Wednesday, November 28, 2012

SEC Charges KCAP Financial with Overvaluing Assets

By Tim Husson, PhD and Tim Dulaney, PhD

The SEC alleges (PDF) that KCAP Financial, a publicly traded business development company (BDC), did not accurately report the fair value of its corporate debt and collateralized loan obligation (CLO) assets during the financial crisis, thereby misleading investors. According to the press release, KCAP valued some of their assets at cost, not at fair market value, overstating the net asset value by over 25% during the peak of the financial crisis.

BDCs are similar to REITs in that they hold primarily one type of asset, and receive special tax treatment if they distribute the vast majority of their earnings to shareholders every year. BDCs primarily invest in small or developing privately held companies, either through debt or equity, and are therefore similar to private equity funds. Traded BDCs (unlike non-traded BDCs) are listed on major stock exchanges and trade similarly to closed-end funds.

From the SEC's release:
“When market conditions change, funds and other entities must properly take into account those changed conditions in fair valuing their assets," said Antonia Chion, Associate Director in the SEC’s Division of Enforcement. “This is particularly important for BDCs like KCAP, whose entire business consists of the assets that it holds for investment.”
The SEC cites the Statement of Financial Accounting Standards No. 157 (PDF) -- also known as FAS 157 -- an accounting standard related to fair value measurements of assets. FAS 157 "focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price)." By reporting assets at cost, KCAP was effectively valuing them at their entry price, even though selling those assets at that price was virtually impossible during the crisis.

According to the SEC's order:
KCAP used an enterprise value (“EV”) methodology to determine fair value for those debt securities that it determined were illiquid [...] The EV methodology did not, however, calculate or inform KCAP – or the public – what the exit price was for that security. Instead, the EV methodology provided KCAP an assessment of whether the entire principal balance owed to it was likely to be repaid by the debt issuer. 
This action by the SEC highlights the importance of, and the difficulties with, reporting fair valuations for illiquid assets. We have seen numerous instances of asset managers misreporting asset values, even in the face of clearly deteriorating market conditions (see, for example, our work on non-traded REITs and on the warehousing of assets in CDOs).

While Level Three assets -- assets whose value is determined using more judgment than market observations -- are often difficult to precisely value, it is critical that mangers and trustees provide investors with whatever information is available regarding their current market values in order to avoid the kinds of unpleasant surprises that lead to litigation.

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