolve. As a result, the 2015 exam may be more useful for investors provided the economy does not change dramatically.

W(h)ither Yields? Dividend Capacity & BDC Stock Prices: A Mortgage REIT Case Study

Does a dividend cut automatically equal a drop in stock price? It ultimately depends on risk-adjusted returns available to investors from other asset classes. In a new whitepaper from Mercer Capital, Travis Harms and Jeff Davis examine the dividend-paying capacity of BDC stocks and the implications of reduced dividends on stock prices. Business development companies are an important and growing source of funding for middle market companies. Along with private equity and other investment funds, BDCs provide billions of dollars of investment capital to private companies in every segment of the economy. The authors also recently attended the 2014 BDC Roundtable, an annual gathering of BDC management teams, investment bankers, valuation firms, and accounting and tax experts.

Valuation Best Practices for Venture Capital Funds

The National Venture Capital Association (NVCA) published the 2014 Venture Capital Yearbook in May 2014. This blog post summarizes Appendix I of the 2014 Yearbook, which includes comments on valuation guidelines and best practices for venture capital investments and funds.

Spotting Young Talent: Belgian Football and VC Investments

Towards the end of 2013, the Belgian football club FC Racing Boxburg awarded 20-month old Bryce Brites a contract. Disbelieving commentary around the signing coalesced around the notion that the evaluation of tender sports talent is completely subjective. Similar incredulity appears to have greeted the valuations implied by transactions involving a couple of (virtually) pre revenue start-up companies.

Portfolio Valuation and Regulatory Scrutiny

Over the past decade, we have been retained by several investment funds to assist them in responding to formal and informal SEC investigations regarding fair value measurement of portfolio investments. Reflecting back on those engagements yields a couple observations and reminders for funds and fund managers as they go through the quarterly valuation process.

Growing Business Development Company Field Highlights Fair Value Requirements for Investment Funds

A recent article on SNL Financial highlights the potential for an “explosion” in the number of publicly traded business development companies, or BDCs, if Congress loosens leverage restrictions historically in place. Business development companies have been a growing source of investment capital for middle market companies and dividends for yield-hungry investors. Congress is currently debating an easing of the leverage limits to 2:1, which would allow BDCs to either maintain dividend yields for investors while taking less credit risk, or increase dividend payouts with the same amount of credit risk. As a result, the contemplated changes increase the attractiveness of the BDC structure, and, if enacted, are expected to precipitate an increasing flow of new public and follow-on offerings.