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A look at the future for business development companies
With new governance for business development companies from the Securities and Exchange Commission, private equity firms will be interested in the upcoming changes.
March 20, 2019
A blog post by Sean Collins, research manager, Deloitte Center for Financial Services
Private capital has long been a leading conduit for financing in middle-market lending. Business development companies (BDCs), a form of closed-end funds, have played a crucial role for firms dependent on this funding. Recently, the Securities and Exchange Commission (SEC) signaled that rules governing certain deal structures may be refreshed “to streamline and enhance the regulatory framework for fund-of-funds arrangements.”1 While the new proposed rules will affect all registered funds, from mutual funds to unit investment trusts, alternative investment advisers that manage BDCs will be especially interested.
Private equity firms provide value through business development companies
Private equity (PE) firms offer BDCs to accredited and institutional investors as an additional diversification vehicle from public equity and debt markets. These regulated investment companies were created in 1980 to bridge the financing gap faced by small and medium-sized businesses in securing funding from banks. The gap expanded after the financial crisis as banks de-levered their balance sheets.2 PE firms and others stepped in by forming BDCs to extend critical credit to businesses. From 2009 to 2012, BDCs grew in number by 74 percent, with assets doubling, as seen in the chart below. Today, we explore how recent developments may change the BDC landscape.
Before diving in, it may be beneficial to provide a brief review of the three SEC-mandated BDC structures. There are three types of funds:
- Traded, which raises funds through an IPO and are listed on a national exchange.
- Non-traded, which continuously offers shares up to a maximum amount and typically makes investments as shares are sold.
- Private, which offers shares in a private offering to accredited investors and generally makes capital calls when investments are found.
Favored BDC structures are shifting as asset growth continues
While growth in both the number of BDCs and assets has continued since 2009, the acceleration has slowed. For example, the five-year compound annual growth rate (CAGR) of total assets from 2010 to 2014 was 24 percent, compared with 5 percent annual growth from 2014 to 2018, as seen in the chart. The number of publicly traded BDCs has also fallen, from 55 in 2014 to 51 at the beginning of 2019 due to mergers and firms opting to operate as private BDCs.3 Coincidentally, BDCs were dropped, first from indexes and subsequently from many ETFs in 2014.4 As a result, institutional investors reduced holdings of publicly traded BDCs over the next several years.5 However, institutional investors’ appetite for this exposure has not been extinguished as evidenced by the growth in private BDCs.
Since 2011, more than 25 private BDCs have been launched.6 To date, the majority still operate as private BDCs and only two have gone public through an IPO.7 The SEC may be seeking to address this shift by potentially simplifying the process for other fund types to invest into public BDCs. As SEC chairman Jay Clayton stated, the goal of its proposal is to “create a consistent, rules-based framework for fund-of-funds arrangements while providing robust protections for investors.”8
Figure 1. BDCs have continued to attract assets and grow their investment portfolios
The future of BDCs looks intriguing
Does slowing asset growth suggest PE firms have less reason to watch this market? Quite the contrary. We suggest a resurgence of interest may be on the horizon, especially considering some banks have tightened credit policies towards large, middle and small market firms over the past year.9,10
While some banks tightened their lending, BDCs received additional flexibility thanks to federal legislation passed last spring. BDCs can now maintain a debt-to-equity ratio of 2:1, an increase from 1:1.11 While higher leverage may increase risk as well as rewards, it is still well below that generally afforded to banks. BDCs with successful strategies now have greater opportunity to differentiate themselves and attract capital from investors seeking additional risk.
What’s the outlook on the regulatory front?
On December 19, 2018, the SEC requested comments concerning new rules that would alter several regulations on BDCs.12 One proposed change concerns the Acquired Fund Fees and Expense Disclosure (AFFE) rule adopted in 2006. This rule stipulates that the acquiring fund (e.g., an ETF or mutual fund) must combine the fees and expenses of the acquired fund (e.g., a BDC) with their own. The new SEC proposal is “designed to prevent duplicative and excessive fees in fund of-funds arrangements by requiring an evaluation of aggregate fees.”13
The SEC also proposed the removal of the “3-5-10 percent” rule in section 12d-1-A that restricts the amounts registered investment companies (mutual funds, unit investment trusts, listed and unlisted closed-end funds, and ETFs and BDCs) can invest in other registered investment companies.12 Currently, the rule limits investments to no more than: 3 percent of another fund’s voting securities, 5 percent of its total assets in any one fund, and 10 percent of its total assets in funds overall. The new rule will also permit investments into non-traded BDCs. While the SEC can provide exemptive relief in certain cases, its proposal aims to “enhance investor protections while providing funds with flexibility to meet their investment objectives in an efficient manner.”14 These adjustments may likely expand the options for investments and could generate more interest in both traded and non-traded BDCs.
The SEC posted hundreds of questions about the proposed amendments and requested final comments by May 2, 2019. Some may appear rather straightforward, such as, “Are we correct that acquiring funds typically buy and sell ETF shares on the secondary market?”15. However, others such as, “Would including these unlisted closed-end funds and BDCs in the scope of ‘acquired funds’ affect an acquiring fund's liquidity risk management, including acquiring funds subject to rule 22e-4 under the Act? If so, how?” require more analysis to fully consider potential effects.16
Considering the potential strategic implications of the proposal, those offering BDCs should ask themselves several questions:
- What does the proposed change to the AFFE rule mean?
- How could the change in the controls provisions (12d-1-A) affect our funds?
- What actions should be taken now to prepare?
What do you think?
Do you think these new rules may drive change in registrations? Might more small and medium-sized businesses seek financing through BDCs?
Join the conversation on Twitter: @DeloitteFinSvcs.
1 SEC, “SEC Proposes Rule Changes for Fund of Funds Arrangements,” December 19, 2018.
2 Tracy Alloway and Arash Massoudi, “Non-bank lending steps out of the shadows,” Financial Times, February 25, 2014.
3 SEC Edgar filings; Deloitte analysis.
4 Olly Ludwig, “S&P, Russel Ditch BDCs From Indexes,” ETF.com, March 5, 2014.
5 SEC,The Coalition for Business Development, et al., “Application for an order pursuant to Section 6(c) of the Investment Company Act of 1940, to exempt certain business development companies from the meaning of the term “Acquired Fund” for purposes of Form N-1A, Form N-2, Form N-3, Form N-4 and Form N-6 under the 1940 Act,” SEC, September 4, 2018.
6 Dechert LLP, “Private Credit, BDCs and Everything in Between: Private BDCs,” webinar, January 26, 2019.
8 SEC , “SEC Proposes Rule Changes for Fund of Funds Arrangements,” December 19, 2018.
9 Federal Reserve, “Senior Loan Officer Opinion Survey on Bank Lending Practices,” January 2018.
10 Federal Reserve, “Senior Loan Officer Opinion Survey on Bank Lending Practices,” January 2019.
11 Aaron Back, “These lenders are cheering the spending bill,” The Wall Street Journal, March 23, 2018.
12 SEC , “SEC Proposes Rule Changes for Fund of Funds Arrangements,” December 19, 2018.
15 SEC, “Fund of Fund Arrangements,” Federal Register, Release Nos. 33-10590, February 1, 2019.
QuickLook is a weekly blog from the Deloitte Center for Financial Services about technology, innovation, growth, regulation, and other challenges facing the industry. The views expressed in this blog are those of the blogger and not official statements by Deloitte or any of its affiliates or member firms.