The views reflected in this article are those of the author, and do not necessarily reflect the views of the American Investment Council.
By Aaron Schlaphoff (Partner), Scott A. Moehrke, P.C. (Partner), Marian Fowler (Partner), and Chris Hamilton (Associate), Kirkland & Ellis LLP
The Consolidated Appropriations Act, 2018, which was signed into law on March 23, 2018 (the “2018 Spending Bill”), included a long sought-after measure to increase business development company (“BDC”) leverage limits. The measure increases the permitted leverage ratio of total debt to equity from one-to-one to two-to-one and streamlines certain regulatory requirements for BDCs. As the BDC market is occupied in large part by private equity managers and, in particular, credit managers seeking assets for credit strategies, this change is a significant development.
BDCs were created by Congress in 1980 to increase retail access to capital markets for small and growing U.S. operating companies. BDCs can be thought of as hybrid investment companies that typically engage in private equity or private credit fund-like investment activities but benefit from the relaxation of certain restrictions otherwise applicable to investment companies registered under the Investment Company Act of 1940 (the “1940 Act”).1 BDCs frequently are of interest to private equity and private credit fund sponsors, as they combine certain appealing aspects of private funds, such as the ability of the manager to receive performance- based compensation, with certain benefits associated with closed- end, 1940 Act-registered funds, such as the ability to access retail investors, have an “evergreen” pool of capital to manage, and flow through tax treatment under Subchapter M of the Internal Revenue Code (which can be more favorable for certain types of investors or strategies).
While industry groups have long lobbied for increased leverage limits for BDCs, historically there has been some opposition to such measures from both Congress and the SEC2 as a result of concerns that increased leverage could lead to increased risk for retail investors. Industry advocates have countered that the one-to-one leverage limit has forced BDCs to move down the capital structure in portfolio company investments to create competitive yield, which itself increases risk, and that permitting greater leverage would enable more investment in small and mid-size businesses, creating jobs and improving the economy.
In addition to increasing leverage limits, the 2018 Spending Bill included measures designed to ease certain offering and regulatory burdens applicable to BDCs by, among other things, directing the SEC to:
• allow certain established BDCs to file automatically effective shelf registration statements;
• permit BDCs to take advantage of certain communication rules under the Securities Act of 1933, which would relax certain restrictions in the securities offering process; and
• let some BDCs incorporate by reference certain of their periodic reports to the SEC, allowing for the automatic updating of certain registration statements.
Together these changes are expected to increase the ease of and market interest in BDC securities offerings.
1 Like other registered investment companies, BDCs are subject to regulation under the 1940 Act, including restrictions on governance, investment activities and affiliated transactions and periodic public reporting and other requirements. While BDCs have the advantage of certain reduced burdens relative to other types of investment companies, there remain complex regulatory and other issues not applicable to private funds that should be considered during formation and throughout management of a BDC.
2 See e.g., Letter from SEC Chair Mary Jo White to House Financial Services Committee, Nov. 2, 2015.