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By: Nicole M. Runyan and William J. Tuttle, Proskauer Rose LLP
Increasing numbers of asset managers are evaluating the potential benefits of including a business development company (BDC) within their suite of managed funds and accounts. A BDC is a hybrid of an investment company and a traditional operating company and, as a result, their operations are subject to a unique and complex adaption of various federal securities laws. Below are 10 practice tips that will help you navigate the BDC space without panicking.
BDCs were established under the Small Business Investment Incentive Act of 1980 as a type of closed-end investment company designed to provide capital to small, developing, and financially troubled companies lacking access to public capital markets, financial and operational management expertise, and miscellaneous forms of traditional equity and debt capital. BDCs elect, pursuant to Section 54 of the Investment Company Act of 1940, as amended (the 1940 Act), to be subject to Sections 55 to 65 and certain other provisions of the 1940 Act. In addition, BDCs are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the Exchange Act), and file Forms 10-K, 10-Q, and 8-K. The common stock of BDCs can be listed on a national securities exchange (e.g., Nasdaq or the New York Stock Exchange), although there are a number of large BDCs that have been offered to institutional investors or through certain retail channels that are not listed. Prior to 2003, the largest BDCs were internally managed, meaning that the BDC manages its assets through its own employees, who are compensated directly by the BDC. Since that time, however, a meaningful majority of new BDCs have been externally managed, meaning that the BDC engages an investment adviser registered under the Investment Advisers Act of 1940, as amended (the Advisers Act), to manage its assets under the supervision of a board of directors. This has allowed a number of large asset managers to offer a BDC to their clients as part of a wide array of products across a number of strategies. Asset managers considering entry into the BDC space should give careful consideration to the proposed investment strategy and how a BDC will fit within the existing platform (including with respect to legal, operations, and other resources necessary to ensure compliance with regulatory restrictions).
Over the past several years, it has become increasingly difficult for a BDC to complete an initial public offering (IPO) as a blind pool. As a result, most BDCs either (1) operate as a private vehicle and build up a portfolio of assets prior to commencement of an IPO (e.g., Bain Capital Specialty Finance, Inc.; TCG BDC, Inc.; and Goldman Sachs BDC, Inc.) or (2) engage in a series of formation transactions pursuant to which they acquire a pool of assets prior to commencement of the IPO (e.g., Golub Capital BDC, Inc. and Garrison Capital Inc.). In the case of BDCs engaging in formation transactions, care must be taken with respect to the structuring, sequencing, and timing of the transactions to ensure that they do not run afoul of the 1940 Act’s restrictions on transactions with affiliates (which take effect at the time a company elects status as a BDC).
A BDC is generally prohibited from acquiring assets other than qualifying assets unless, after giving effect to any acquisition, at least 70% of its total assets are qualifying assets. Qualifying assets generally include securities of eligible portfolio companies, cash, cash equivalents, U.S. government securities, and high-quality debt instruments maturing in one year or less from the time of investment. As a general matter, a company is an eligible portfolio company if it (1) is organized under the laws of any U.S. state and has its principal place of business in the United States; (2) is not an investment company or a company that would be an investment company except for the exclusions under Section 3(c) of the 1940 Act; and (3) either (a) does not have any class of securities listed on a national securities exchange or (b) has an aggregate market value of its voting and non-voting equity securities of less than $250 million. Subject to certain limitations on investing in securities and insurance-related businesses, the remaining 30% of a BDC’s total assets can be invested opportunistically, including in non-U.S. issuers, joint ventures, aircraft finance businesses, and unsecured consumer loans. Asset managers should ensure that they expect to have access to an appropriate level of qualifying assets following completion of the launch of a BDC.
Externally managed BDCs typically pay their investment advisers a base management fee and an incentive fee, although the rates can vary meaningfully depending on the BDC’s investment strategy, the year in which the BDC was launched, and whether the BDC is listed or unlisted. Fee structures are often a significant negotiation point at the time of any BDC IPO, as the underwriters and management review and assess market comparables. Fee structures have changed over the past several years, and managers considering establishing a BDC, or taking a private BDC public, should be certain to evaluate fee arrangements within the current market.
The base management fee is typically paid at an annual rate of between 1% and 2% of gross assets (often calculated excluding cash and cash equivalents) and is generally paid quarterly in arrears. The incentive fee typically has two parts: one based on the BDC’s income and the second based on capital gains. The income-based component of the incentive fee is typically between 15% and 20% of the BDC’s net investment income (calculated before payment of the incentive fee) over a specified annual rate of return (hurdle) of between 6% and 8% and is generally paid quarterly in arrears. The capital gains component of the incentive fee is typically between 15% and 20% of a BDC’s realized gains over a period, less its realized losses and unrealized capital depreciation over the same period, and is paid annually. The capital gains component of the incentive fee is subject to a statutory cap of 20% of realized gains less realized losses and unrealized capital depreciation. By contrast, the base management fee and the income-based component of the incentive fee are not subject to any statutory maximum.
Over the past several years, many BDCs have incorporated caps on their incentive fees such that they are not payable to the investment adviser absent certain returns to stockholders over a period of time (often three years). In addition, many BDCs have incorporated limitations on the income-based component of the incentive fee such that it is payable only on amounts received by the BDC in cash. Asset managers should carefully consider market trends in BDC fee structures as well as fees across other investment vehicles they offer in connection with fixing the fee structure for any new BDC, especially as the asset manager will be limited in its ability to adjust the fee structure without approval of the BDC’s stockholders.
The initial investment advisory agreement between a BDC and its investment adviser may have a term of no more than two years from its date of execution and must be approved by (1) a majority of the BDC’s board of directors; (2) a majority of the directors who are not interested persons (within the meaning of the 1940 Act) of the BDC (at an in-person meeting called for that purpose); and (3) the holders of a majority of the outstanding voting securities of the BDC (which means the affirmative vote of the lesser of (a) 67% or more of the shares of the BDC present or represented by proxy at a stockholder meeting if the holders of more than 50% of the outstanding shares are present or represented by proxy at such meeting or (b) more than 50% of the outstanding shares). The initial stockholder approval is typically accomplished before the BDC accepts money from outside investors. However, any subsequent modification to the investment advisory agreement (other than fee reductions) will generally require that the BDC seek stockholder approval of such modification.
Following an initial two-year term, the investment advisory agreement will remain in effect from year to year thereafter if approved annually by the BDC’s board of directors or by the affirmative vote of the holders of a majority of outstanding voting securities of the BDC, and, in either case, a majority of the directors who are not interested persons of the BDC (at an in-person meeting called for that purpose).
In connection with their consideration of the investment advisory agreement, the directors of the BDC must request and evaluate (and the BDC’s investment adviser must provide) such information as may reasonably be necessary to evaluate the terms of the investment advisory agreement. The resulting analysis should focus on a number of items, including (1) the nature, extent, and quality of services performed by the investment adviser; (2) the investment performance of the BDC and the investment adviser; (3) the costs of providing services to the BDC; (4) the profitability of the relationship between the BDC and its investment adviser, including realized and potential economies of scale; and (5) comparative information on fees and expenses borne by other comparable BDCs or registered investment companies and other advised accounts. No single factor in this analysis is required to be dispositive.
Given the technical nature of the requirements for the approval of an investment advisory agreement and the amount of information provided to directors as part of the approval process, asset managers should carefully set the fee structure such that amendments will not be required except in extreme circumstances and consider the timings of required approvals and plan accordingly.
The 1940 Act requires that the holders of a majority of the outstanding voting securities of a BDC be able to terminate the investment advisory agreement at any time without penalty upon not more than 60 days’ written notice to the investment adviser. In addition, the investment advisory agreement must provide that it terminates automatically in the event of its assignment. For purposes of the 1940 Act, the acquisition by any person of greater than 25% of the voting securities in an investment adviser will generally constitute an assignment, as will the failure of any greater than 25% holder to continue holding greater than 25% of the voting securities of the investment adviser. As a result, a change of control transaction of the investment adviser to a BDC will generally require that the BDC seek stockholder approval of the investment advisory agreement, regardless of whether economic terms are changing.
As a general matter, Section 15(f) of the 1940 Act prohibits an investment adviser from receiving compensation or other benefit in connection with the sale of an interest in the investment adviser that results in an assignment unless (1) during the three-year period following the consummation of a transaction, at least 75% of the BDC’s board of directors are not interested persons of the new investment adviser or predecessor adviser; and (2) an unfair burden is not imposed on the BDC as a result of the transaction relating to the sale of such interest, or any of its applicable express or implied terms, conditions, or understandings. The term unfair burden includes any arrangement during the two-year period after the transaction whereby the investment adviser (or predecessor or successor adviser), or any interested person of such an investment adviser, receives or is entitled to receive any compensation, directly or indirectly, from the investment company or its stockholders (other than certain advisory and services fees) or from any person in connection with the purchase or sale of securities or other property to, from, or on behalf of the investment company (other than certain underwriting compensation).
Asset managers evaluating change of control transactions should take care to ensure that no party inadvertently takes action that would result in the assignment of an investment advisory agreement prior to receipt of appropriate stockholder approvals and also address as part of the transaction documentation appropriate allocation of responsibility for ensuring compliance with Section 15(f).
The 1940 Act prohibits a BDC from knowingly participating in certain types of transactions with its affiliates without prior approval of its directors who are not interested persons and, in some cases, prior approval by the Securities and Exchange Commission (SEC). These restrictions generally prohibit a BDC from engaging in joint transactions with other entities that share the same investment adviser (or investment adviser controlling, controlled by, or under common control with such adviser). Certain types of co-investments across a platform of affiliated funds, including a BDC, could constitute such a prohibited joint transaction. The staff of the SEC has granted no-action relief permitting purchases of a single class of privately placed securities provided that the investment adviser negotiates no term other than price and certain other conditions are met. However, many BDCs and their investment advisers seek exemptive orders from the SEC in order to permit greater flexibility to negotiate the terms of co-investments. Under the terms of this relief, a required majority, as defined in the 1940 Act, of the BDC’s board of directors would be required to make certain conclusions in connection with any negotiated co-investment transaction, including that the terms of the proposed transaction do not involve overreaching by the BDC or its stockholders and that the transaction is consistent with the BDC’s investment strategies and policies. Asset managers should consider whether the strategy for their BDC overlaps with that of other funds and accounts and, if so, whether the ability to co-invest on originated or other negotiated transactions is important to the successful implementation of the investment strategy across relevant accounts.
The 1940 Act contains asset coverage requirements that limit the ability of BDCs to incur leverage. Until March 2018, a BDC was generally only allowed to borrow amounts by issuing debt securities or preferred stock (collectively referred to as senior securities) if its asset coverage, as defined in the 1940 Act, equaled at least 200% (equivalent to a 50% debt-to-total capital ratio) after such borrowing. For purposes of the 1940 Act, asset coverage means the ratio of (1) the total assets of a BDC, less all liabilities and indebtedness not represented by senior securities, to (2) the aggregate amount of senior securities representing indebtedness (plus, in the case of senior securities represented by preferred stock, the aggregate involuntary liquidation preference of such preferred stock). Since March 2018, BDCs have been able to increase the maximum amount of leverage that they are permitted to incur, so long as the BDC meets certain disclosure requirements and obtains certain approvals. Under these modified asset coverage requirements, a BDC will be able to incur additional leverage, as the asset coverage requirements for senior securities (leverage) applicable to the company pursuant to Sections 18 and 61 of the 1940 Act will be reduced to 150% (equivalent to a 66-2/3% debt-to-total capital ratio). Effectiveness of the reduced asset coverage requirement to a BDC requires approval by either (1) a required majority of such BDC’s board of directors with effectiveness one year after the date of such approval or (2) a majority of votes cast at a stockholder meeting of such BDC’s stockholders at which a quorum is present, which is effective the day after such stockholder approval. In addition, a BDC which does not have its common stock listed on a national securities exchange must offer each stockholder of record on the approval date of the reduced asset coverage requirements the opportunity for the BDC to repurchase such stockholder’s securities held on such date. The BDC then must repurchase, by tender offer or otherwise, 25% of the securities held by electing stockholders of record on the approval date in each of the four succeeding calendar quarters following the quarter during which the reduced asset coverage ratio was approved.
BDCs can incur leverage through a variety of means, including traditional senior secured credit facilities, collateralized loan obligations, warehouse credit facilities, institutional notes offerings, retail (baby bond) notes offerings, debentures from the Small Business Administration, and preferred stock. In the current environment, many BDCs have established both debt facilities that provide for revolving borrowings at a floating rate above the London Interbank Offered Rate (LIBOR) (or an equivalent) and debt facilities (or notes offering) that provide for term borrowings at a fixed rate.
Asset managers entering the BDC space should consider carefully the desired asset coverage requirement to which the BDC will be subject and also evaluate the types of leverage that fit best with the intended investment strategy.
BDCs are required to adopt and implement written policies and procedures reasonably designed to prevent violations of the federal securities laws by the BDC, including policies and procedures that provide for the oversight of compliance by the BDC’s investment adviser, administrator, transfer agent, and any principal underwriters. These policies and procedures are required to be approved by the BDC’s board of directors on a finding that the policies and procedures are reasonably designed to prevent violations of the federal securities laws. Adequacy of the policies and procedures must be reviewed at least annually. BDCs are also required to have a chief compliance officer, whose designation and compensation are approved by the BDC’s board of directors, including a majority of the directors who are not interested persons. This individual must deliver, no less than annually, a written report to the board of directors addressing the operation of the compliance program and any material compliance matters and meet in executive session with the directors who are not interested persons no less frequently than annually. The investment adviser to a BDC is also required to comply with its own regulatory requirements under the Advisers Act and compliance manuals and policies.
Asset managers entering the BDC space should ensure that the existing compliance team has sufficient bandwidth for the new product or consider whether additional resources (whether at the asset manager or through retention of a third party) will be necessary.
As the BDC industry has grown and become an attractive vehicle for asset managers, it has experienced a number of novel consolidation transactions. Consolidation transactions could be an attractive and efficient way for asset managers to gain access to the BDC market whether through acquiring another asset manager (or the books and records related to managing the BDC), which may be an ideal option as certain asset managers evaluate succession planning, or purchasing the investment advisory contract directly from the stockholders. In addition, existing BDCs may be able to gain scale through the acquisition of BDCs managed by other asset managers and/or through the consolidation of multiple BDCs across the same platform. Any of these structures require careful analysis of a number of difficult issues ranging from 1940 Act restrictions to tax planning to securities laws. Asset managers evaluating the BDC space should consider whether a consolidation or M&A transaction might be a more efficient means of gaining access to capital, as compared to raising capital in a newly formed BDC or otherwise acquiring the resources to expand its platform.
Nicole M. Runyan, a partner at Proskauer Rose LLP, counsels registered funds and their independent board members, as well as investment advisers and sponsors, across a wide range of regulatory, transactional, and compliance matters. Nicole advises on the creation, registration, and operation of new and existing products designed for institutional or retail investors. Most recently, she has counseled clients on the design and offering of alternative investment products and strategies, such as BDCs and private equity, requiring innovative legal analysis and a broad business understanding. William J. Tuttle is a partner in the Corporate Department at Proskauer Rose LLP and focuses his practice on capital markets and corporate matters. Will represents BDCs, asset managers, issuers, closed-end funds, and underwriters/investment banks. His experience includes facilitating public and private securities transactions for investment banks and strategic mergers and acquisitions for companies. In addition, he counsels investment advisers on structuring and forming new investment funds, with an emphasis on leveraged loan funds.
To find this article in Lexis Practice Advisor, follow this research path:
RESEARCH PATH: Capital Markets & Corporate Governance > Investment Management > Registered Investment Companies > Practice Notes
For a review of regulations under the Investment Company Act of 1940, see
> INVESTMENT COMPANY ACT OF 1940 EXEMPTIONS AND EXCEPTIONS
For a discussion of registering investment companies, see
> INVESTMENT COMPANY REGISTRATION WITH THE SEC
For an overview of investment company structure and governance, see
> CORPORATE STRUCTURE AND GOVERNANCE OF AN INVESTMENT COMPANY
To review recent BDC trends, see
> MARKET TRENDS 2018/19: BUSINESS DEVELOPMENT COMPANIES
RESEARCH PATH: Capital Markets & Corporate Governance > Trends and Insights > Market Trends > Practice Notes