A recent article on SNL Financial (subscription required) 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. BDCs make debt and equity investments in middle market companies, ranging from senior secured debt to unsecured subordinated debt to preferred and common equity. In order to qualify as a business development company, BDC balance sheets have historically been limited to a 1:1 debt-equity ratio. 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.
BDC fair value reporting requirements are essentially the same as those facing private equity funds. However, as SEC registrants, there is greater transparency regarding BDC results, especially fair value measurements.
BDCs generally measure the fair value of portfolio investments using techniques under the market or income approaches. Valuation techniques are often selected with reference to the subject investment’s position in the investee’s capital structure.
- Equity investments are most commonly measured using a market multiple of EBITDA or some other performance benchmark to derive the fair value of the enterprise as a whole. A “waterfall” analysis is then performed in which the balances of senior securities are deducted to measure the fair value of the residual equity. Less frequently, a discounted cash flow technique under the income approach is used to measure the fair value of the enterprise (prior to application of the waterfall) or the subject equity investment directly.
- Senior debt investments are usually measured with a yield-based technique under the income approach. Using this technique, future interest payments and return of principal are discounted to the measurement date at a yield that is commensurate with changes in market yields and coverage ratios for the subject investment since origination.
- Performing junior debt investments are also usually measured using a yield-based technique. Fair value measurement of distressed or non-performing debt investments may be supplemented by use of a waterfall methodology (i.e., as if an equity investment).
For BDCs, private equity, and other investment funds, the inescapable consequence of fair value reporting is that reported portfolio values are subject to a healthy dose of judgment. When the future expectations embedded in a fair value measurement fail to materialize, regulators and investors have the benefit of evaluating real-time judgment with perfect hindsight. As a result, it is imperative that what seem to be innocuous fair value-related judgments be made in a manner consistent with the fund’s valuation policy, incorporate rigorous analysis, and be supported by thorough, contemporaneous documentation.
Mercer Capital assists BDCs and other investment funds with ongoing fair value measurement consulting services. Contact us today to see how we can help.
- Steady stream of BDC IPOs could ‘explode’ with leverage cap reform as REITs struggle (SNL Financial – subscription required)
- The Ins and Outs of Business Development Companies
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