Current SEC regulations require that companies use market values when appraising their assets to fair value. When market prices are not immediately apparent though, as in the case of BDC loans, determining a fair value becomes a less uniform process. While Accounting Series Releases 113 and 118 provide some guidance on marking illiquid assets to fair value, lack of a standardized method has led to discrepancies on loan value impairments among different BDCs.
Inconsistencies in BDC loan appraisals can be seen in the fair value changes of two loans to the same company (Iracore) by TCP and Garrison Capital. TCP Capital reported a senior secured note with a maturity date of 6/1/2018 at 63.5% of cost, while Garrison Capital marked the loan at 93.7% of cost, despite having a longer maturity date by almost three years and a lower rank on the capital structure. Iracore is a pipeline company depressed by oil and gas markets. TCP and Garrison’s distinct decisions on whether the swing in the public markets was material or not resulted in different levels of impairment. TCP likely factored the current energy market into their loan valuation, while Garrison did not.
In October 2014, six loans were made by four BDCs in a club deal for SourceHOV, a business outsourcing company. Two of the loans were first lien at 7.75% interest and a maturity of 10/31/2019. The other four were second lien at 11.5% interest and a maturity of 4/30/2020. By the first quarter of 2016, the fair values as a percentage of cost for these loans varied dramatically.
Despite holding the same positions on the capital structure, all four BDCs reached very different conclusions on SourceHOV’s outlook. The most notable discrepancy is between the first lien TICC loan and the second lien BlackRock and Harvest loans. With a higher rank in capital structure, TICC’s loan should have been impaired less than the other, riskier two loans.
Despite SEC regulation mandating that companies use market values when pricing market securities, the evaluative process can become subject to interpretation when dealing with illiquid assets. BDCs can be particularly susceptible to making valuations that are less aligned with true value and more aligned with their own interests. Inflated balance sheets result in boosted performance metrics and in turn higher management fees. It is important to be mindful that the process of security valuation is not standardized among BDCs when choosing where to place capital.