(Article from Registered Funds Alert, September 2017)
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In June 2017, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) began issuing examination requests to investment advisers of BDCs requesting certain information pertaining to BDC operations (the “BDC Request Letters”). Among other things, the BDC Request Letters request a significant amount of information related to the role of BDC investment advisers and associated fees and payments. The BDC Request Letters also indicate potential increased interest on the part of the SEC Staff in BDCs which, for the most part, generally have steered clear of involvement in SEC enforcement matters. As the market share of BDCs continues to grow, and the SEC continues to shift examination and enforcement resources to investment sectors with a heavy retail nexus, we expect that the SEC’s interest in BDCs and their investment advisers will continue to grow as well.
As is the case with many request letters, the BDC Request Letters are broad, and request varying levels of information. For example, one letter requests information in the following categories: general information; fund compliance, risk management, and internal controls; fund corporate governance; conflicts of interest/insider trading; fund investment activities; compensation arrangements; fee and expense reimbursement; valuation of fund portfolio assets; capital structure; financial records; and other records that pertain to the adviser. In contrast, another letter simply seeks information categorized with respect to the BDC and its adviser. In addition, one letter has nearly 100 itemized requests, while another letter has approximately half that number.
Much of the information requested in the BDC Request Letters is typical of examination document requests – information about directors/trustees and officers, information about service providers, and general compliance information. Notably, however, one of the letters requests trade blotter and holdings information in Excel format, indicating that the SEC may be using data analytics to assess, and perhaps compare, BDCs. Another request letter also asks for information about trade blotters, but broadens the scope of earlier letters by requesting in a separate attachment information about former clients and proprietary and/or trading accounts and access persons.
A notable characteristic of these request letters is that they request information about fee and expense reimbursement calculations. Unlike other types of registered funds, BDC investment advisers typically charge incentive fees in addition to management fees. While externally managed BDCs must include extensive disclosure regarding the calculation of incentive fees in their registration statements, to date, the SEC Staff has not taken a formal position regarding how they believe incentive fees should be calculated. One of the letters specifically asks for written policies and procedures addressing the calculation of fees and reimbursement of fund expenses, Excel spreadsheets supporting the calculation of management fees and incentive fees, a schedule of all expense reimbursements made to a BDC, and an Excel spreadsheet with quarterly NAV calculations. This may signal that the SEC is gathering information in advance of a more thorough review of incentive fee calculations in the future. Given the SEC’s prior interest in private equity fee matters, coupled with a focus on retail investors, this development may be viewed as a natural progression – as private equity “goes retail,” the examiners follow.
Another focus area of the BDC Request Letters is investments in eligible portfolio companies (“EPCs”), an investment requirement unique to BDCs. BDCs were established as a means of making capital more readily available to small, developing, and financially troubled companies that would not otherwise have access to capital markets or conventional financing. As such, BDCs typically cannot acquire other assets unless at least 70% of a BDC’s total assets are invested in securities of EPCs. The BDC Request Letters ask for a list of a BDC’s holdings for each quarter and an indication as to whether the security is an EPC. They also request a list of portfolio companies to which the BDC has provided or offered to provide managerial assistance, whether these companies are identified as EPCs, as well as the specific criteria that define the entity as an EPC. The letters also request identification of any positions that lost status as an EPC due to the issuance of a class of securities that are “margin eligible.”[1] These requests in the BDC Request Letters concerning EPCs indicate that the SEC Staff may be focused on how BDCs are classifying and treating EPCs, including whether in the SEC’s view advisers may be taking a lax approach to maintaining the required level of EPC investments in order to pursue other, potentially more lucrative, discretionary investments.
Issuance of the BDC Request Letters follows the FINRA targeted exam letters that were issued in August 2016 to certain of its broker-dealer registrants requesting: (1) a list of each BDC offered by a firm and the firm’s role in the offering (i.e., dealer manager, distributor, etc.); (2) for each BDC offered, a list of all participating broker-dealers that have selling arrangements with the firm and sample copies of selling agreements utilized; (3) an Excel list of all broker-dealers that sold the BDCs to customers in initial or follow-on offerings and information about the sales from those offerings; and (4) a copy of the firm’s due diligence procedures. FINRA has not announced the results of the targeted exam, although it did indicate in its 2017 Regulatory and Examination Priorities Letter that it would be considering the suitability of non-traded BDCs, among other products, for certain types of investors.
Collectively, the FINRA target exam letters, followed by the BDC Request Letters from the SEC suggest that regulators intend to take a close look at fee and expense practices in the BDC sector, which is consistent with recent messaging from SEC senior leadership concerning the importance of protecting potentially vulnerable retail investors. Although it remains to be seen whether the level of SEC scrutiny will approximate the increased spotlight placed on the private equity industry in 2012, the BDC Request Letters suggest that the industry should brace for a level of sustained scrutiny, which will likely have a concomitant market effect of enhancing overall levels of transparency in the BDC industry.
[1] The 1940 Act defines EPCs to include any domestic operating company that, among other things, does not have a class of securities that is marginable under Federal Reserve Board rules. Generally, margin stock includes equity securities registered on a national securities exchange, any over-the-counter security trading in the Nasdaq Stock Market’s National Market, any debt security convertible into a margin stock, and most mutual funds under Regulation U.