(Article from Registered Funds Alert, September 2020)
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A “black swan” event, such as the March 2020 downturn related to the COVID-19 pandemic, can significantly disrupt the operations of investment companies, in part due to difficulties in complying with requirements for raising capital under federal securities laws during market distress. In this Alert we discuss below how such disruptions can impact closed-end funds and BDCs (together with closed-end funds, “regulated funds”), and potential ways for sponsors of regulated funds to financially support a regulated fund during such disruptive events in a manner consistent with the requirements of the 1940 Act and other relevant federal securities laws. Sponsors are in a position to act more quickly to support a regulated fund than third parties due to their familiarity with the regulated fund (e.g., due diligence is not required) and are often willing to accept certain risks to act in the best interests of shareholders. A more in-depth exploration of these topics will be available in an upcoming issue of The Investment Lawyer.
Potential Disruptive Effects of a Downturn on Regulated Fund Operations
a. Reduced Ability to Borrow or Issue Debt/Preferred Shares Pursuant to Regulatory Requirements and Under Existing Lending Arrangements
Regulated funds must adhere to certain asset coverage ratios to draw on lines of credit or issue indebtedness or preferred shares (collectively, “senior securities”) under the 1940 Act. A decrease in the value of a regulated fund’s assets correspondingly reduces its asset coverage, thereby limiting its ability to borrow additional money or issue other senior securities. This hampers a regulated fund’s ability to take advantage of potential investment opportunities that may arise due to asset mispricings in a market dislocation or to conduct normal operations.
In addition to 1940 Act considerations, reductions in asset valuations also may lead to a contractual breach by a fund of asset coverage covenants in existing credit facilities or other lending arrangements, potentially causing an event of default.
b. Reduced Ability to Pay Preferred Share Dividends or Declare Distributions to Common Shareholders
Regulated funds with preferred stock or public debt outstanding may not declare any distribution (except a dividend payable in stock of the issuer), unless at the time of declaration, the regulated fund is in compliance with the 1940 Act asset coverage ratios. Credit facilities for regulated funds also may include similar contractual restrictions. Such restrictions may affect regulated funds intending to qualify as regulated investment companies under the Internal Revenue Code, as amended, as they are required to distribute at least 90% of their income to shareholders annually or be subject to entity level taxation. A regulated fund’s inability to pay dividends could cause substantial reputational harm to the fund or the sponsor, particularly if the fund is designed to provide investors with current income.
c. Reduced Ability to Repurchase Shares
A regulated fund with senior securities outstanding (other than privately negotiated debt) may not repurchase any of its outstanding shares unless the regulated fund is in compliance with the asset coverage requirements discussed above. The share repurchase programs of tender offer closed-end-funds and BDCs and interval closed end funds operating under Rule 23c-3 of the 1940 Act may be negatively impacted by an inability to comply with the asset coverage limits, which could result in redeeming outstanding senior securities or suspending the repurchase program.
d. Inability to Issue Common Shares
The 1940 Act generally prohibits a regulated fund from issuing common shares at a price below current NAV per share without shareholder approval. Under normal circumstances, shareholders may be willing to approve a share issuance if the discount (i.e., the difference between the NAV and market price) is narrow, resulting in limited economic dilution to current shareholders. If the fund’s share price trades at a premium (i.e., market price is higher than NAV), only board approval is required. During market disruptions, share prices begin to depress, thus limiting a regulated fund’s ability to raise common equity without shareholder approval. Both a regulated fund’s shareholders and its board may be reluctant to approve issuing shares at a significant discount to NAV because of the higher economic dilution that current shareholders would experience compared to normal circumstances.
Affiliated Capital Infusion Alternatives
The occurrence of a significant market downturn can cause typical sources of liquidity (e.g., revolving credit facilities with banks, underwritten public debt or common stock equity issuances) for regulated funds to become unavailable or unfavorable, whether due to reduced lending or regulatory constraints. In such circumstances, the sponsor of a regulated fund may provide an alternative source of capital.
a. Equity Issuance
A sponsor can purchase common shares from a regulated fund in a private transaction to provide additional capital relatively quickly. Fortunately, unlike the numerous affiliated transaction prohibitions in the 1940 Act, the 1940 Act does not restrict a sponsor’s ability to purchase securities issued by a regulated fund. However, sponsors must purchase the shares at or above NAV, which for publicly traded funds likely will be above the current market value per share to comply with the general prohibition under the 1940 Act on issuing common shares below NAV.[1]
b. Lending by the Sponsor to a Regulated Fund on an Unsecured Basis or the Issuance by the Regulated Fund of Preferred Shares to the Sponsor
To the extent that a regulated fund is not in danger of breaching its asset coverage requirements, as discussed above, a sponsor could act as a rapid form of liquidity to the fund by lending on an unsecured basis or purchasing preferred shares. Similar to an equity issuance, lending on an unsecured basis is not prohibited under the joint or affiliated transaction provisions of the 1940 Act. A secured loan from an affiliate, however, is viewed as prohibited for 1940 Act purposes.
c. Rights Offering Backstopped by the Sponsor or an Affiliate
One exception to the 1940 Act’s general prohibition against issuing shares below NAV commonly used by closed-end funds is a rights offering to current shareholders, which may be issued at a subscription price below NAV to incentivize participation. Since shareholders will experience dilution upon issuance of shares in a rights offering when shares are trading below NAV, the SEC, through no-action relief, requires boards to make certain determinations, including a good faith determination that the offering would result in a net benefit to existing shareholders, including those who choose not to exercise their rights.
To alleviate the risk of a failed rights offering, a regulated fund’s sponsor could act as a standby purchaser, or backstop, for the shares by agreeing to participate in the rights offering and oversubscribe to a significant degree. Acting as a standby purchaser of shares in a rights offering eases some of the economic burden on a sponsor by allowing the sponsor to purchase shares closer to the current market price, unlike a common share issuance at NAV, as discussed above.
d. Voluntary Waiver of Fees by the Sponsor
When a regulated fund is in distress or finds expenses too high, sponsors often waive some or all of their management and/or incentive fees (if applicable) for a period of time to reduce the regulated fund’s ongoing expenses. Unlike the transactions described above, where a sponsor provides capital to a regulated fund, the benefit of fee waivers for sponsors is that they simply limit a revenue stream as opposed to actively putting capital at risk. During market disruptions, sponsors too may find themselves capital-constrained and waivers may be a more attractive way to help a fund.
Significant market events can come with little warning and stress test the operations of regulated funds. Even though the 1940 Act carries with it a number of significant constraints regarding affiliated transactions, sponsors should be aware that they are not fully handcuffed from providing support to their regulated funds in such circumstances.
[1] Of course, a sponsor can also purchase equity securities of a listed fund in the open market in accordance with any limitations on insider trading or market manipulation, but while that may have some effect on the share price, it will not result in an infusion of capital to the fund.