Nelson Mullins Financial Services Conference

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Jonah Benson
5 years ago
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1 Nelson Mullins Financial Services Conference

2 Business Development Companies Moderator: Jonathan H. Talcott, Nelson Mullins Panelists: Cary Schaefer, Fidus Investment t Corporation Larry Herman, Morgan Keegan & Company, Inc. Brent Hodges, FBR Capital Markets & Co. Alan Roth, Wildman Harrold LLP

3 What is a BDC? A business development company is: A type of specialty finance company Primarily making mezzanine loans to private companies An investment company under the Investment Company Act of 1940 A type of closed-end investment fund Either externally or internally managed Usually treated as a partnership for tax purposes

5 BDC Market Overview The public BDC universe contains approximately 27 companies that have a combined market capitalization of approximately $15 billion. The largest three BDCs have approximately 48% of the overall market capitalization Half of the BDCs have market capitalizations below $300 mm. 5

7 Structure General: A business development company ( BDC ) is a publiclyoffered, closed-end investment company, registering its shares under the Securities Act of 1933 (the 1933 Act ) on Form N-2 and electing to be treated as a BDC under the Investment Company Act of 1940 (the 1940 Act ) on Form N-54A. BDCs are generally organized as corporations in states with favorable law for investment companies, such as Maryland or Delaware. Regulation: In addition to 1933 Act registration and the 1940 Act election, a BDC is subject to regulation under the Securities Exchange Act of 1934 as a public company (meaning it must file 10- Qs, 10-Ks, 8-Ks and proxy statements, for example) and is eligible for flow-through taxation under Subchapter M of the Internal Revenue Code (the IRC ).

8 Management A majority of a BDC s board members must not be interested persons of the BDC under 1940 Act and stock exchange requirements. The board must meet at least quarterly and an executive session consisting only of non-interested directors must meet at least twice yearly. Also, if the BDC is externally managed, the investment advisory agreement must be initially approved by the board and shareholders and approved annually after the initial two-year term, must be terminable without penalty on 60 days notice, and must provide for automatic termination in the event of an assignment, which includes any change of control of the adviser. The external manager must be an investment adviser registered pursuant to the Investment Advisers Act of 1940.

9 Investments At least 70% of a BDC s total assets must be qualifying assets, which are: Securities acquired in a private placement, if the portfolio company meets the following criteria: - It is organized under state t law, with its principal i place of business in the United States; - It is an operating company rather than an investment company; and - It either: (a) does not, prior to the investment, have a class of margin securities under Regulation T; (b) is a small and solvent company with total assets not exceeding $4 million and paid-in in capital of at least $2 million; or (c) is controlled by the BDC (generally 25% or more of the company s voting stock) or by the BDC and others as a group and the BDC has a seat on such company s board.

10 Investments (Continued) Securities tesof aus U.S.-based operating company controlled o by the BDC or by the BDC and others as a group, regardless of whether the BDC acquires the securities in a private placement. Securities of a U.S.-based operating company purchased in a private placement from the portfolio company or its officers, directors or 5% shareholders, h when such company is insolvent or the securities are purchased in connection with a bankruptcy or reorganization. Securities of a U.S.-based operating company purchased from anyone in a private placement if there is no ready market for the securities and the BDC already owns 60% or more of the portfolio company s fully diluted equity securities. Securities received as a distribution ib ti on, in exchange for, or upon exercise of warrants, options or rights to acquire securities described above. Cash, cash equivalents, U.S. government securities or high quality short-term debt securities.

11 Investments (Continued) Important: Securities described above (except those of small and solvent companies) qualify only if the BDC either controls the portfolio company or provides, or offers to provide, significant managerial assistance to the company. Significant managerial assistance is defined as significant guidance and counsel concerning the company s management, operations or business objectives and policies. The 70% test is applied each time the BDC purchases a portfolio security, based on the BDC s most recently determined asset fair values.

12 Affiliated Transactions and Co-Investing BDCs are subject to extensive restrictions on affiliated transactions. Covered transactions include most transactions between or involving the BDC (or a controlled portfolio company) and the BDC s officers, directors, 5% shareholders, investment adviser, or any entity controlled by any of these affiliates. Co-investing with the BDC s investment adviser or another entity for which the investment adviser provides investment management services is generally not permitted, absent a specific exemption from the SEC.

13 Taxation BDCs may rely on Subchapter M of the IRC to avoid corporate-level federal income tax. To do so, the BDC must: Derive at least 90% of its gross income for the taxable year from dividends, interest, and gains (without including losses) from the sale of securities and other investment related income; Distribute to its shareholders annually at least 90% of its ordinary income plus the excess of its realized short-term capital gain over its net realized long-term capital loss; and Satisfy the following diversification requirements as of each quarter end: - At least 50% of the value of its total assets must be invested in securities, government securities, cash and cash items. - With respect to 50% of the value of its total assets, the investment in securities of any one issuer may not represent: More than 5% of the assets of the BDC, and More than 10% of the voting securities of the issuer. No more than 25% of the BDC s total assets may be invested in the securities of any one issuer, other than the government or other investment companies.

14 Leverage The 1940 Act restricts how much leverage a BDC may have. Specifically, a BDC may issue debt securities and preferred stock as long as its total assets are at least 200% of the amount of debt and preferred stock (known as the asset coverage test). A BDC may also borrow up to 5% of its assets for temporary or emergency purposes.

15 Distribution of Shares A BDC may only sell its common shares (or warrants or options) at a price below the current net asset value of those shares if: A majority of the BDC s outstanding voting shares, and a majority of its voting shares that are not held by affiliates, approved the BDC s policy and practice of making such sales at the last annual meeting of shareholders within one year immediately prior to any such sale, except in the case of an IPO; A majority of the BDC s directors (meaning both a majority of directors who have no financial interest in the transaction and a majority of directors who are not interested persons) have determined that such sales would be in the best interests of the BDC and its shareholders; and A majority of the BDC s directors have determined in good faith, immediately prior to solicitations of firm commitments or the issuance of the shares, that the price closely approximates the market value of the shares, less any commission or discount.

16 Portfolio Securities Valuation The 1940 Act imposes strict requirements regarding securities valuation. The BDC must: Provide quarterly valuations; Use market quotations whenever available; and When not available, use fair value, which is defined as the amount the BDC could reasonably expect to receive upon a current sale, as determined in good faith by the board of directors.

17 BDCs must: Other 1940 Act Requirements Use a qualified custodian for its assets; Not issue additional common stock at a price below net asset value without shareholder approval; Adopt a Code of Ethics for directors, officers and investment adviser personnel relating to personal trading activities; Adopt written proxy voting policies; i Maintain detailed books and records; Adopt and implement policies and procedures designed to prevent violation of the federal securities law, and to review the adequacy of such policies annually; Maintain a fidelity bond; and Have a Chief Compliance Officer who maintains detailed compliance procedures and reports directly to the board, which approves his or her compensation.

THE BDC ALTERNATIVE: Is It Right for You?

THE BDC ALTERNATIVE: Is It Right for You? Cynthia M. Krus Sutherland Asbill & Brennan LLP cynthia.krus@sutherland.com (202) 383-0218 Steven B. Boehm Sutherland Asbill & Brennan LLP steven.boehm@sutherland.com