Eversheds Sutherland and the Small Business Investor Alliance’s Business Development Company Roundtable | Panel: Private Credit Accounting and Valuation

Managing Director Patricia Luscombe recently spoke on the Private Credit Private Credit Accounting and Valuation panel at Eversheds Sutherland and the Small Business Investor Alliance’s BDC Roundtable in Washington, D.C. The panel featured accounting and valuations experts discussing the state of business development companies (BDCs), the performance of the portfolio companies held by the BDCs in an inflationary and rising interest rate environment and the U.S. Securities and Exchange Commission (SEC)’s Rule 2a-5.

We have outlined some key takeaways based on panelist conversations below:

• Despite volatility in the public markets and a slowdown in growth, the private markets remain less turbulent and company fundamental performance continues to be reasonably stable.
• The fair values of investments owned by BDCs declined primarily because of a widening of private credit spreads in 2022.
  • The Lincoln PMI and the LSDI, key insights into private company and credit performance, showed that although there is some weakening of fundamental performance overall with slower earnings growth and EBITDA margin compression, defaults, while increasing modestly, are substantially lower than the all-time highs seen during COVID-19.
  • Many expect the rising interest rate environment to greatly impact valuations later this year as companies are forced to pay higher interest expenses, impacting their liquidity and potentially causing fair value of BDC investments to decline.
• Rule 2a-5, the new SEC fair value rule for the Investment Company Act of 1940, does not materially change the overall fair value process, but instead provides clarification to board members on oversight duties.
  • Many fund managers have adjusted the valuation approval process so now the Valuation Designee is ultimately responsible for fair value determination; however, it is still important to have the portfolio management team’s outlook on each portfolio company investment in the valuation process.
  • As a result of the Valuation Designee now managing fair value determinations, the documentation provided to many boards for oversight has reduced in length and now focuses on dashboard and executive summary information such as summarizing the largest valuation movers and highlighting underperforming investments.
  • Under Rule 2a-5, back testing, which tracks the exit price of an investment to its model predicted fair value prior to exit, must be reported to boards once annually, so the Valuation Designee has to develop processes to determine back testing results. In addition to back testing, calibration of investment price to a selected valuation model and inputs is an important testing method, and due to market volatility, understanding how opportunistic trades and incremental investments impact calibration is increasingly important.
  • Due diligence of valuation service providers has also increased as a result of Rule 2a-5’s requirement of boards to determine the qualifications of valuation service providers once annually. Some areas of focus include: the overall valuation process, the consistency of the valuation model template, how private credit market data is incorporated across valuation clients, the valuation challenge process and how service providers treat crossly held investments across clients and due diligence in protection of proprietary client information within information technology systems with a great focus on cybersecurity of the valuation service provider.