Capital Roundtable BDC Conference February 25, BDC Basics What Every New BDC Must Know Before Launching

Transcription

1 Capital Roundtable BDC Conference February 25, 2015 BDC Basics What Every New BDC Must Know Before Launching 1

2 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 2

3 Part I: History and Overview of the BDC Model 3

4 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 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 Hybrid between an operating company and an investment company 4

5 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 5

6 BDCs vs. Private Equity 6

7 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 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 7

8 The BDC Industry at Dec 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 externally managed 10 internally 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. 8

9 BDC Equity Capital Raised ($ in millions) $5,000.0 $4,000.0 $3,000.0 $4,076.7 $2,000.0 $3,550.9 $3,229.5 $2,360.5 $1,000.0 $0.0 $2,097.7 $1,570.2 $908.3 $1,291.0 $466.9 $1,059.5 $823.4 $533.9 $707.8 $497.8 $141.2 $311.0 $0.0 $ IPOs Follow-on Equity Offerings * Includes traded BDCs, as of December 31,

10 BDC Debt Capital Raised ($ in millions) $3,500.0 $3,000.0 $2,500.0 $738.0 $2,000.0 $1,500.0 $1,077.5 $415.0 $1,000.0 $500.0 $0.0 $2,391.4 $1,477.5 $150.0 $1,505.8 $1,222.0 $780.0 $650.0 $650.0 $193.0 $ Debt Convertible Debt * Includes traded BDCs, as of December 31,

11 BDC Price / Book (NAV) Median Price/Book = 0.87x Internally managed Externally managed As of 12/31/14 - traded BDCs only 11

12 BDC Yields 20% 18% 16% 14% Average Yield = 10.0% 12% 10% 8% 6% % 2% 0% As of 12/31/14; Excludes BDCs that are not paying dividends 12

13 Part II: BDC Structures 13

14 Types of BDC Structures 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 14

15 Traded BDCs 15

16 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. 16

17 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 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. 17

18 Initial Portfolio Acquisitions 18 May start with or without an initial portfolio Market has generally favored vehicles with existing portfolios Initial portfolio may be acquired from an affiliated fund on a pre- IPO basis Recent staff guidance has provided more flexibility for these transactions Considerations in connection with the acquisition of an initial portfolio: 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 Typically an audited schedule of investments is required More fulsome financial statements may also be acquired in certain cases

19 Non-Traded BDCs 19

20 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 20 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)

21 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 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

22 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. 22

23 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): 23 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 VII Peaks Co-Optivist Income BDC II, Inc. - $50 million - Affiliated with VII Peaks Capital, LLC

24 Additional Requirements for Non-Traded BDCs Suitability requirements May only be sold to investors who meet certain suitability standards, typically through the independent broker-dealer or RIA channels 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 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 24

25 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 25

26 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 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 26

27 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 27

28 Private BDCs 28

29 What is a Private BDC? 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 29

30 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 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 N- 54A Comply with regulatory requirements of the 1940 Act, and the reporting requirements including the Exchange Act, Sarbanes- Oxley Act, etc. 30

31 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: 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. 31

32 Part III: Regulatory and Reporting Requirements 32

33 How Does a Company Become a BDC? 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 33

34 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 34

35 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 Concentration Geography and industry sectors Fair value and Level 3 reconciliation tables 35

36 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. 36

37 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 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. Requirement to maintain and enforce a Code of Ethics for officers of the BDC Includes reporting of all securities holdings and transactions. 37

38 1940 Act Requirements (cont.) Restrictions on investing in other investment companies. A BDC may not invest: 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 Restrictions on investment funds investing in a BDC 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 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 A BDC must maintain and make available for inspection prescribed books and records. BDCs must make available significant managerial assistance to their portfolio companies 38

39 1940 Act Requirements (cont.) Must appoint a Chief Compliance Officer Must maintain a compliance program compliant with Rule 38a- 1 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. Subject to regular examinations by the SEC 39

40 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 40 Typically based on precedents

41 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. 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) 41

42 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 $50 Debt $50 Equity Other investment companies are restricted to a 300% asset coverage requirement with respect to issuing debt. $50 Equity $25 Debt $50 Equity BDCs may exclude leverage at the SBIC level if the SEC grants exemptive relief, which many have received. 42

43 BDC Use of Leverage Average Debt/ Equity = 0.53x As of 12/31/14; Excludes SBA debt; includes preferred securities as debt 43

44 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 44 Mass Mutual exception (i.e., no terms negotiated other than price) Recent staff guidance has provided additional flexibility without exemptive relief

45 Part IV: Management and Operational Considerations 45

46 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: 46 Hercules Growth Technology, Inc. MCG Capital Corporation Main Street Capital Corporation

47 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 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 47

48 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. 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. 48

49 Portfolio Valuation Process 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: 49 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

50 General Principles of Valuation 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). 50

51 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 51 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 Cost structure and financial condition

52 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 52

53 BDC Proposed Legislative Changes Industry continues to seek to modernize the BDC model Various bills have been introduced over the years, including during 113 th Congress: H.R, 31 - Next Steps for Credit Availability Act, co-sponsored by Nydia Velazquez (D-NY) and Gregory Meeks (D-NY) H.R Small Business Credit Availability Act, sponsored by Mick Mulvaney (R-SC) H.R 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 114 th Congress, which convened in January 2015 Efforts led by Small Business Investor Alliance and several BDC management teams Focused on same issues 53

54 Proposed Legislative Changes Section, Rule or Form to be Explanation Amended Ownership of Registered Investment Advisers 1940 Act Section 60 Allows BDCs to own registered investment advisers Asset Coverage Limit Reductions 1940 Act Sections 18 and 61(a) 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 Registration and Reporting Parity Impact on BDCs 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. Would allow BDCs to incur more leverage, enabling them to raise additional assets to invest in small to mid-size U.S. companies. Forward incorporation (Form N-2) 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. 54

55 Proposed Legislative Changes Section, Rule or Form to be Amended Flexible Communications Prospectus Safe Harbors (Rules 134, 163 and 163A) Research (Rules 138 and 139) WKSI Status (Rules 405 and 433) Explanation Free writing prospectuses are useful to convey recent developments or other updated disclosure, as a way of avoiding recirculation of an updated preliminary prospectus. Allows BDCs to communicate with investors more freely during the preparation and filing periods for a registration statement. 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. Impact on BDCs 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. 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. 55

56 Proposed Legislative Changes Section, Rule or Form to be Amended Shelf Registration (Rule 415) Final Prospectus (Rule 497) Written Confirmation (Rules 172 and 173) Free-Writing Prospectus Safe Harbor (Rule 164) Explanation Rule 415 specifies which offerings qualify for shelf registration and imposes certain obligations to remain qualified under the rule. Rule 497 governs when investment companies must file prospectuses during the registration process. Relieves BDCs of requirement to provide written confirmations of sales, notifications of allocation, and deliveries of securities. Provides safe harbor to BDCs for post-filing free-writing prospectuses. Impact on BDCs Allows for SEC review of BDC N-2 shelf-registration statement in advance of accessing public markets. Offers more certainties with respect to timing. 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. Would permit BDCs greater flexibility in the sales process in parity with other issuers covered by the rule. BDCs would be able to more freely communicate to potential investors. 56

57 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. 57

58 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 EGC is defined as having less than $1 billion total annual gross revenues in its most recent fiscal year. EGCs are exempt from certain requirements of the Sarbanes-Oxley Act 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. 58

59 Part V: Convergence of BDCs and SBICs 59

60 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 60

61 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 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. Garrison Capital, Inc. Hercules Technology Growth Capital MCG Capital Corporation Medallion Financial Corp Medley Capital Corp. Monroe Capital Corp. New Mountain Finance Corp. OFS Capital Corporation PennantPark Investment Corp. Rand Capital Corporation Saratoga Investment Corporation Stellus Capital Investment Corp TCP Capital Corp Additional BDCs are in the process of obtaining an SBIC license 61

62 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 62

63 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. 63

64 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

65 Contact Information Lisa Morgan Partner Harry S. Pangas Partner For more information, please visit our practice site at and our corporate site at 65

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