Non-Traded BDC Regulatory Update Presented by: Owen J. Pinkerton IMN s 11 th Annual New York Non-Traded REIT Industry Symposium June 26, 2014
Agenda Business Development Company (BDC) Overview Regulatory overview Select offering statistics Current regulatory issues SEC Overview of review process Total Return Swaps Rules 3-09 and 4-08(g) of Regulation S-X Examinations of registered investment advisers (RIAs) FINRA FINRA Rule 14-06 Blue Sky Overview of common questions/concerns from the states
Business Development Company Overview
Regulatory Overview of BDCs Summary Created by the Small Business Investment Incentive Act of 1980 as a result of a perceived crisis in the capital markets in the 1970s. Special type of closed-end fund designed to provide small, growing companies access to capital, while also enabling private equity funds to access the public capital markets. Hybrid between an operating company and an investment company. Regulated as an investment company, but to a lesser extent as provided by Sections 55-65 of 1940 Act Required to file periodic reports under the Securities Exchange Act like operating companies (i.e., Forms 10-K, 10-Q and 8-K and proxy statements) BDCs generally elect to be taxed as a Regulated Investment Company (RIC)
Regulatory Overview of BDCs (cont.) Brief Overview of Regulatory Requirements Must offer to provide managerial assistance to portfolio companies; Must have majority-independent board of directors; Must value assets at least quarterly; Must maintain 200% asset coverage ratio; Must appoint a chief compliance officer (who reports to the board) and maintain compliance procedures designed to prevent violations of federal securities laws; Must adopt of code of ethics that requires reporting requirements of investment personnel; Must maintain a fidelity bond to protect the BDC against larceny and embezzlement; All securities must be held by custodian that meets requirements under the 1940 Act; and All BDCs and their investment advisers subject to regulatory exams by the SEC.
Regulatory Overview of BDCs (cont.) Regulations of BDCs vs. other investment companies Character of Investments Must generally invest at least 70% of total assets in qualifying assets pursuant to Section 55(a) of the 1940 Act Generally requires investments in eligible portfolio companies which are private U.S. companies or U.S. companies with a market cap not greater than $250 million Other categories of investment companies are not subject to these requirements Leverage Must maintain 200% asset coverage ratio (1:1 assets to leverage) as opposed to 300% asset coverage ratio for other investment companies
Regulatory Overview of BDCs (cont.) Affiliated Transactions BDCs, like other investment companies, subject to restrictions on transaction with affiliates, but restrictions on BDCs less onerous than restrictions on other investment companies In order to co-invest with an affiliate, must obtain exemptive relief from the Division of Investment Management or invest in transactions where price is the only negotiated item (such as syndicated loans) Adviser Compensation Investment advisers to BDCs are able to receive capital gains incentive fees in an amount not to exceed 20% of realized capital gains Investment advisers to other investment companies generally prohibited from receiving capital gains incentive fees
Regulatory Overview of BDCs (cont.) Regulatory Matters Significant to Non-Traded BDCs Quarterly Valuation of assets BDC s board required to value assets at least quarterly Net asset value (NAV) included as line item on balance sheet in 10-K and 10-Q Provides transparency regarding value of assets to investors during offering stage Restriction on sales below NAV a BDC may not sell its shares at a price below NAV (after excluding underwriting discounts and commissions) Result is that if NAV increases, BDC must increase offering price accordingly Although not required under the 1940 Act, most, if not all, BDCs also decrease offering price if there is a material decrease in NAV
Regulatory Overview of BDCs (cont.) Blue Sky Matters Like non-traded REITs, securities of BDCs not covered securities under NSMIA and must be registered in every state where offers and sales are made BDCs are not registered investment companies which are carved out under NSMIA BDCs are subject to NASAA Omnibus Guidelines which were originally drafted for limited partnership offerings FINRA Matters BDCs (both traded and non-traded) are considered to be direct participation programs (DPPs) under FINRA rules and therefore their offerings are regulated under Rule 2310 Offerings by registered investment companies, on the other hand, are not DPPs and regulated under Rule 5110
Select Offering Statistics As of May 30, 2014, there were approximately 46 BDCs that have shares listed on a national securities exchange: Aggregate market capitalization of approximately $33.4 billion Total assets of over $50 billion First non-traded BDC (FS Investment Corporation) launched its initial public offering in January 2009; offering closed in 2012; securities listed on NASDAQ in April 2014. As of May 30, 2014, there were 10 non-traded BDCs that had ongoing offerings or whose offerings closed: Aggregate capital raise of approximately $ 12.0 billion 1 Total assets of nearly $ 14.9 billion 1 1 Includes capital raised by FS Investment Corporation of approximately $2.65 billion which was raised through an offering of shares through the IBD and RIA channels. FS Investment Corporation listed its shares on NASDAQ in April 2014. Also includes approximately $3.05 billion raised by FS Investment Corporation II which terminated its offering in March, 2014.
Select Offering Statistics Current pipeline of new issuers, includes: FS Energy and Power Fund II; NexPoint Capital, Inc. (Highland Capital); and Griffin-Benefit Street Partners BDC Corp. (Griffin Capital and Providence Equity)
Select Offering Statistics (cont.) (current offerings through the dates indicated, $ in millions) (Data taken from SEC filings)
Select Offering Statistics (cont.) (offering price/nav as of March 31, 2014)
Current Regulatory Issues
SEC: Review Process BDCs are reviewed by Division of Investment Management (IM) BDCs are not subject to Industry Guide 5 IM does not conduct no reviews of post-effective amendments or follow-on offerings IM has the ability to conduct selective reviews but has historically conducted a broader review of registration statements filed by nontraded BDCs
SEC: Total Return Swaps Common financing tool for BDCs is utilizing a total return swap (TRS) Essentially an arrangement where a BDC can obtain exposure to basket of investments without owning them Through a special-purpose vehicle, a BDC enters into an agreement with a counterparty whereby the BDC selects investments that meet predetermined standards (e.g., generally senior secured syndicated loans) BDC s exposure limited to collateral it posts (approximately 25% of notional value) BDC pays interest to the counterparty and receives all interest and dividends from the loans held by the counterparty as well as realized gains from sales of loans
SEC: Total Return Swaps (cont.) BDC 100% SPV Post Collateral (25% 35%) Interest Payments Interest/Dividends from Portfolio Companies Realized gains from sales of investments Bank (Counterparty) Investments selected by BDC Investments generally limited to sr. secured loans traded on over-the-counter market Investments
SEC: Total Return Swaps (cont.) Reasons to Enter Into a TRS Cheap form of leverage that can be tapped quickly Way to utilize proceeds quickly Method of increasing exposure to positions without directly owning them Reasons Not to Enter Into a TRS Regulatory discomfort (although this may be changing) Limitations on being able to pay fees on TRS assets to investment adviser (see following slide)
SEC: Total Return Swaps (cont.) Regulatory treatment of TRSs: Qualifying assets SEC staff has taken the position that you can look through to the assets held pursuant to the TRS for purposes of complying with 70% test Leverage SEC staff has taken the position that the difference between the collateral posted and the notional amount of the TRS is a senior security for purposes of 200% asset coverage ratio
SEC: Total Return Swaps (cont.) Advisory fees: Note: The discussion below is subject to the terms of the advisory contract. The SEC staff will defer to the terms of the advisory contract if it clearly sets forth the treatment of advisory fees under a TRS structure. Management fees assets on the balance sheet are assets for purposes of calculating management fees. Examples include collateral posted, unrealized gains from the TRS Income incentive fees cannot pay income incentive fees on income from TRS assets since the BDC s investment in the SPV results in all income and gains being treated as gains under GAAP Capital gains incentive fees cannot pay capital gains incentive fees on gains from the sale of TRS assets since BDC does not own such assets
SEC: Total Return Swaps (cont.) Advisory fees (cont.): If the BDC wants to compensate the adviser for managing TRS assets, and the advisory contract is silent as to the treatment of incentive fees, the SEC staff requires that stockholder approval be obtained in addition to board approval under Section 15 of the 1940 Act before paying such fees Possible silver lining: SEC staff considering whether to allow a BDC to pay capital gains incentive fees to investment adviser at the termination of the TRS agreement Consistent with GAAP since investment by BDC is in the SPV, so all income from portfolio companies and gains from sales of investments would be treated as realized gains Stay tuned
SEC: Rules 3-09 and 408(g) Background In September 2013, the Division of Investment Management issued a guidance update regarding the applicability of Rules 3-09 and 4-08(g) of Regulation S-X to BDCs This followed comments relating to 3-09 and 4-08(g) issued by IM in its reviews of BDC registration statements The guidance update indicated that Rules 3-09 and 4-08(g) apply to BDCs because they are general rules that apply to all issuers and are not superseded by any rules specific to investment companies in Article 6 of Regulation S-X
SEC: Rules 3-09 and 408(g) (cont.) Summary of rules Rule 3-09 requires the inclusion of full financial statements of a majority-owned subsidiary (BDC owns 25%+ of outstanding voting securities) if: the subsidiary meets the asset, income or investment tests set forth in Rule 1-02(w) of Regulation S-X (relating to significant subsidiaries) at a 20% threshold Rule 408(g) requires the inclusion of summarized annual financial information for subsidiaries (BDC owns 25%+ of outstanding voting securities) if: the subsidiary meets the asset income or investment tests set forth in Rule 1-02(w) of Regulation S-X (relating to significant subsidiaries) at a 10% threshold
SEC: Rules 3-09 and 408(g) (cont.) Other considerations: Rule 3-09 audited financial statements are only required for years during which the subsidiary met one of the significance tests at a 20% threshold Years where one of the significance tests not met at a 20% threshold may be presented as unaudited Timing Rule 3-09 financial statements must be filed by the later of the Form 10-K due date and the date the financial statements would be due if the subsidiary were an SEC registrant For non-traded BDCs, the due date is March 31 for an issuer with a fiscal year-end Rule 408(g) generally applies on an individual or aggregate basis, but IM has indicated it would not object if financial information presented only for subsidiary that meets significance threshold
SEC: Examinations of RIAs All registered investment advisers (RIAs) are subject to periodic examination by the SEC On February 20, 2014, the SEC s Office of Compliance, Inspections and Examinations (OCIE) sent a letter to all RIAs that have never been examined by the SEC The letter alerted them that OCIE is launching a new initiative to prioritize examinations of RIAs that have been registered for at least three years but have never been examined Two types of examinations: risk-assessment and focused review Risk assessment is high level review of overall business Focused review is a comprehensive exam on one or more components of the RIAs business RIAs to private funds are not included as part of this initiative
FINRA: Customer Account Statements FINRA Rule 14-006 does not specifically address BDCs except to say: Several commenters requested that FINRA broaden the proposal to accommodate programs, such as business development companies that use a NAV on a periodic basis. The new proposed amendments do not specify the use of a daily NAV, but rather would accommodate any DPP or REIT that provides a per share estimated value reflecting a valuation disclosed in the issuer report where a third-party valuation expert or experts determine, or provide material assistance in the process of determining, the valuation.
Blue Sky: Overview of State Comments BDCs subject to NASAA Omnibus Guidelines which were initially drafted to cover limited partnership offerings NASAA intends to formulate BDC-specific guidelines after the REIT Guidelines are updated could be a few years before we see anything We continue to get comments asking why certain definitions and other provisions that have no applicability to a corporation are not included in the charter States asking for more prospectus disclosure of items required to be included in the charter by the Omnibus Guidelines On a positive note, states now recognize importance of the investment advisory agreement and permit items required by the Omnibus Guidelines to be included in the advisory agreement
Need more information? For more information, please contact me at: Owen J. Pinkerton Morris, Manning & Martin LLP 1401 Eye Street, NW Washington, DC 20005 (202) 216-4812 opinkerton@mmmlaw.com