Z. Christopher Mercer
Excerpts from page 2:
The purpose of this white paper is to review the principal financial statement components of BDCs with a view to clarifying the factors that are most likely to influence financial performance…
…the relative value of BDC shares is often evaluated with reference to the corresponding net asset value (book value) per share…
…the largest asset category on a BDCs balance sheet is the investment portfolio. A BDC’s investment strategy will be manifest in the composition (and risk) of the investment portfolio…
Excerpts from page 6:
Net Asset Value Per Share Net asset value (NAV) per share is an important reference point for BDCs and is disclosed on the face of the balance sheet.
The ratio of stock price to NAV per share is an important barometer of relative value for BDCs.
Given distribution requirements, BDCs cannot increase NAV per share meaningfully by retaining net investment income. Instead, NAV per share fluctuates primarily with appreciation or depreciation in underlying portfolio investments.
Alternatively, issuing new shares at a premium to NAV (or repurchasing shares at a discount to NAV) is accretive to NAV per share. BDCs are generally required to obtain special shareholder permission to issue new shares at a price less than NAV per share. This can effectively close the market for new equity issuances for BDCs trading at a price-to-book ratio of less than 1.0x, which in turn, limits the BDC’s ability to grow the balance sheet…
Excerpts from pages 7 – 9:
Investment income represents the revenue of a BDC: interest income from debt investments, dividends from equity investments, and various fees for loan origination and the like. While some BDCs generate significant amounts of fee income, interest and dividends from portfolio investments comprise the bulk of investment income…
Net Investment Income
BDCs have two sources of potential return: current income and capital appreciation. Net investment income measures the current income return on the BDC’s investment portfolio…
The Mercer Capital white paper summarizes aggregate income statement data for a group of 28 publicly traded BDCs for the quarters ended September 30, 2012 and September 30, 2013.
On an unlevered basis, net investment income for the group during the third quarter [of 2013] represented a 5.3% return on assets; including the effect of leverage, the current income return on equity registered 8.1%…
Net Realized Gains & Losses
Upon exiting an investment, BDCs record a gain or loss measured by the difference between the proceeds received upon exit and the amortized cost of the investment.
Net realized gains or losses during a period provide perspective on the credit performance of management’s prior investment decisions, but do not directly reflect investment performance during the period.
For example, a realized loss on investment may be deferred simply by not exiting the investment; conversely, a gain may be realized during a given quarter even if the decision to sell the investment and realize the gain was not optimal from an investment perspective.
On a cumulative basis, the net realized gains and losses permit evaluation of a BDC’s underwriting and investment process without the period to period “noise” associated with reporting the investment portfolio at fair value…
Net Change in Unrealized Gains & Losses
The difference between the fair value and amortized cost of a portfolio investment is the unrealized gain or loss. As the fair value of a portfolio investment is remeasured each quarter, the unrealized gain or loss associated with the investment may fluctuate. The sum of the increases or decreases in unrealized gain or loss across the portfolio during a period is recognized in the earnings of the current period…
Figure 4 summarizes aggregate income statement data and provides common size performance measures for the group of 28 publicly traded BDCs.
Excerpts from page 7:
The Income Statement
|Figure 4: Aggregate BDC Income Statement||Q3 2013||Q3 2012|
|Quarters Ended September 30|
|Dollars in Millions|
|Net Investment Income||$505.3||$468.4|
|Net Realized Gains (Losses)||-$42.8||-$36.7|
|Net Change in Unrealized Gains (Losses)||$103.9||$210.3|
|Net Increase (Decrease) in Equity||$565.7||$637.7|
|Common Size Performance Measures|
|Effective Yield on Assets||11.0%||11.6%|
|Effective Costs of Funds||5.5%||5.5%|
|Other Expenses as % of Assets||4.0%||4.0%|
|Net Investment Income as % of Assets||5.3%||5.9%|
|Net Investment Income as % of Equity||8.1%||8.8%|
|Total Return on Assets||5.9%||8.1%|
|Total Return on Equity||9.1%||12.0%|
Excerpts from Page 4:
BDCs are required to report investments on the balance sheet at fair value rather than historical cost. Fair value is defined in ASC 820 [FASB Accounting Standards Codification] as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
Fair value is measured from the perspective of a market participant that is a party to a hypothetical transaction for the subject asset or liability at the measurement date.
Market participants are defined as
- unrelated parties
- knowledgeable of the subject asset
- able to transact
- motivated, but not compelled to transact
Fair value is the so-called “exit price” of the subject asset for a market participant in the principal or (in the absence of such a market) most advantageous market for the asset.
For an excellent discussion of fair value, see:
Fair Value: The Audit Committee’s Role
Point of View
Excerpts from the Mercer Capital white paper Page 4, continued:
ASC 820 states that valuation techniques consistent with the market approach, income approach, and/or cost approach should be used to measure fair value. Inputs to the various valuation techniques may be either observable or unobservable; the FASB has established a hierarchy which prioritizes inputs into three broad levels.
- Level 1 inputs are observable quoted prices in active markets for identical assets
- Level 2 inputs generally include observable quoted prices for similar assets in active markets or quoted prices for identical assets in markets that are not active
- Level 3 inputs are unobservable inputs that are developed based upon the best information available under the circumstances, which might include the reporting entity’s own data.
Unobservable inputs should reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability.
BDCs generally measure the fair value of portfolio investments using techniques under the market or income approaches…
Excerpts from Page 5:
…the inescapable consequence of fair value reporting is that the reported value of the largest asset on a BDCs balance sheet is subject to a healthy dose of judgment. One should bear in mind, however, that interim fair value measurements are ultimately exposed to the discipline of realized exits. In other words, while the inevitable vagaries of fair value measurement influence the reported earnings of the BDC from quarter to quarter, the cash flows and dividend-paying capacity of the BDC are determined by realized investment exits…