1. business and industrial
2. company
3. merger and acquisition

Capital Roundtable BDC Conference
February 25, 2015
BDC Basics – What Every New BDC Must
Know Before Launching
1
BDC Basics
• Part I: History and Overview of the BDC Model
• Part II: BDC Structures
• Part III: Regulatory and Reporting Requirements
• Part IV: Management and Operational Considerations
• Part V: Convergence of BDCs and SBICs
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©2015 Sutherland Asbill & Brennan LLP
Part I:
History and Overview
of the BDC Model
3
©2015 Sutherland Asbill & Brennan LLP
Overview
•
Created by the Small Business Investment Incentive Act of 1980 (the
“1980 Amendments”) as a result of a perceived crisis in the capital
markets in the 1970s.
•
Private equity and venture capital firms believed the “small private
investment company” exemption (Section 3(c)(1) of the 1940 Act)
limited their capacity to provide financing to small, growing businesses.
•
Provided Regulated Investment Company (RIC) tax status in 1990.
•
Special type of closed-end fund that:
 Provides small, growing companies access to capital
 Enables private equity funds to access the public capital markets.
 Enables retail investors to participate in the upside of pre-IPO investing
with complete liquidity
•
4
Hybrid between an operating company and an investment company
©2015 Sutherland Asbill & Brennan LLP
Benefits of the BDC Model
•
Access to public capital markets
•
Shares are traded on national exchanges
•
Flow-through tax treatment as a RIC
•
Reduced burden under 1940 Act, as compared to closed-end funds
 Restrictions on leverage
 Restrictions on affiliated transactions
•
External model permits management fee and “carried interest” incentive
fee structure
•
Publicly available financial information through quarterly reporting
•
Portfolio is typically diversified
 Reduces risk typically associated with private equity investments
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©2015 Sutherland Asbill & Brennan LLP
BDCs vs. Private Equity
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©2015 Sutherland Asbill & Brennan LLP
How the BDC Market Developed
•
Prior to 2003, the largest BDCs were primarily internally managed.
 Choice reflected the success of the internally managed, income producing
BDC model
7
•
In 2004, Apollo Investment Corporation raised $930 million in less than
three months which ignited the growth in the BDC industry.
•
There has been a steady stream of BDC IPOs since that period.
•
At the end of 2014, traded BDCs collectively had approximately $59
billion in total assets
•
During 2014, BDCs raised approximately $6.2 billion in capital,
including IPOs, follow-on equity, and debt offerings
©2015 Sutherland Asbill & Brennan LLP
The BDC Industry – at Dec 2014
•
66 Total Operating BDCs
 51 traded BDCs with aggregate market cap
of $32.9 billion and $61 billion in assets
 13 non-traded BDCs with aggregate capital
of $11.8 billion raised
 2 private BDCs with aggregate capital of
$825.8 million raised
•
6 IPOs Completed in 2014
10 internally
managed
56 externally
managed
 Alcentra Capital Corp
 American Capital Senior Floating Ltd.
 CM Finance Inc.
 Newtek Business Services, Inc.
 TPG Specialty Lending Inc.
 TriplePoint Venture Growth BDC Corp.
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©2015 Sutherland Asbill & Brennan LLP
BDC Equity Capital Raised
($ in millions)
$5,000.0
$4,000.0
$4,076.7
$3,000.0
$3,550.9
$2,000.0
$3,229.5
$2,360.5
$2,097.7
$1,570.2
$1,000.0
$908.3
$1,291.0
$1,059.5
$466.9
$0.0
2006
2007
$823.4
$141.2
$0.0
2008
2009
IPOs
$533.9
$707.8
2010
2011
$497.8
2012
$680.3
$311.0
2013
2014
Follow-on Equity Offerings
* Includes traded BDCs, as of December 31, 2014
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©2015 Sutherland Asbill & Brennan LLP
BDC Debt Capital Raised
($ in millions)
$3,500.0
$3,000.0
$738.0
$2,500.0
$2,000.0
$1,077.5
$415.0
$1,500.0
$2,391.4
$1,000.0
$1,477.5
$1,505.8
$150.0
$1,222.0
$500.0
$650.0
$780.0
$650.0
$265.0
$193.0
$0.0
2006
2007
2008
2009
Debt
2010
2011
2012
2013
2014
Convertible Debt
* Includes traded BDCs, as of December 31, 2014
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©2015 Sutherland Asbill & Brennan LLP
BDC Price / Book (NAV)
1.60
1.48
1.40
1.40
1.22
1.20
1.00
0.80
Median Price/Book = 0.87x
1.14
1.09
1.061.04
1.011.00
0.970.970.960.960.960.95
0.930.91
0.900.890.890.880.88
0.860.860.850.840.84
0.830.830.830.820.820.820.810.81
0.800.790.790.79
0.74
0.710.69
0.63
0.60
0.56
0.40
0.20
0.00
Internally managed
Externally managed
As of 12/31/14 - traded BDCs only
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©2015 Sutherland Asbill & Brennan LLP
BDC Yields
20%
18%
0.17
0.16
16%
14%
12%
10%
8%
0.15
0.15
0.14
0.14
Average Yield = 10.0%
0.120.12
0.120.120.120.120.12
0.110.11
0.110.11
0.100.100.10
0.100.100.100.100.10
0.100.100.100.10
0.100.090.09
0.090.090.090.09
0.09
0.080.08
0.08
0.07
0.07
6%
0.06
0.05
4%
2%
0%
As of 12/31/14; Excludes BDCs that are not paying dividends
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©2015 Sutherland Asbill & Brennan LLP
Part II:
BDC Structures
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©2015 Sutherland Asbill & Brennan LLP
Types of BDC Structures
•
•
•
14
Traded BDCs

Listed on NASDAQ or NYSE

Formed either as a blind-pool vehicle, or through the acquisition of an existing
portfolio

IPO through traditional firm commitment underwritten offering
Non-Traded BDCs

Shares are not listed on an exchange

Shares sold through continuous offerings up to preset maximum amount

Liquidity offering through periodic repurchase offers

Typically have fixed 5-7 year period before exchange listing or traditional IPO
Private BDCs

Shares are not listed on an exchange

Shares are sold through private placement offering and funding effected through
a capital call model

Intention to conduct IPO in near term

Generally no liquidity prior to a qualifying IPO
©2015 Sutherland Asbill & Brennan LLP
Traded BDCs
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©2015 Sutherland Asbill & Brennan LLP
IPO Process Overview
•
Typically requires 6 – 8 months to complete IPO
•
Fees and expenses range from $800k - $1mm
•
Consider formation / structuring issues
 Portfolio acquisition / manage any built-in gain
 Form of consideration
 SEC staff expressing more flexibility in acquisition of affiliate assets
•
Consider any necessary exemptive relief
 Co-investment with sister funds
•
Prepare registration of investment adviser (if externallymanaged)
•
Develop compliance / corporate governance programs
•
Select service providers
 Public accountants, valuation assistance, custodian, etc.
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©2015 Sutherland Asbill & Brennan LLP
IPO Process Overview (cont.)
•
Organize the entity - typically as a Delaware or a Maryland
corporation
•
File an IPO registration statement on Form N-2 under the
Securities Act

17
The JOBS Act allows “emerging growth companies” to confidentially file an
initial registration statement, minimizing market and reputational risk
•
Register a class of securities under the Exchange Act
•
Apply to list securities on the NASDAQ/NYSE
•
File Form N-54A to make an election to be regulated as a BDC
•
Have N-2 registration statement declared effective by the SEC
•
Comply with regulatory requirements of the 1940 Act
•
Comply with reporting requirements including the Exchange Act,
Sarbanes-Oxley Act, etc.
©2015 Sutherland Asbill & Brennan LLP
Initial Portfolio Acquisitions
•
May start with or without an initial portfolio

•
Initial portfolio may be acquired from an affiliated fund on a preIPO basis

•

Required approvals at the private fund level
Funding / timing issues on a pre-BDC basis
 Use of a bridge facility or notes
 Equity may be issued in certain cases
Tax implications
 Timing and recognition of accrued but unrealized appreciation/depreciation
in initial portfolio
Disclosure requirements for initial portfolio


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Recent staff guidance has provided more flexibility for these transactions
Considerations in connection with the acquisition of an initial
portfolio:


•
Market has generally favored vehicles with existing portfolios
Typically an audited schedule of investments is required
More fulsome financial statements may also be acquired in certain cases
©2015 Sutherland Asbill & Brennan LLP
Non-Traded BDCs
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©2015 Sutherland Asbill & Brennan LLP
Development of Non-Traded BDCs
•
REITs have successfully used the non-traded model for years.
•
In January 2009, FS Investment Corporation launched the first
non-traded BDC
 Affiliated with GSO / Blackstone
 Raised $2.67 billion through a continuous offering
 Listed its shares during 2014 to provide shareholder liquidity
•
15 non-traded BDCs have successfully had registration
statements go effective with the SEC
•
13 non-traded BDCs are currently selling shares in continuous
offerings and have collectively raised $11.9 billion
•
Traditional closed-end funds are now launching non-traded funds
 Priority Senior Secured Income Fund (joint venture between Behringer
Harvard Holdings and Prospect Capital Management)
 FS Global Opportunities Fund (advisory/sub-advisory relationship between
Franklin Square and GSO/Blackstone)
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©2015 Sutherland Asbill & Brennan LLP
Non-Traded BDC Structures/Features
•
A Non-Traded BDC enables retail investors that meet certain
suitability standards to participate in the upside of pre-IPO
investing.
 Shares not listed on any exchange but issued on a continuous basis
 Price volatility of shares reduced through the adjustment of the public
offering price so that shares are not sold below NAV
 Non-traded issuers typically offer to repurchase a portion of outstanding
shares on quarterly basis. Periodic tender offers by closed-end funds,
including BDCs, excepted from Regulation M under the Securities
Exchange Act of 1934 if made at net asset value or if they comply with
Rule 23c-3 of the Investment Company Act of 1940. Certain BDCs have
received No Action relief under Regulation M for repurchase programs that
peg the repurchase price to something other than NAV.
 Offering must be registered in each state where offers and sales are made
•
21
All the non-traded BDCs that are currently offering and in
registration are externally managed
©2015 Sutherland Asbill & Brennan LLP
Non-Traded BDC Structures/Features
•
Non-traded BDCs are generally structured as a combination of
an investment adviser or sub-adviser and a distributor. For
example,
 GSO/Blackstone serves as the sub-adviser for Franklin Square’s funds,
while FS2 Capital Partners is the dealer manager.
 KKR Asset Management is the investment sub-adviser for Corporate
Capital Trust, while CNL Fund Advisors serves as the dealer manager.
 Apollo Global Management serves as investment sub-adviser for CION
Invetsment Corp., while ICON Securities serves as the dealer manager
 SIC Advisors (investment personnel of Medley) is the investment adviser to
Sierra Income Corporation, while SC Distributors is the dealer manager.
 Business Development Corporation of America is the only non-traded BDC
that does not utilize a third-party investment adviser or sub-adviser.
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©2015 Sutherland Asbill & Brennan LLP
Non-Traded BDCs
These non-traded BDCs are making continuous offerings and have raised in excess
of $11.9 billion to date (as of the most recent financials):
•
•
Business Development Corporation of America - $1.6 billion
Business Development Corporation of America II - $200 million
- Affiliated with AR Capital, LLC
•
CION Investment Corporation - $476 million
- Affiliated with ICON Capital Corp. and Apollo Global Management, LLC
•
Corporate Capital Trust, Inc. - $2.1 billion
- Affiliated with CNL Fund Advisors Company and KKR Asset Management
•
•
•
•
FS Energy and Power Fund - $2.9 billion
FS Energy and Power Fund II – escrow not yet broken
FS Investment Corporation II - $3.2 billion
FS Investment Corporation III - $649 million
- Affiliated with GSO / Blackstone
•
HMS Income Fund, Inc. - $236 million
- Affiliated with Hines Securities, Inc. and Main Street Capital Corporation
•
MacKenzie Realty Capital, Inc. - $14.7 million
- Affiliated with MacKenzie Capital Management, LP
•
NexPoint Capital, Inc. – $10 million
- Affiliated with NexPoint Advisors LP and Highland Capital Funds Distributor
•
Sierra Income Corporation - $555 million
- Affiliated with Medley Capital, LLC and SC Distributors, LLC
•
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VII Peaks Co-Optivist Income BDC II, Inc. - $50 million
- Affiliated with VII Peaks Capital, LLC
©2015 Sutherland Asbill & Brennan LLP
Additional Requirements for
Non-Traded BDCs
•
Suitability requirements

•
•
•
FINRA review – more time-consuming and thorough review than traded BDCs
State blue sky review

Must be approved to sell securities in each state where solicitations will occur,
requiring compliance with the “Omnibus Guidelines” published by the National
Association of State Securities Administrators (“NASAA”)

Completing blue sky process can take several months
Continuous offering over a period of time

•
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May only be sold to investors who meet certain suitability standards, typically through
the independent broker-dealer or RIA channels
Prospectus supplements filed periodically to report material events and provide
updates on fundraising efforts and portfolio composition
Liquidity Event

Typically complete liquidity event within five to seven years following completion of
offering

Liquidity event could include: (1) sale of all or substantially all of company’s assets
either on a complete portfolio basis or individually followed by a liquidation, (2) listing
of company’s shares on a national securities exchange, or (3) merger or another
transaction in which shareholders receive cash or shares of a publicly traded company
©2015 Sutherland Asbill & Brennan LLP
NASAA Omnibus Guidelines:
Compliance with “Blue Sky Laws”
•
Sponsor Requirements
 Sponsor must have adequate experience and net worth
 Limited indemnification of Sponsor, which may affect charter of the
issuer
•
Suitability of Investors
 Default minimum suitability standards of either $70,000 gross
income and $70,000 net worth or $250,000 net worth
 Suitability standards may vary across states
 States may impose concentration restrictions (i.e., 10% of net
worth in the issuer or all non-traded BDCs)
 Minimum investment amounts
 Suitability typically determined through subscription agreement
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©2015 Sutherland Asbill & Brennan LLP
NASAA Omnibus Guidelines:
Compliance with “Blue Sky Laws” (cont.)
•
Fees, Compensation and Expenses

Sponsor’s compensation must be “reasonable”
 For BDCs, compensation presumptively reasonable if limited to
“participation in net gains” of the issuer
 For Sponsor providing services to the issuer, fees must be competitive as
compared to independent third-parties

•
26
Offering document must estimate and itemize fees and expenses
Conflicts of Interest

Issuer may only invest in joint ventures or general partnerships with nonaffiliates so long has “controlling interest”

Issuer may only invest in joint ventures or general partnerships with affiliated
entities provided there are no duplication of fees and each investor has right of
first refusal to buy the affiliates’ interests in the venture

Limited ability to invest in joint ventures or general partnerships with non publicly
registered affiliates

Multi-tiered arrangements permissible so long as not designed to circumvent the
Guidelines, there are no duplication of fees, no decrease in the voting rights of
stockholders and the fiduciary obligations of the various parties are adjusted
©2015 Sutherland Asbill & Brennan LLP
NASAA Omnibus Guidelines:
Compliance with “Blue Sky Laws” (cont.)
•
Rights and Obligations of Participants (i.e. Stockholders)
 10% holders have right to call stockholders meetings
 Majority approval of stockholders required to amend entity charter,
dissolve the company, remove the Sponsor, elect a new Sponsor
or approve the sale of substantially all of the assets of the company
 Stockholder right to inspect and copy the company’s records,
including stockholder list
 Distribution Reinvestment Plans (“DRPs”) may not charge sales
commissions for shares issued under the DRP
 Stockholders must be able to elect or revoke participation in
the DRP
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©2015 Sutherland Asbill & Brennan LLP
Private BDCs
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©2015 Sutherland Asbill & Brennan LLP
What is a Private BDC?
29
•
Typically sponsored by large private equity firms with an existing
investor base
•
Operates similar to a non-traded BDC, but draws down capital
via a capital call model, similar to a private fund structure
•
Shares are offered through a private placement offering to the
sponsor’s existing investor base, rather than via a continuous
public offering
•
BDC/RIC structure helps mitigate need for offshore feeder fund
structure for foreign/tax exempt investors
•
Generally target an initial public offering and exchange listing,
similar to the non-traded BDC structure
•
Private placement structure eliminates need for “blue sky”
registration process faced by traditional non-traded BDCs
©2015 Sutherland Asbill & Brennan LLP
Private BDC Process
•
Organize the entity - typically as a Delaware or a Maryland
corporation
•
File a registration statement on Form 10 to register a class of
securities under the Exchange Act
 No registration statement on Form N-2 needs to be filed under the
Securities Act
30
•
Prepare a private placement memorandum and subscription
agreement for the private offering
•
Make an election to be regulated as a BDC by filing a Form N54A
•
Comply with regulatory requirements of the 1940 Act, and the
reporting requirements including the Exchange Act, SarbanesOxley Act, etc.
©2015 Sutherland Asbill & Brennan LLP
Private BDCs Operating
•
Three private BDCs have been organized to date

TPG Specialty Lending, Inc. (completed qualifying IPO in 2014)

Carlyle GMS Finance, Inc.

TCW Direct Lending LLC
•
In September 2013, the SEC adopted amendments Rule 506 under Reg
D and Rule 144A under the Securities Act to implement elements of the
JOBS Act
•
Made the process of forming a private BDC potentially more attractive

Eliminated the prohibition on using general solicitation under Rule 506
where all purchasers of the securities are accredited investors and the
issuer takes reasonable steps to verify that the purchasers are accredited
investors.

The SEC adopted Rule 506(c), pursuant to which issuers can offer
securities through means of general solicitation, provided that:



31
all purchasers in the offering are accredited investors,
the issuer takes reasonable steps to verify their accredited investor status, and
certain other conditions in Regulation D are satisfied.
©2015 Sutherland Asbill & Brennan LLP
Part III:
Regulatory and
Reporting Requirements
32
©2015 Sutherland Asbill & Brennan LLP
How Does a Company Become a
BDC?
33
•
Organize the BDC as a Delaware or a Maryland corporation
•
Register a class of securities under the 1934 Act
•
Make an election to be a BDC - file a Form N-54A (Notification
of election to be subject to sections 55 through 65 of the 1940
Act)
•
Register a class of securities on Form N-2
•
List securities on the New York Stock Exchange (NYSE) or the
Nasdaq Stock Market, Inc. (Nasdaq), or the BDC can be a nontraded BDC
•
Comply with the Sarbanes-Oxley Act of 2002 and Dodd-Frank
Act
•
Comply with regulatory requirements of the 1940 Act
©2015 Sutherland Asbill & Brennan LLP
SEC Reporting Requirements for
BDCs
•
Form 10-K (Annual Report)
•
Form 10-Q (Quarterly Report)
•
Form 8-K (Current Report)
•
Proxy Statements
•
Sections 13 and 16 Filings
 Forms 3, 4 or 5 for reporting beneficial ownership by insiders
 Schedules 13D and 13G for reporting beneficial ownership by others
•
Regulation G and Regulation FD
•
Comply with the Sarbanes-Oxley Act of 2002
•
Disclosure Controls and Procedures
•
Internal Control over Financial Reporting/Attestation
 JOBS Act provides that “emerging growth companies” may take
advantage of reduced reporting obligations on internal controls during
the first five years
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©2015 Sutherland Asbill & Brennan LLP
Financial Statement Disclosures
•
Valuation policy
•
Control investments, investments in affiliates vs. investment in
non-affiliates
•
Schedule of investments
 Disclose non-income producing investments
 Disclose assets held in securitized vehicles
35
•
Concentration – Geography and industry sectors
•
Fair value and Level 3 reconciliation tables
©2015 Sutherland Asbill & Brennan LLP
NASDAQ/NYSE Listing Standards
•
BDCs that have their securities listed or traded on
NASDAQ/NYSE must comply with the corporate governance
listing standards, including:
 A listed BDC must have an audit committee composed solely of
“independent directors” (as defined by the applicable exchange or
association).
 Director nominees of a listed BDC must be selected or recommended for
the Board’s selection by a nominating committee or the vote of a majority of
the BDC’s independent directors (depending on the exchange).
 The non-management, or “independent directors”, of the BDC must hold
regularly scheduled executive sessions.
 The BDC must adopt a code of business conduct and ethics, various
committee charters and, in the case of NYSE-listed BDCs, corporate
governance guidelines.
 All such documents must be posted on the company’s website.
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©2015 Sutherland Asbill & Brennan LLP
1940 Act Requirements
•
BDC must have a majority of independent directors - persons
who are not “interested persons” as defined in Section 2(a)(19)
of the 1940 Act.
•
Custodian Agreement
 A BDC generally must place and maintain its securities and similar
investments in the custody of a bank qualified under Section 26(a)(1) of the
1940 Act or a broker dealer, or be subject to additional audit and
operational procedures related to securities held in safekeeping.
•
Fidelity Bond

•
Requirement to maintain and enforce a Code of Ethics for
officers of the BDC

37
A BDC must maintain a bond issued by a reputable fidelity insurance company, in an
amount prescribed by the 1940 Act, to protect the BDC against larceny and
embezzlement. The bond must cover each officer and employee with access to
securities and funds of the BDC.
Includes reporting of all securities holdings and transactions.
©2015 Sutherland Asbill & Brennan LLP
1940 Act Requirements (cont.)
•
Restrictions on investing in other investment companies. A BDC
may not invest:



•
Restrictions on investment funds investing in a BDC

•
38
A BDC is prohibited from protecting any director or officer against any liability to
the company, or its security holders, arising from willful misfeasance, bad faith,
gross negligence or reckless disregard of the duties involved in the conduct of
such person’s office.
Bookkeeping and records requirements

•
Neither a public (i.e. registered) or private investment fund may own more than
3% of the outstanding voting stock of a BDC
Limitations on indemnification

•
In more than 3% of the outstanding voting stock of an investment company
More than 5% of the value of its total assets in an investment company
More than an aggregate of 10% of its total assets in investment companies
A BDC must maintain and make available for inspection prescribed books and
records.
BDCs must make available significant managerial assistance to
their portfolio companies
©2015 Sutherland Asbill & Brennan LLP
1940 Act Requirements (cont.)
•
Must appoint a Chief Compliance Officer
•
Must maintain a compliance program compliant with Rule 38a1 of the 1940 Act, which requires:
 Adoption and implementation of policies and procedures designed to
prevent violation of the federal securities laws.
 Review of these policies and procedures annually for their adequacy and
the effectiveness of their implementation.
•
Compliance polices and procedures for the registered
investment adviser under Rule 206(4)-7 of the Investment
Advisers Act of 1940
 Requires an investment adviser of a BDC to adopt and implement
policies and procedures.
 Requires maintenance and enforcement of a code of ethics for advisor’s
employees.
•
39
Subject to regular examinations by the SEC
©2015 Sutherland Asbill & Brennan LLP
Other Important Limitations
•
BDCs are not permitted to sell shares below net asset value
without shareholder approval
 Approval must be obtained annually
 Markets have imposed limitations on how much an BDC can sell below
NAV
•
BDCs may seek to receive an SEC order granting exemptive
relief permitting, among other things:
 Co-investment among affiliates
 Ownership of a registered investment adviser
 Exclusion of leverage from the asset coverage calculation for debt held by
an SBIC subsidiary
 Issuance of restricted stock to officers / employees
 Issuance of stock options to independent directors
•
Exemptive relief process may take from 6 – 18 months
depending on complexity
 Typically based on precedents
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©2015 Sutherland Asbill & Brennan LLP
“Good” vs. “Bad” BDC Assets
•
A BDC must invest 70% of its assets in “good” BDC assets.
•
70% basket includes securities issued by an “eligible portfolio
company,” as defined in Section 2(a)(46), which includes:

U.S. issuers that are neither an investment company as defined in section 3
(other than a wholly-owned SBIC) nor a company which would be an investment
company except for the exclusion from the definition of investment company in
section 3(c) and
 (i) do not have any class of securities listed on a national securities
exchange; or
 (ii) have a class of securities listed on a national securities exchange, but
have an aggregate market value of outstanding voting and non-voting
common equity of less than $250 million.
•
A BDC can generally invest with flexibility in “bad” assets that do
not fall within the “70% basket”.

41
The SEC Staff has never been called upon to consider whether utilizing a
specific strategy for the entire “30% basket,” e.g., investing solely in foreign
companies, might run afoul of the intent of Section 55(a)
©2015 Sutherland Asbill & Brennan LLP
Limitations on Borrowings
•
BDCs must have 200% asset coverage (Total Assets/Total Debt).
 For example, a BDC with $50 in equity can borrow up to $50
 A BDC would be able to invest $100 in growing businesses
$50
Equity
•
42
$50
Equity
Other investment companies are restricted to a 300% asset coverage
requirement with respect to issuing debt.
$50
Equity
•
$50
Debt
$25
Debt
$50
Equity
BDCs may exclude leverage at the SBIC level if the SEC grants
exemptive relief, which many have received.
©2015 Sutherland Asbill & Brennan LLP
BDC Use of Leverage
1.00
0.91
0.90
0.80
0.70
0.87
0.85
0.800.80
Average Debt/ Equity = 0.53x
0.78
0.76 0.75
0.74 0.73
0.70
0.68 0.67
0.65 0.64
0.630.63 0.62
0.60
0.60 0.59
0.520.520.52
0.50
0.40
0.30
0.20
0.50
0.480.48
0.460.46 0.45
0.440.44
0.40
0.38
0.29
0.25 0.24
0.16
0.10
0.00
As of 12/31/14; Excludes SBA debt; includes preferred securities as debt
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©2015 Sutherland Asbill & Brennan LLP
Limitations on Transactions with
Affiliates
•
Section 57 addresses the ability of BDCs to engage in certain
types of transactions with affiliates:
 Section 57 is less onerous than its counterpart for registered
investment companies (Section 17).
•
Depending on the nature of the affiliation with the BDC,
transactions involving a BDC and one or more of its affiliates
require either:
 Authorization by the required majority of the board of directors,
which consists of a majority of the board, including a majority of
disinterested board members; or
 An order of the Commission.
•
Co-investment between a BDC and an affiliated fund generally
requires SEC exemptive relief
 Mass Mutual exception (i.e., no terms negotiated other than price)
44
 Recent staff guidance has provided additional flexibility without
exemptive relief
©2015 Sutherland Asbill & Brennan LLP
Part IV:
Management and
Operational Considerations
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©2015 Sutherland Asbill & Brennan LLP
Internally-Managed Structure
•
BDC is managed internally by executive officers (i.e., no
external adviser)
•
Must comply with SEC executive compensation disclosure
requirements
•
Certain performance-based compensation is permitted,
including:
 Issuance of at-the-market options, warrant, or rights pursuant to an
executive compensation plan; or
 Maintenance of a profit sharing plan
•
Otherwise, the BDC must use cash assets as compensation
•
Exemptive orders permitting the issuance of restricted stock
have been issued in a number of circumstances including:
 Hercules Growth Technology, Inc.
 MCG Capital Corporation
 Main Street Capital Corporation
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©2015 Sutherland Asbill & Brennan LLP
Externally-Managed Structure
•
Portfolio managed by external investment adviser
•
Investment adviser must be registered under the Advisers Act
•
May utilize an external administrator for expense reimbursement
purposes
•
Adviser is permitted to take a base management fee, as well as
an incentive fee on both:
 Investment income
 Realized capital gains
47
•
Contrasts with most registered closed-end funds, which are
typically prohibited from taking an incentive fee on capital gains
•
Incentive fees are often subject to hurdle/catch-up features
©2015 Sutherland Asbill & Brennan LLP
Calculation of Adviser’s Incentive
Fee
•
SEC Staff has taken no formal position on the calculation of the fee but requires
BDCs to contain extensive disclosure in registration statements regarding the
manner in which the fee will be calculated in varying scenarios.
•
Section 205(b)(3) of the Advisers Act permits external investment advisers to
BDCs to receive incentive fees, provided that the BDCs do not have outstanding
any equity-based compensation arrangement or profit-sharing plan.
•
48

Section 205(b)(3) provides an exception from the general prohibition on an investment
adviser charging an incentive fee based on a share of capital gains.

May assess an incentive performance fee of up to 20% on a BDC’s realized capital
gains net of all realized capital losses and unrealized capital depreciation over a
specified period.
Section 205(b)(3) of the Advisers Act makes no reference to whether the
unrealized capital depreciation by which the fee must be reduced includes:

Only depreciation below the original cost of the security in question, or

Whether it includes a decrease in value in a security above the original cost but below
the point of a previous unrealized capital appreciation.
©2015 Sutherland Asbill & Brennan LLP
Portfolio Valuation Process
49
•
Investments are reported at fair value, as determined in good
faith by the board of directors.
•
ASC 820 – Fair Value Measurements and Disclosures (formerly
FAS 157).
•
“Fair value” – Price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between
market participants at measurement date.
•
Key Controls in the Valuation Process:

Documented approval of trades

Controls over inputs in valuation write-ups

Segregation between preparation and review of valuations

Use of independent third-party valuation consultants to assist

Identified and monitored problem loans

High level analytical reviews

Completeness of disclosures

All controls evidence Sarbanes-Oxley 404 readiness
©2015 Sutherland Asbill & Brennan LLP
General Principles of Valuation
•
50
Investments classified into three levels:

Level 1: Inputs are unadjusted, quoted prices in active markets for identical financial
instruments at the measurement date.

Level 2: Inputs include quoted prices for similar financial instruments in active markets
and inputs that are observable for the financial instruments, either directly or indirectly,
for substantially the full term of the financial instrument.

Level 3: Inputs include significant unobservable inputs for the financial instruments
and include situations where there is little, if any, market activity for the investment.
The inputs into the determination of fair value are based upon the best information
available and may require significant management judgment or estimation.
•
Majority of BDCs classify debt and equity investments as Level 3
instruments.
•
Debt investments with broker quotes may be considered a Level
2 instrument (broadly syndicated loans).
©2015 Sutherland Asbill & Brennan LLP
Factors That Impact Valuation
•
•
•
General Economic Factors

Changes in interest rates and credit spreads and return on equity

Changes in aggregate demand level

Changes in economic outlook
Industry Factors

Change in supply or demand for product

Change in competition

Barriers to entry
Company Specific Factors

Current and expected life cycle of company – Achievement of milestones, company
performance relative to projections

Experience and competence of the top management team and board of directors

Existence of intellectual capital and intangible assets
 Proprietary technology, products, or services
 Quality of work force
 Strategic relationships with major suppliers or customers

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Cost structure and financial condition
©2015 Sutherland Asbill & Brennan LLP
Taxation as a RIC
•
A BDC may elect to be taxed as a “regulated investment
company,” or RIC, under the Internal Revenue Code
•
Taxation as a RIC:
 Allows “pass through” tax treatment for income and capital gains
that are distributed to shareholders.
 A BDC must distribute at least 90% of its investment income to
shareholders annually.
 The BDC may retain, distribute or “deem distribute” capital gains.
 BDC must meet minimum source of income requirements annually
and meet requirements on a quarterly basis with respect to the
portfolio diversification.
•
Conversion to RIC status
 Formation considerations – Built-in gains
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©2015 Sutherland Asbill & Brennan LLP
BDC Proposed Legislative Changes
53
•
Industry continues to seek to modernize the BDC model
•
Various bills have been introduced over the years, including
during 113th Congress:

H.R, 31 - Next Steps for Credit Availability Act, co-sponsored by Nydia
Velazquez (D-NY) and Gregory Meeks (D-NY)

H.R. 1973 - Small Business Credit Availability Act, sponsored by Mick
Mulvaney (R-SC)

H.R. 1800 - Small Business Credit Availability Act, co-sponsored by
Michael Grimm (R-NY) and Tom Graves (R-GA)
•
None were ultimately passed
•
Industry continues to pursue similar legislative changes
through 114th Congress, which convened in January 2015

Efforts led by Small Business Investor Alliance and several BDC
management teams

Focused on same issues
©2015 Sutherland Asbill & Brennan LLP
Proposed Legislative Changes
Section, Rule or Form to be
Explanation
Amended
Ownership of Registered Investment Advisers
Impact on BDCs
1940 Act – Section 60
Allows BDCs to own registered
investment advisers
Eliminate need for BDCs to seek
SEC exemptive relief, leveling the
playing field between BDCs that
have been granted exemptive relief
and those that have not.
Lowers the asset coverage
requirement for BDCs from 200%
to 150%, subject to shareholder
approval and disclosure of the
increased indebtedness, and
allows BDCs to issue multiple
classes of preferred stock
Would allow BDCs to incur more
leverage, enabling them to raise
additional assets to invest in small
to mid-size U.S. companies.
Allows BDCs to incorporate
already-filed information by
reference.
Would allow BDCs to raise capital
more efficiently and respond to
market conditions more quickly.
Investors also able to readily
access most important information
about an issuer.
Asset Coverage Limit Reductions
1940 Act – Sections 18 and 61(a)
Registration and Reporting Parity
Forward incorporation (Form N-2)
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©2015 Sutherland Asbill & Brennan LLP
Proposed Legislative Changes
Section, Rule or Form to be
Amended
Flexible Communications
Impact on BDCs
Free writing prospectuses are useful
to convey recent developments or
other updated disclosure, as a way
of avoiding recirculation of an
updated preliminary prospectus.
Would allow BDCs to communicate
to potential investors without
violating gun-jumping provisions.
Permits BDCs to release factual and
forward-looking business
information, keeping BDCs in step
with market.
Would permit BDCs to release
factual business information with
more certainty; more flexibility in
communicating to investors.
Prospectus Safe Harbors
(Rules 134, 163 and 163A)
Allows BDCs to communicate with
investors more freely during the
preparation and filing periods for a
registration statement.
Research (Rules 138 and 139)
Provides safe harbors for brokers
and dealers providing market
analysis to investors. Publications,
distributions or reports within either
rule will not constitute offers to/for
sale under 1933 Act.
Allows BDCs to:
(1)Qualify as WKSIs;
(2)File automatic shelf registrations;
and
(3)Use free-writing prospectuses.
WKSI Status (Rules 405 and 433)
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Explanation
Allows broker-dealers and other
providers of market research more
flexibility to disseminate research on
BDCs and allows more
communication of information to the
market about BDCs.
Less stringent disclosure and
communication requirements.
Would allow BDCs to file automatic
shelf registrations to take advantage
of frequently changing market
windows.
©2015 Sutherland Asbill & Brennan LLP
Proposed Legislative Changes
56
Section, Rule or Form to be
Amended
Explanation
Impact on BDCs
Shelf Registration (Rule 415)
Rule 415 specifies which offerings
qualify for shelf registration and
imposes certain obligations to
remain qualified under the rule.
Allows for SEC review of BDC N-2
shelf-registration statement in
advance of accessing public
markets. Offers more certainties
with respect to timing.
Final Prospectus (Rule 497)
Rule 497 governs when investment
companies must file prospectuses
during the registration process.
Allows a BDC to file final
prospectus with SEC, and not
deliver prospectus to individual
investors. Would synchronize BDC
prospectus filing requirements with
those of other registrants and save
considerable time and money.
Written Confirmation (Rules 172
and 173)
Relieves BDCs of requirement to
provide written confirmations of
sales, notifications of allocation,
and deliveries of securities.
Would permit BDCs greater
flexibility in the sales process in
parity with other issuers covered by
the rule.
Free-Writing Prospectus Safe
Harbor (Rule 164)
Provides safe harbor to BDCs for
post-filing free-writing
prospectuses.
BDCs would be able to more freely
communicate to potential investors.
©2015 Sutherland Asbill & Brennan LLP
Impact of the Volcker Rule
•
Final Dodd-Frank Volcker Rule issued December 10, 2013
 Generally prohibits banking entities from:
 Engaging in short-term proprietary trading, or
 Investing in, or having certain relationships with, hedge funds and private
equity funds, referred to as “covered funds” under the Volcker Rule.
 BDCs are excluded from the definition of “covered fund” under the Volcker
Rule
 As a result, a banking entity generally may invest in a BDC, including one
that potentially engages in activities subject to restriction under the Volcker
Rule so long as that banking entity does not hold the power to vote 25% of
such BDC’s voting shares, provided that it is otherwise permitted to do so
under applicable banking law.
 Likewise, a banking entity may manage such a BDC, so long as it does so
in compliance with applicable securities and banking law.
 As written, the Volcker Rule potentially creates incentives for banks to
invest in BDCs.
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©2015 Sutherland Asbill & Brennan LLP
Impact of the JOBS Act on BDCs
•
Designed to encourage capital formation for small U.S. businesses
•
Permits “emerging growth companies” (EGCs) to confidentially file an
initial registration statement

•
EGCs are exempt from certain requirements of the Sarbanes-Oxley Act


•
58
EGC is defined as having less than $1 billion total annual gross revenues in its most
recent fiscal year.
EGCs planning an IPO have more time to ramp up their SOX programs, allowing the
companies to focus on expanding their business
For the five years following an IPO, companies with revenues of less than $1 billion a
year are not required to comply with Section 404(b) of SOX, which requires external
auditors to attest to the EGC’s internal controls over financial reporting unless:

The company’s revenue grows to more than $1 billion,

The company issues more than $1 billion in nonconvertible debt over a three-year period, or

The company’s worldwide public float exceeds $700 million.
EGCs must continue to comply with the other provisions of SOX,
including management certification that internal controls are operating
effectively.
©2015 Sutherland Asbill & Brennan LLP
Part V:
Convergence of BDCs and SBICs
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©2015 Sutherland Asbill & Brennan LLP
BDC - SBIC Trends
•
SBIC Subsidiaries
 19 BDCs have one or more SBIC subsidiaries.
 Provides access to low-cost debt (a fully funded SBIC with $75
million in regulatory capital can access up to $150 million in
leverage from the SBA with an option for a second license for an
additional $75 million).
 SBICs under common control can access up to $225 million in
leverage, which Congress may increase to $350 million.
•
Fund Platforms
 BDCs are building platforms of funds that complement the BDC’s
business
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©2015 Sutherland Asbill & Brennan LLP
BDCs With SBIC Subsidiaries
•
•
Four (4) SBICs elected to become BDCs and conducted successful IPOs

Main Street Capital Corporation / $64,500,000

Triangle Capital Corporation / $71,550,000

Fidus Investment Corporation / $70,050,000

Capitala Finance Corp / $80,000,000
One (1) BDC began IPO process with one or more SBIC subsidiaries

•
•
61
Golub Capital BDC, Inc.
Fourteen (14) BDCs have received an SBIC license for a wholly-owned
subsidiary or acquired an SBIC subsidiary:

Fifth Street Finance Corp.

New Mountain Finance Corp.

Garrison Capital, Inc.

OFS Capital Corporation

Hercules Technology Growth Capital

PennantPark Investment Corp.

MCG Capital Corporation

Rand Capital Corporation

Medallion Financial Corp

Saratoga Investment Corporation

Medley Capital Corp.

Stellus Capital Investment Corp

Monroe Capital Corp.

TCP Capital Corp
Additional BDCs are in the process of obtaining an SBIC license
©2015 Sutherland Asbill & Brennan LLP
How Does an SBIC Convert to a
BDC?
•
Conversion Transaction
 Approval of LPs in advance of valuation and merger
 Merger of SBIC into subsidiary of BDC
 Amend limited partnership agreement
 SBA approval
•
SEC Review
 Affiliate transaction issues
 Compensation issues
 Disclosure issues
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©2015 Sutherland Asbill & Brennan LLP
BDC/SBIC Structure
•
Exemptive Relief
•
Relief to get SBIC leverage treatment at BDC level
•
Section 18(a):
 Question of whether BDC with an SBIC subsidiary must comply
with the asset coverage requirements of Section 18(a) (as modified
by Section 61(a) for BDCs) on a consolidated basis.
 The senior securities issued by the SBIC Subsidiary would be
excluded from the SBIC Subsidiary’s individual asset coverage
ratio by Section 18(k) if the SBIC Subsidiary were a BDC.
 Exemption requested- senior securities representing indebtedness
issued by the SBIC Subsidiary may be excluded from the BDC’s
consolidated asset coverage ratio.
 The SEC regularly provides this exemptive relief, which
generally does not take as long as other forms of relief.
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©2015 Sutherland Asbill & Brennan LLP
What are the Incentives for an SBIC
to Convert to a BDC?
•
Why Are BDCs Attractive to SBICs?
 Ability to access public market
 Flexibility in funding portfolio investments
 Permanent capital base
 Additional compensation incentives
•
Why Are SBICs Attractive to the BDC Market?
 Existing portfolio – not blind pool
 Existing management team with track record
 Market niche – lower middle market
 Additional leverage capacity
64
©2015 Sutherland Asbill & Brennan LLP
Contact Information
John J. Mahon
Partner
202.383.0515
[email protected]
Lisa Morgan
Partner
202.383.0523
[email protected]
Harry S. Pangas
Partner
202.383.0805
[email protected]
For more information, please visit our practice site at
www.publiclytradedprivateequity.com and our corporate site at
www.sutherland.com.
65
©2015 Sutherland Asbill & Brennan LLP
Disclaimer
All Rights Reserved. This communication is for general informational purposes only
and is not intended to constitute legal advice or a recommended course of action in
any given situation. This communication is not intended to be, and should not be,
relied upon by the recipient in making decisions of a legal nature with respect to the
issues discussed herein. The recipient is encouraged to consult independent counsel
before making any decisions or taking any action concerning the matters in this
communication. This communication does not create an attorney-client relationship
between Sutherland and the recipient.
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©2015 Sutherland Asbill & Brennan LLP