BDCs: Is Private Equity Going Public?

What is a BDC? As part of the Small Business Incentive Act of 1980, Congress created a new public investment company vehicle called a ‘business development company’ in order to encourage the flow of public capital to private businesses. BDCs are publicly registered, closed-end investment companies with shares that trade like stock on an exchange or Nasdaq. As a result, BDCs are available to public investors who otherwise would not generally have access to private equity funds. Unlike traditional private equity funds, BDCs operate for an indefinite period and continually recycle their contributed capital. Historically, BDCs have made debt and equity investments in small and middle-market private companies and returned the bulk of the profits to stockholders in the form of quarterly dividends.

Regulatory Framework. As publicly-traded funds, BDCs are subject to the reporting requirements of the Securities Exchange Act of 1934. They are also subject to many provisions of the Investment Company Act of 1940. BDCs must file periodic, quarterly and annual reports with the SEC as well as proxy statements. BDCs must publicly file quarterly and annual financial statements identifying the current fair value of each portfolio company held by the BDC. Determining the fair value of illiquid portfolio company investments requires the BDC to make judgments concerning the value of these investments and to disclose the methodology behind these valuations, thereby exposing the BDC to stockholder and SEC scrutiny. Earnings fluctuations require public disclosure and explanation.

BDCs are also subject to Sarbanes-Oxley and the corporate governance requirements of the self-regulatory organisations that govern the markets upon which the BDC’s securities are traded. A BDC’s books are subject to periodic SEC examinations. Private equity funds accustomed to relative anonymity may have difficulty adjusting to the transparency demanded of BDCs.

Governance. BDCs, typically organised as Maryland corporations because of that state’s favourable treatment of publicly-traded investment entities, are governed by boards of directors which must be made up of a majority of disinterested directors (i.e., persons unaffiliated with the BDC’s sponsor and investment adviser). BDCs are typically operated in accordance with an investment advisory agreement with an investment adviser, likely an entity affiliated with the BDC’s private equity sponsor. A BDC may also contract with an entity affiliated with its sponsor for the provision of administrative services. Investment advisers to BDCs must be registered under the Investment Advisers Act of 1940, creating additional regulatory hurdles for BDC sponsors and their investment advisers. Advisory agreements must be renewed periodically and must be approved by a BDC’s disinterested directors, each of whom is subject to fiduciary duties that must be adhered to when considering the renewal of these agreements. Additionally, these advisory agreements must allow a BDC’s board or a majority of its stockholders to terminate the agreement on short notice without penalty.

BDC Economics. A BDC’s investment adviser typically receives a management fee of between two per cent and 2.5 per cent of the BDC’s gross asset value (including leverage), although the management fee percentage may be reduced in the BDC’s first year of operation. In addition, the investment adviser typically receives a 20 per cent incentive fee (or ‘carried interest’) on income and gains payable after surpassing an annualized hurdle rate. Unlike placement fees incurred in connection with traditional private equity fund offerings, underwriting commissions incurred in connection with a BDC’s public offering typically are treated as an expense of the BDC rather than an expense borne by fund managers.

Investment Restrictions. At least 70 per cent of a BDC’s assets must be ‘qualifying assets,’ which generally consist of securities of private or thinly traded public US companies, cash, cash equivalents, US government securities and high-quality debt investments. The 70 per cent qualifying assets test is applied after each portfolio investment. In order for portfolio company securities to be counted as qualifying assets, a BDC must either control the portfolio company or offer to and, upon request, provide ‘significant managerial assistance’ to the portfolio company. ‘Control’ means the power to exercise a controlling influence over the management or policies of the company, and control may be presumed if the BDC owns at least 25 per cent of the company’s voting securities and is the largest single holder of the company’s securities.

BDCs may utilise leverage, but are subject to 1940 Act limits which generally require at least 200 per cent asset coverage as measured after any borrowing. BDCs also face significant restrictions on their ability to conduct transactions with affiliates, which limit co-investment opportunities for a BDC and its sponsor’s existing fund vehicles. The SEC has the authority to grant relief from these restrictions on transactions with affiliates, but the process can be costly and time consuming.

Tax Status. Generally, a BDC will elect to be treated as a regulated investment company (RIC) for tax purposes and thereby avoid corporate level taxation on ordinary income and capital gains distributed to its stockholders as dividends. As a RIC, a BDC is required to distribute at least 90 per cent of its ordinary income and realised net short-term capital gains in excess of realised net long-term capital losses and to meet specified source-of-income and asset diversification requirements. Distributions out of capital gains to individual stockholders are generally eligible for favourable capital gain tax treatment.

BDCs Then and Now. Prior to the recent wave of BDC registrations, a number of sophisticated financial sponsors struggled to launch BDCs. Ultimately most of these efforts failed as a result of regulatory, business and tax concerns, with Allied Capital and American Capital Strategies standing out as high-profile success stories.

Apollo’s BDC and many other recently registered BDCs intend to provide mezzanine and senior secured loans to under-served middle-market companies. In the current environment, where interest rates are low and public investors are rewarding stocks that pay dividends, the sponsors of these BDCs hope to find a receptive audience. Nevertheless, recent changes to the terms of some BDC offerings suggest that there may be less appetite for these vehicles than was expected. While BDCs may prove to be a good fit for this market niche, BDCs have not proven to be an especially attractive alternative to traditional venture capital and buy-out funds. Historically, successful BDCs have maintained relatively consistent dividend yields, making BDCs more suitable for investment funds that seek current income as opposed to the long-term capital gains sought by traditional venture capital and buy-out funds.

Conclusion. For their sponsors, BDCs offer some important benefits, chief among them, a permanent source of capital and the ability to extend the sponsor’s franchise to retail investors. These benefits come at the price of increased transparency, a host of investment restrictions and a rigid regulatory environment.

For investors, BDCs offer the opportunity to invest in potentially high-yield investment vehicles that are typically closed to public investors. However, the price of access may be steep. Investors purchasing BDC shares in an IPO will almost always be purchasing shares that will begin trading at a discount to their IPO price, as IPO purchasers absorb underwriting commissions and other organisational expenses.

It is possible that the recent BDC entrants will succeed where their predecessors have failed. Given the constraints of the BDC structure, however, BDCs are not likely to displace traditional private venture capital and buy-out funds.

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