Business Development Companies (BDCs) Accounting for loan transfers Prepared by: Jon Waterman, Partner, Business Development Companies National Practice Leader, RSM US LLP jonathan.waterman@rsmus.com, +1 312 634 3351 Faye Miller, Partner, National Professional Standards Group, RSM US LLP faye.miller@rsmus.com, +1 410 246 9194 October 2014 In recent years, the debt markets have seen a wide variety of credit facilities, term loans and asset-based revolvers employing some element of a first-out and a last-out tranche. As the name suggests, first-out loans or tranches are characterized by one lender group being paid ahead of other lenders in certain circumstances and thus becoming the first out among otherwise equally ranked creditors. The carving out of loans into these types of tranches is growing in popularity with senior lenders and mezzanine lenders alike, as they allow for a lender to originate an exceptionally large loan that would otherwise be too large for it to handle alone. As the need for yield is particularly attractive in the low interest rate environment, we have seen different types of lenders (BDCs, banks, insurance companies and institutional investors, to name a few) seek participation in these types of transactions. Although the portfolio composition of a BDC is dependent on management s investment strategy and risk appetite, it is common for debt securities to represent a substantial portion of the portfolio mix of BDCs, as they provide a constant revenue stream and cash flow source for quarterly dividend payments to shareholders.
In some instances, these debt holdings are part of loan participation or syndication structures in which multiple parties enter into an agreement as creditors or lenders with an agent ensuring the payments of principal and interest are allocated properly to the various participating lenders or creditors (hereafter referred to as participants). In some such arrangements, participants may choose different preferences to enhance their yield or strengthen their standing in order of priority of repayment. Interest is typically allocated to each individual participant based on their position in the agreement, meaning a participant that has chosen to be compensated last (last-out lender) will earn more interest than the first-out lender in return for assuming additional risk. This structure appeals to those seeking flexibility to leverage risk on an individual loan basis, as opposed to the portfolio as a whole. As a result, managements involvement with these types of transactions is a growing trend in the BDC industry. Questions have emerged regarding the proper accounting treatment for transfers of financial assets involving first-out and last-out loans, particularly as it relates to the criteria for sale treatment under the Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 860, Transfers and Servicing (ASC 860). The accounting analysis is heavily dependent upon the legal form of any assets transferred, in particular whether a whole loan is being transferred or a portion of a loan, as the issuance of Statement of Financial Accounting Standard No. 166 (which is now codified in ASC 860) in 2009 tightened the criteria under which an entity can consider a transfer of a part of a loan to be sold in their financial records. It is important that management understand the accounting consequences when contemplating a transfer of financial assets, which are discussed in greater detail below. Economic characteristics and structuring of first-out-last-out arrangements While these arrangements may vary in scope and size, most first-out and last-out arrangements typically occur with middle-market club deals or unitranche facilities that are provided under a single credit agreement with a single set of security documents. The intercreditor understanding in these arrangements is typically set forth in an Agreement Among Lenders (AAL) that is entered into among the various lenders to the facility; however, the borrower generally is not a party to this document. The AAL provides lenders with a first-out and last-out payment stream and typically sets forth the economic and voting arrangements between the first-out lenders and the last-out lenders. Under the first-out and last-out arrangements, payments are made to an agent who is responsible for distributing to the first-out and last-out lenders their portion of the payment based on the agreed-upon allocation. Payments are usually paid ratably to the first-out and last-out lenders until the occurrence of certain waterfall trigger events. Upon the occurrence of these waterfall trigger events, the first-out lenders receive priority payment on their interest and principal before any payment is distributed to the last-out lenders. Some AALs may include provisions allowing for other lenders to be brought into the facility after initial closing. For example, an original lender may enter into an assignment agreement with an outside lender to assign or transfer a portion of the loan after the initial closing. In such cases, special consideration should be given to the accounting treatment for the transfer in light of the requirements for sale treatment under ASC 860. Accounting implications ASC 860 applies to transfers of loans and other financial assets. Thus, an important first step in understanding the accounting implications is to consider if a transfer of financial assets occurs such that ASC 860 is applicable. To illustrate, a lending arrangement, such as those discussed above, can be structured as a loan participation, in which a single lender makes a loan to a borrower and subsequently transfers undivided interests in the loan to other outside parties. Alternatively, the transaction could be structured as a loan syndication, where several lenders share in lending to a single borrower (each lender agrees to lend a specific amount to the borrower and has the right to repayment from the borrower). If a transfer or sale of a loan or portion of a loan occurs (as is the case with a loan participation), the transfer is subject to ASC 860, and a determination must be made of whether or not the transaction qualifies for sale treatment, based on guidance outlined in ASC 860-10. This is in contrast to an arrangement that is legally structured as a syndication whereby there is no transfer or assignment post-closing if the additional lenders shared in the lending upfront. By definition, as noted in ASC 860-10-55-4, a syndication does not involve a transfer of a financial asset and is therefore not subject to ASC 860. In evaluating ASC 860 for those arrangements that involve a transfer, one needs to determine whether the transferor and its consolidated affiliates included in the financial statements being presented have surrendered control over transferred financial assets or third-party beneficial interests. This determination: Should first consider whether the transferee would be consolidated by the transferor (for implementation guidance, see paragraph ASC 860-10-55-17D) Should consider the transferor s continuing involvement in the transferred financial assets Requires the use of judgment that should consider all arrangements or agreements made contemporaneously with, or in contemplation of, the transfer, even if they were not entered into at the time of the transfer. ASC 860-10-40-5 contains the requirements related to surrendering control that must be met for a transfer of a loan (whether in whole or part) to be eligible for sale accounting. These provisions require the transferred assets to be isolated from the transferor, that the transferor does not maintain effective control through certain agreements to repurchase or redeem the transferred assets and that the transferee 2
has the right to pledge or exchange the assets acquired. As is more fully explained in ASC 860-10-55-18, true sale and nonconsolidation opinions from an attorney are often required to support a conclusion that the transferred assets are isolated from the transferor. Additionally, ASC 860 requires transfers of a partial loan to meet the definition of a participating interest in order for sale treatment to result. To meet the definition of a participating interest, as it relates to transferring a portion or portions of loans and retaining a portion, each portion must encompass all of the following characteristics, which are elaborated on more fully in ASC 860-10-40-6A and the implementation guidance beginning at ASC 860-10-55-17E: From the date of transfer, it represents a proportionate (pro rata) ownership interest in an entire financial asset. From the date of transfer, all cash flows received from the entire financial asset are divided proportionately among the participating interest holders (including any interest retained by the transferor, its consolidated affiliates or its agents) in an amount equal to their share of ownership. No party has the right to pledge or exchange the entire financial asset unless all participating interest holders agree to pledge or exchange the entire financial asset. The priority of cash flows has the following characteristics: Rights of each holder have the same priority No participating interest holder s interest is subordinated to the interest of another participating interest holder Priority does not change in the event of bankruptcy or other receivership of the transferor, the original debtor, or other participating holders Participating interest holders have no recourse to the transferor other than for standard representations and warranties, contractual servicing obligations or contractual obligations to share in set-off benefits. First-out, last-out and similar arrangements created by transferring or assigning a portion or portions of a loan with the various portions having differing priorities and different interest rates would fail several of the characteristics listed above. A further discussion of common conditions that could cause the transfer of a partial loan to fail to qualify for sale accounting can be found in our white paper, Significant accounting and regulatory implications to accounting for loan participation and other partial loan sales, published in June 2010. If a participation or partial loan sale does not meet the definition of a participating interest, the portion transferred should remain on the books and the proceeds recorded as a secured borrowing unless or until the definition is met or all remaining portions of the entire loan have been transferred. Similarly, any transfer that does not meet the control-related requirements of ASC 860-10-40-5 should be accounted for as a secured borrowing. Conversely, those transfers that do meet all requirements for sale treatment are accounted for as sales as elaborated on in ASC 860-20. The proper accounting for the income and expense components is complicated in a transfer that does not qualify for sale treatment whereby a secured borrowing needs to be recorded. The interest income from the entire loan should be recorded, even if a portion of the loan has been transferred post-close. Interest expense should be recorded on the secured borrowing for the amount of interest income pertaining to the transferred portion that is due to the party or parties it was transferred to. Rather than reflecting a gain or loss on sale, since the transaction is accounted for as a secured borrowing, the related fair value gain or loss from both the gross asset and liability (if the fair value option is elected for the liability) will run through the statement of operations, typically in the change in unrealized gain/loss on investments and secured borrowings line item. Most loan tracking systems or software packages aren t equipped to handle the complexities of these types of transactions, so some modifications of the systems or entry of a new financial instrument that has been transferred is generally required. Proper recognition of any ancillary fee income (i.e., structuring, origination, underwriting fees, etc.) also needs to be considered in light of the requirements of ASC 310-20, Nonrefundable Fees and Other Costs. Loan origination fee income (along with direct loan origination costs) is deferred and amortized into income over the life of the loan; however, if a portion of the loan has been transferred, a determination of whether any of that income recognition should be accelerated should be undertaken. Loan origination fees are defined in ASC 310-20-20 to include certain syndication and participation fees to the extent they are associated with the portion of the loan retained by the lender. Fair value option for secured borrowings When a transfer of a loan or portion of a loan does not meet the requirements for sale treatment, as indicated above, the loan or portion transferred remains as an investment on the balance sheet, with a secured borrowing liability for the proceeds received. As investments are recorded at fair value on the balance sheet of a BDC, management may want to consider electing the fair value option under ASC 825, Financial Instruments, for the secured borrowing liability. (Note that with certain exceptions elaborated on in ASC 825-10-25, this election can only be made when the entity first recognizes the secured borrowing. Additionally, any decision to elect the fair value option should be made with careful deliberation, as it is not revocable). Under this fair value election, the carrying amount of a secured borrowing would be inversely impacted by any interest rate-related increase or decrease in an investment s value, resulting in an offsetting unrealized gain or loss that will minimize the impact flowing through the statement of operations. Alternatively, if the option is not elected, only unrealized gains or losses from the asset will flow through the statement of operations, while the corresponding gain or loss on the secured borrowing has no profit and loss impact. 3
As interest rate risk impacts the value of a financial asset, if the fair value option is not elected on a related secured borrowing, the value of the asset could potentially be reduced; however, the corresponding liability is not also reduced, and instead recorded, in accordance with the participation agreement. This potentially creates a situation where the BDC results are not hedged and could be adversely affected solely by a change in interest rates. Asset coverage ratio and compliance Any partial loan sales by a BDC that fail to meet the definition of a participating interest, as well as any other transfers that do not qualify for sale treatment, need to be considered for regulatory purposes as a limitation on the level of leverage a BDC can incur under the Investment Company Act of 1940 (1940 Act). As the secured borrowing would appear to qualify as other indebtedness under the 1940 Act, it should be included in the leverage ratio calculation and would limit a BDC from obtaining additional leverage once the BDC crossed over the 200 percent ratio level. Representatives from the Securities and Exchange Commission (SEC) have advised reporting entities to follow generally accepted accounting principles (GAAP) when questions have surfaced related to whether a secured borrowing should be included in the leverage ratio calculation, thus confirming the point above to treat the secured borrowing as a senior security, as defined in the 1940 Act, and include it in the leverage ratio calculation. We are advising market participants who desire sale treatment not to create a first-out or last-out arrangement by assigning or otherwise transferring a portion of a loan with differing terms or priorities than portions retained or sold to others. Management may want to consider having all willing lenders participate in the initial funding and closing of loans with differing terms and priorities as syndicates, such that there is no transfer that would need to be evaluated in light of the criteria in ASC 860 for sale treatment. Upfront planning can help to avoid unpleasant accounting consequences, such as secured borrowing treatment and the related ramifications on regulatory leverage ratios, as well as enhanced disclosures that would need to be incorporated if ASC 860 was applicable. Tactful planning and long-term goal-setting play a key role in employing a successful investment strategy. Key in this is recognizing that the accounting treatment for loan participations and other transfers may drastically vary depending on whether a portion of a loan or entire loan is transferred, as well as certain technicalities outlined in the agreements. Management can proactively assess the long term financial reporting implications of each opportunity to ensure their investment strategy aligns with the desired financial statement presentation and maintains compliance with regulatory requirements. Conclusion RSM US LLP s BDC practice has seen an uptick in first out and last out arrangements over the past 12-18 months. We have seen different types of lenders (BDCs, banks, insurance companies and institutional investors, to name a few) seek participation in these types of transactions. If contemplating such an arrangement in a manner that will involve a transfer of a loan or portion of a loan to other lenders or investors, the nuances of ASC 860, specifically the requirements for sale treatment, should be considered. 4
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