I was scratching my head for a while after my initial reading of the Securities and Exchange Commission action against Madison Capital Funding. The SEC dove into a valuation process that seemed relatively straight-forward to me, but labeled it a fraud.
Madison’s business model is a bit complex. It originates loans. (This was 2020, before it was called private credit.) Then 30-60 days later it sells half of the loan interest to a private fund. Madison was also the investment adviser to the fund.
Since there is gap between the loan origination and the sale, the transfer is considered an affiliate transaction under 206(3) of the Advisers Act. That means you need to get written client consent. This is obviously tricky when you’re on both sides. To comply. Madison engaged a third-party agent to provide an independent review of the loan sales and to provide approval on behalf of the fund.
Madison’s fund agreements provided that the loan interests would be transferred at fair value and on terms that one would have obtained in a comparable arm’s length transaction. Given the 30-60 day gap from origination to sale, Madison marked the loans at par value less the unamortized fee or discount. Madison did update its credit review before the transfer and only sold loans that still met credit criteria.
That all seems pretty good.
The COVID pandemic hit in March 2020. Madison continued it practice and sold 143 loan interests from March 2020 to May 2020. Other than one loan, the other 142 loans have been fully paid by the borrowers or are continuing to perform.
With those results, it sounds like good underwriting and process to me.
The SEC thought otherwise. It claims that all of those loans should have been subject to downward price pressure during this period. Madison should have been marking down those loans. The SEC took the position that Madison failed to determine the effect of market disruption on the fair market vale of those loans.
I think the SEC examiners forgot that back in March 2020 we all thought that COVID thing would blow over in two months. There was lots of uncertainty in the markets. It still seems reasonable to me that a performing loan originated a month or two earlier should not have a dramatic change in price. That the loans all worked out, except one, looks like a really good track record to me and that the pricing was right.
Nonetheless, Madison settled with the SEC for a little over $5 million for willful violation of Section 206(4) of the Advisers Act.
Maybe there are other facts that were left out of the order that makes the SEC cases more of winner. As written it looks like the SEC was double-guessing an investment adviser’s reasonable valuation.
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