(Article from Registered Funds Alert, June 2018)
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Business development companies (“BDCs”) recently won a substantial legislative victory that industry advocates have been seeking for years. The Small Business Credit Availability Act (the “SBCA Act”) was signed into law in March 2018 as part of an omnibus spending bill that will fund the federal government through September 2018. The SBCA Act loosens leverage restrictions and directs the Securities and Exchange Commission (the “SEC”) to reduce the limitations on security offerings that have historically constrained BDC offerings.
The BDC industry has been advocating for more than five years to secure these changes, which industry participants hope will allow BDCs to lend more money and allow them to compete more aggressively in the U.S. middle-market loan space. Despite the long buildup, the SBCA Act arrived somewhat suddenly when it was added to the omnibus spending bill late in the legislative process, and now industry insiders, observers and investors alike all have questions about the bill, its inner workings, and its practical effects. In this Alert, we address some frequently asked questions regarding the SBCA Act.
Leverage Changes
What were the previous regulatory limits on a BDC’s use of leverage?
BDCs have always had the ability to use leverage, albeit limited, as part of their investment strategy. Historically, BDCs have had greater flexibility than other types of registered investment funds—such as traditional closed-end funds and mutual funds—in their use of leverage. Whereas Section 18(a) of the Investment Company Act of 1940, as amended (the “1940 Act”), requires registered investment companies to maintain 300% asset coverage for borrowings, which equates to a 1:2 debt-to-equity ratio, Section 61(a) of the 1940 Act requires BDCs to have 200% asset coverage, or a 1:1 leverage ratio (registered closed-end funds have a similar 200% requirement with respect to preferred stock issuances). In other words, a registered investment company can only borrow $50 for every $100 of equity capital on its balance sheet, while a BDC has been permitted to borrow $100 for every $100 in equity. Despite the additional flexibility provided for BDCs, the prior BDC leverage limit is much lower than limits on other lenders that BDCs sometimes compete against. For example, banks and private funds can usually incur significantly higher leverage.
How does the SBCA Act address BDC leverage restrictions, and why does it matter?
While the default leverage limit applicable to BDCs remains the same, the SBCA Act amended Section 61(a) of the 1940 Act to give a BDC the option to effectively double the amount of leverage it may utilize. If a BDC meets certain requirements, the asset coverage requirement applicable to that BDC will be lowered from 200% to 150%, which translates to permitting BDCs to now have up to a 2:1 leverage ratio. Thus, a BDC may now borrow $200 for every $100 in equity capital on its balance sheet.
BDCs have historically felt that the 1:1 leverage limitation was too restrictive and limited their ability to provide much-needed capital to middle-market companies. To generate the types of returns that are attractive to investors with low leverage, BDCs have argued that they were in effect corralled into investing primarily in the riskiest, highest yielding debt. Increasing the leverage limit may allow some BDCs to deploy additional lower-risk senior capital to borrowers and lessen their dependence on the higher-risk junior capital and mezzanine debt in order to obtain consistently attractive yields. For example, an investment that yields 6% using 2:1 leverage could produce roughly the same returns as an investment using 1:1 leverage that yields 9%.
A number of BDCs have utilized various means to obtain effective leverage that exceeds the existing 1:1 limit without the additional leverage counting against the 200% asset coverage requirement. The leverage of certain joint ventures operated by a BDC typically is not counted against the BDC’s leverage limit if the joint venture subsidiary is not consolidated for accounting purposes. Similarly, BDCs may own and operate Small Business Investment Companies as subsidiaries, and the leverage of those entities also does not count towards that of the BDC. BDCs can also invest in collateralized debt obligations, which are themselves leveraged.
While the newfound leverage flexibility may be a boon to certain BDCs, not all of them will fully utilize the new leverage limit. Some may not elect to raise their leverage limits, and almost all do not fully utilize the leverage limits available today. According to data from Thomson Reuters, the BDC industry as a whole uses only about $0.69 of debt for every dollar of equity capital, which is significantly less than the 1:1 limitation.
BDCs use less leverage than they are legally permitted for several reasons. Perhaps the most relevant reason is that certain BDCs issue rated debt securities, and ratings agencies typically require a debt-to-equity ratio of less than 0.85 as a prerequisite for an investment-grade rating. Standard & Poor’s (“S&P”) has publicly stated its view that increased leverage in an already competitive environment may cause a net increase for credit risk for the industry. That ratings agency placed all BDCs it rates on “CreditWatch” with negative implications (and lowered its outlooks to negative on several BDCs). Fitch Ratings did not take any immediate rating actions on BDCs, but the agency said it “generally views the potential leverage increase as a ratings negative.”
Even if a BDC were willing to take a potential ratings hit with respect to its future offerings, indentures and other documents relating to its outstanding debt may contain covenants that contractually restrict the BDC from taking actions that negatively impact its creditworthiness or increase its leverage past a certain point. These covenants further impede increases in leverage for BDCs seeking to use the new leverage limit.
Are BDCs automatically able to make use of the higher leverage ratios?
No, the increase in permissible leverage is not automatic and the prior 1:1 limit remains the default standard for BDCs. For a BDC to increase its leverage to the extent permitted by the SBCA Act, it must meet certain requirements. Specifically a BDC may increase its permissible leverage ratio only after: (i) either (A) obtaining the approval of a majority of the BDC’s independent directors or (B) obtaining the approval of a majority of shareholders cast at a special or annual meeting where a quorum is present; and (ii) publicly disclosing such approval within five business days and making ongoing disclosures about the increase, the actual amount of leverage utilized and the principal risks associated with the leverage strategy. The required initial disclosure of the approved change would be done through a current report filing on Form 8-K (or other annual or quarterly report) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which would also be published by the BDC electronically on its website.
The routes to approval are not equivalent. BDCs that seek the ability to increase their leverage ratios through the approval of their independent directors cannot utilize the increase in leverage until one year after the board votes. BDCs that obtain approval via shareholder votes, on the other hand, would be able to increase their leverage past the 1:1 ratio the day after such approval is obtained.
Could a BDC seek both board approval and shareholder approval?
Yes. A BDC could have its board vote on the increased leverage proposal, which is administratively a far simpler task, and then also put the matter to shareholders at a special meeting or the next regularly scheduled annual meeting. In fact, many BDCs are doing just that. The statutory one-year waiting period would begin whenever the board approves the measure. If the shareholders approve the measure at a shareholder meeting, then the BDC would be permitted to make use of the increased leverage the day after. If, however, the board approves the measure but the shareholders do not, the BDC could still make use of increased leverage after the one-year period has tolled, which will be sooner than had they relied solely on obtaining shareholder approval and experience delays in obtaining that approval.
While this two-stage approval approach is permitted under the SBCA Act, it could put the board in the unenviable position of feeling compelled to reconsider relying on the new leverage limit if the proposal is later rejected by the BDC’s shareholders. Boards will need to satisfy themselves that, notwithstanding a negative vote (or a failure to achieve quorum), the increase in leverage is supported by prospects for improved performance (and does not result in a disproportionate increase in fees captured by the adviser).
Could a newly formed BDC authorize increased leverage through a sole shareholder vote?
Yes. While nothing in the SBCA Act permits a newly formed BDC to automatically begin operations with a 150% asset coverage ratio, there is also nothing in the SBCA Act that would prevent a sole initial shareholder from voting to approve the ability to rely on the reduced asset coverage requirement. A new BDC would then either include appropriate disclosure in its registration statement regarding its ability to rely on the 150% asset coverage limit or file a Form 8-K within five days if its registration statement is already effective.
Do the SBCA Act’s approval provisions overrule any fundamental policy to the contrary?
If a BDC has an existing fundamental policy limiting its use of leverage and then attempts to increase its permissible use of leverage pursuant to the SBCA Act, it is unclear whether merely obtaining board approval would be sufficient. Section 13(a)(3) of the 1940 Act requires shareholder approval to deviate from an existing fundamental policy, but not to adopt a new one that encompasses the old. The SBCA Act’s approval procedures do not speak to fundamental policies in general, and so its approval procedures could be read as necessary, but not always sufficient, levels of approval. The question would then be whether the BDC’s board allowing the BDC to utilize the increased leverage limit would be “deviating” from a BDC’s existing fundamental policy. Such a question can only be answered with reference to the specific policy in question. For example, for a BDC that has a fundamental policy that is tied to compliance with statutory limits, or a fundamental policy to use no more than a specified fraction of the leverage it is permitted to utilize by law, it would not be deviating from that fundamental policy if it continued to abide by the same proportional limitation after changing its leverage ceiling. If, however, the fundamental policy specifies that the BDC will not fall below a certain specified asset coverage ratio (or exceed a certain debt-to-equity ratio), then such an existing fundamental policy would contravene the changes contemplated by the SBCA Act. In that case, it would appear that the BDC would need to receive shareholder approval to effect such a change.[1]
There is potentially an argument based on statutory interpretation that would suggest that Congress intended to create a limited exception to the rules regarding fundamental policies, but it is unclear whether the SEC ultimately would agree. Generally speaking, where there is a clear contradiction between an existing law and a new law, the new law is read to take precedence on matters where the two conflict. For example, in 1996, Congress enacted Section 12(d)(1)(G), which provides that the limitations on funds owning other funds contained elsewhere in Section 12 do not apply if, among other things, the acquired and acquiring companies are part of the same fund group. It did not, however, explicitly make reference to the prohibitions under Section 17 that are also implicated by those transactions. The SEC stated in that case that since Section 12(d)(1)(G) was created to obviate the need for certain fund structures to obtain exemptive relief, continuing to require them to obtain relief for the related Section 17 matters would frustrate the purpose of Congress’s actions, so no specific relief with respect to Section 17 would be required for transactions relying on 12(d)(1)(G). Here, that argument is less clear. A BDC would have to make the argument that Congress, in enumerating the specific approval procedures with respect to the leverage ratio changes, intended to put aside other additional mechanisms of shareholder protection with respect to the leverage issue. If that were the case, then the requirement that any BDC with a fundamental policy restricting leverage must still obtain shareholder approval before deviating from that fundamental policy would frustrate Congress’s intent.
Are there any other protections for existing BDC shareholders with respect to the leverage changes?
As mentioned above, if a BDC elects to increase its maximum leverage ratio by obtaining the votes of a majority of its independent directors, a one-year waiting period is required before the BDC can begin to utilize the increased leverage. The one-year period is intended to allow shareholders who disagree with the increase in leverage to sell their stake in the BDC.
In addition, if an unlisted BDC approves an increase in its leverage ceiling, it is required to offer its existing shareholders some form of liquidity. Regardless of whether a BDC approves the leverage change through a board vote or a shareholder vote, if its common shares are not listed on a national exchange, the BDC must extend to each person that is a shareholder as of the date of the approval the opportunity to sell the BDC shares held by that shareholder as of the approval date.
If a shareholder accepts the offer, the BDC would be required to repurchase 25% of that shareholder’s eligible shares each quarter of the four calendar quarters following the quarter in which the leverage change was approved. While most non-traded BDCs have some mechanism for offering shareholders periodic liquidity, many private BDCs do not, and the only planned liquidity events are dissolution or a future listing at some point in the future. Having to deal with a forced liquidity event may dramatically impact such private BDCs, to the point where it might be untenable for them to enact the leverage change.
Are lenders likely to extend additional credit to BDCs that increase their leverage?
Generally, yes, but each BDC is situated differently. The borrowing ability of a BDC with a well-established track record that invests primarily in senior loans is very different from the borrowing ability of a newly created BDC that proposes to invest primarily in mezzanine loans. The industry focus, investment strategy and proven access to deals will also impact the ability of a given BDC to borrow.
Historically, in part because BDCs have been required to maintain relatively low leverage ratios, credit rating agencies have considered BDCs to have good credit quality and they have been viewed as attractive borrowers by traditional banks and bond markets. Banks have reliably lent BDCs money at much lower interest rates than the rate of return BDCs expect to earn from their investments. Bank debt has historically been cheaper to BDCs, and so, if as discussed above, ratings agencies and banks revise down their view on the creditworthiness of higher-leveraged BDCs, such changes likely will increase the cost of borrowing for those BDCs.
Even if traditional borrowing costs increase, it’s unlikely that most BDCs would find themselves entirely unable to access additional credit. Because they are statutorily required to maintain a set asset coverage ratio, if the BDC breaks that limit, it is required to suspend dividends and sell assets until it is in compliance with the asset coverage requirement. This generally protects creditors, even if it is at the expense of shareholders. Furthermore, all BDCs, including non-traded and private BDCs, are required to make public disclosures akin to those of a public company. As a result, lenders have better access to financial information on a quarterly basis and can take comfort in the fact that the financials of the BDC are subject to the scrutiny of the public and the SEC.
Security Offerings
What does the SBCA Act change about securities offerings by BDCs?
The SBCA Act requires the SEC to amend a number of rules and forms so as to allow BDCs access to various accommodations to the rules and regulations regarding the registration, communications and offering processes for registered transactions under the Securities Act of 1933, as amended (the “Securities Act”), that BDCs and registered investments companies, including traditional closed-end funds, have thus far been excluded from using. The changes will treat BDCs like other non-investment company issuers that perform registered offerings and streamline the offering process.
What does the SBCA Act change about BDC shelf registrations?
While BDCs have been permitted to use shelf registration statements on Form N-2 to register multiple offerings of securities in order to raise capital, currently those filings do not automatically become effective. This stands in contrast to the shelf registration process available under Form S-3, which permits shelf registration statements of “well-known seasoned issuers” (“WKSIs”) to be automatically effective upon filing. Automatically effective registration statements provide flexibility for WKSIs to time securities sales with optimal market conditions without waiting for the SEC staff to review and comment on a registration statement and declare it effective. BDCs, along with registered investment companies, were expressly excluded from the statutory definition of a WKSI, pursuant to Rule 405 of the Securities Act.
The SBCA Act revises the definition of WKSI to make that status available to certain BDCs. The law removes the exclusion of BDCs from the definition of WKSI and adds registration statements filed by BDCs on Form N-2 to the definition of “Automatic Shelf Registration Statement.” For those BDCs that will qualify as WKSIs,[2] this change will dramatically reduce the costs associated with starting and supporting shelf offering programs.
What does the SBCA Act change about incorporation by reference for BDCs?
Form S-3 allows a company to incorporate by reference the disclosure from its current and future Exchange Act reports to satisfy the disclosure requirements of the Form. Incorporation by reference occurs when disclosure in one filed document is legally deemed to be included in another document. Currently, Form N-2 does not allow for periodic reports to be incorporated by reference. The SBCA Act requires the SEC to amend Form N-2 to permit a BDC that has been an Exchange Act reporting company for 12 months and has a $75 million common share public float to incorporate by reference current and future publicly filed periodic reports into their registration statements. These changes should streamline the registration process for BDCs by making it less cumbersome to maintain a current shelf offering document and reduce the bulk of offering documents generally.
The SBCA Act also directs the SEC to amend the rules under the Exchange Act to allow a BDC to incorporate previously filed financial statements into its proxy materials under Schedule 14A, similar to what is permitted under Form S-3.
The SBCA Act also requires the SEC to revise Rule 497 of the Securities Act to allow a BDC to file a form of prospectus that contains substantive changes from or additions to a previously filed and effective base prospectus similar to how non-investment company issuers file such supplements under Rule 424(b).
What does the SBCA Act change about prospectus delivery for BDCs?
The SBCA Act extends “access equals delivery” treatment to BDCs. BDCs are currently often required to deliver a final prospectus to each purchaser by printing and mailing hard copies to investors. “Access equals delivery” under Rule 172 under the Securities Act, which deems electronic availability of the prospectus equivalent to physical delivery in certain circumstances, previously was unavailable to BDCs. The SBCA Act requires the SEC to adopt rules bringing parity to BDCs in this regard, and will allow BDCs to provide a notice of registration in lieu of sending the final prospectus. These changes should significantly reduce the cost and burden associated with prospectus delivery.
What does the SBCA Act change about market communication for BDCs?
Currently, BDCs are not eligible to rely on certain safe-harbors contained under Rules 134, 163, 163A, 168 and 169 under the Securities Act, which permit issuers to release certain factual and forward-looking business information under certain safe harbors from the Securities Act’s gun-jumping provisions and other restrictions. The SBCA Act directs the SEC to allow BDCs to utilize these rules, which should permit BDCs to more easily communicate with the market. Similarly, the SBCA Act directs the SEC to modify Rules 138 and 139 which will permit broker-dealers and other providers of market research more flexibility to disseminate research on BDCs and thereby further enhance communication to the market regarding BDCs.
These changes, in conjunction with the other offering-related changes discussed above, align the rules governing BDC offering communications with the more permissive rules available to operating companies. Individually and in the aggregate, the SBCA Act’s modifications to BDC offering rules will make it quicker and easier for BDCs to raise capital through registered offerings.
When will BDCs be able to take advantage of the registered offering-related changes?
The SBCA Act directs the SEC to effect the changes described above by March 23, 2019. BDCs will not be able to take advantage of the securities offering changes until the date the SEC takes the directed actions. If the SEC fails to act to revise the rules and forms as directed within the window provided by the law, however, the SBCA Act permits BDCs to treat such revisions as having been made in accordance with the specifications set out for the SEC within the SBCA Act, until such time as the SEC adopts the directed revisions.
Are the SBCA Act’s reforms everything BDCs need to reach their full potential?
While the SBCA Act’s reforms are welcomed and important changes for the BDC industry, there are other problematic rules that BDCs need reprieve from before they can reach their full potential. Perhaps the clearest example of a regulatory issue that still needs to be addressed is the requirements governing acquired fund fees and expenses (“AFFE”). The AFFE rules require 1940 Act funds that invest in BDCs to include the BDC’s expenses in their own funds’ expense ratios. The application of this disclosure requirement to BDCs distorts and overstates the expenses of mutual funds and other registered funds when those funds invest in BDCs.
The rationale for AFFE does not make much sense in the context of listed BDCs. When an acquiring fund purchases shares in a mutual fund, for instance, those shares are purchased at the target fund’s NAV. The NAV reflects the value of the portfolio asset but does not effectively capture the present value of the future management fees, and these future management fees will represent a reduction in the investor’s returns. The AFFE rule is supposed to force the acquiring fund to disclose this to the investors by disclosing the target fund’s expense ratios alongside their own. When an acquiring fund purchases a listed BDC, however, it does so at the BDC’s market price, and that price theoretically does account for future expenses. Given that the BDC’s trading price will already reflect its operating expense structure, reflecting the operating expenses again under the AFFE rule results in the double-counting of the target BDC’s expenses. Accordingly, the AFFE rule disclosure requirements result in acquiring funds significantly overstating their own expense ratios, which of course makes BDCs dramatically less attractive investments for mutual funds and other registered funds.
The AFFE disclosure rules have effectively resulted in a ban on BDCs from most indices. Since many institutional investors use indices to guide their investment strategies (including tracking an index), the AFFE disclosure rules made it problematic for the operators of indices to continue including BDCs. In 2014 the MSCI, Russell and S&P indices all removed BDCs from their respective indices primarily because of the AFFE rule disclosure requirement.[3] The trend of steady growth in the number of public BDCs for more than a decade prior to 2014 flattened following the change, as has institutional ownership of BDCs. However helpful the SBCA Act is, if Congress and the SEC truly want to see BDCs live up to their full potential, their work is not yet done—addressing the AFFE roadblock would be a great next step.
[1] Consider, for example, that when the SEC adopted Rule 35d-1, which in effect required certain funds to change their fundamental investment policies to require portfolios to be invested at least 80% in investments implied by the name of the fund to avoid misleading investors, the SEC noted that funds required to make changes to fundamental policies might be required to obtain shareholder approval if a preexisting fundamental policy conflicted with the new rule requirement. See https://www.sec.gov/divisions/investment/guidance/rule35d-1faq.htm#P23_1077.
[2] To qualify as a WKSI, a BDC must (i) have been an SEC-reporting company for at least 12 calendar months and have filed all material required to be filed with the SEC in a timely manner over the preceding 12 calendar months; (ii) have not had any material defaults on indebtedness or longterm leases since the end of the last fiscal year; (iii) either have (A) a worldwide float of at least $700 million (i.e., market value of outstanding voting and nonvoting common equity held by non-affiliates) or (B) issued for cash during the past three years at least $1 billion in aggregate principal amount of non-convertible debt securities in primary offerings registered under the Securities Act and; (iv) not be an “ineligible issuer,” as that term is used in the Securities Act, or an asset-backed issuer.
[3] See, e.g, https://www.fitchratings.com/gws/en/fitchwire/fitchwirearticle/Removal-of-BDCs?pr_id=823651(discussing the rationales for removing BDCs from indices and its potential effects on those BDCs).