July 2012

Financial Services

In the fi rst of a series of three articles on business development companies (BDCs), we examined the factors driving the current popularity these investment vehicles enjoy among investors, asset managers and businesses. In this, the second installment in the series, we examine the numerous accounting and reporting requirements BDCs must meet. Some of these mandates mirror those of registered investment companies, while others more closely refl ect the reporting requirements of public commercial and industrial companies. In this article, we will identify the reporting responsibilities that BDCs must carry out, and examine strategies for accomplishing these requirements with maximum accuracy and effi ciency.

When Congress enacted the laws that created BDCs in 1980, the fi nancial statements for these new entities originally included schedules and fi nancial presentations that were similar to those of registered investment companies (RICs). Over the past three decades, these statements and disclosures have evolved and today look much more like those of public commercial or industrial companies.

Like other commercial or industrial companies registered with the Securities and Exchange Commission (SEC), BDCs must fi le quarterly Form 10-Qs and annual Form 10-Ks, including all of the required disclosures of each. They

must also report signifi cant events to shareholders by fi ling Form 8-K, generally within four days after the event.

Furthermore, Form N-17f-2 is required if there is no outside custodian, consistent with traditional RICs. In the absence of an outside custodian, a BDC’s independent auditor will need to perform a security count of the securities and issue a certifi cation report. (Accordingly, many BDCs hire an outside custodian.)

Filing an annual report using Form 10-KWhen preparing its 10-K, a BDC must comply with the requirements of Regulation S-K under the Securities Act of 1933. It must also comply with applicable Form N-2 requirements for registration under the Investment Company Act of 1940, which include:

• A description of companies in its portfolio in which its equity ownership exceeds 5%

• Identifying portfolio managers and describing the BDC’s investment process

• Making disclosures in Form 10-K consistent with its capital-raising prospectus

Although BDCs make similar fi lings to those of companies registered under the Securities and Exchange Act of 1934 (1934 Act), the

Accounting and reporting considerations for business development companiesby Matt Forstenhausler

Ernst & YoungAssurance | Tax | Transactions | Advisory

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This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither Ernst & Young LLP nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.

accounting employed to create the fi nancial statements should follow investment company regulations under Article 6 of Regulation S-X, which mandates fair valuation of investments.

Sarbanes-Oxley requirementsGenerally, investment companies are excluded from those Sarbanes-Oxley Act (SOX) requirements of reporting on internal controls. BDCs, however, because they are fi ling under the requirements of the 1934 Act, must also meet SOX reporting requirements. This means management must document, test and opine on internal controls and have their independent auditors perform an integrated audit on internal controls as part of their annual audit of the BDC’s fi nancial position and operations.

Fortunately, this requirement does not apply to the fi rst 10-K a BDC fi les; it begins with the second fi ling. Despite this “free pass” on the fi rst fi ling, management should consider internal control requirements as they begin to establish policies and procedures, and begin documenting and testing their systems in anticipation of the integrated audit requirements associated with their second 10-K fi ling.

SEC reporting timelineOften when asset managers contemplate offering a new product, they default to using the standard date of December 31 as the entity’s fi scal year-end. Unfortunately, many managers fail to realize that it may be advantageous to select a different year-end. Managers can benefi t by choosing another date for a BDC’s year-end, particularly if the manager’s other investment vehicles have a calendar year-end. This could effectively spread out the reporting process across the fund complex. The BDC must still report quarterly results on Form 10-Q, but having the year-end audit performed off-cycle could help with the timing of the annual fi nancial reporting for the BDC and lessen the workload of accounting team members associated with December 31st reporting requirements.

Even the end date of the tax year need not be December 31. Managers might fi nd it helpful to coordinate the tax year-end with the fi scal year-end for fi nancial reporting purposes, but there is no requirement to do so.

Investment valuationRecently, there has been considerable discussion about the best way to value investments. Increasingly, BDCs are hiring external valuation agents to accomplish this task; traditionally, many performed their own valuations. Today, many banks and credit facilities that loan money to BDCs ask for a signifi cant amount of the investments to be valued by third parties. From a regulatory perspective, BDCs are not required to use external valuation agents, but there is a reason many entities do: it gives the BDC’s Board of Directors much more useful information when they are approving fi nal valuations.

It is important to note that even if a BDC utilizes outside valuation experts, the Board — and the Board alone — has the ultimate responsibility for the fi nal approval of the investment valuations. This is a statutory requirement. When a BDC obtains outside valuations, the Board should ask: are there differences between the fi ndings of the independent agents and valuation information provided by management? If so, how can these differences be reconciled? The Board should never simply accept the valuation agent’s numbers at face value. There is an important distinction between abdicating a Board’s valuation responsibilities to a third party versus using the fi ndings of an external specialist in good faith to help formulate a Board’s fi nal decisions.

Final thoughtsThough BDC accounting and reporting requirements may be no more challenging that those of RICs or of other SEC-registered companies, they are unique. To meet these requirements, compliance offi cers, auditors, legal counsel and all those responsible for BDC compliance should have a working knowledge of the rules that govern BDCs — including SOX requirements — and of all standard processes and procedures currently embraced by the BDC industry.

This approach applies to taxes as well. In the fi nal article of this three-part series on BDCs, we will identify the specifi c tax advantages that make BDCs attractive to investors, and examine the specifi c requirements for achieving these advantages.

Matt Forstenhausler is a partner in the Financial Services Offi ce of Ernst & Young LLP. Matt is based in New York and can be reached at +1 212 773 1781 or matt.forstenhausler@ey.com.