Advocating Direct Investments Through Education. Portfolio Construction Using Non-Traded Business Development Companies (BDCs)

Transcription

1 Advocating Direct Investments Through Education Portfolio Construction Using Non-Traded Business Development Companies (BDCs)

2 Table of contents Overview... 3 I Basics of BDCs... 3 II Portfolio Construction III Assessing the Investing Environment IV Life Cycle of a Non-Traded BDC V Basic BDC Accounting VI Taxation of Non-Traded BDCs VII Risks and Suitability of Non-Traded BDCs VIII Comparing Non-Traded and Traded BDCs Copyright 2013 Investment Program Association Portfolio Construction Using Non-Traded BDCs 2

3 Overview Business development companies (BDCs) are closed-end investment companies that pool the capital they raise by selling shares to make debt or equity investments in privately held or thinly traded US corporations that otherwise might have limited access to capital. BDCs may be traded, which means their shares can be bought and sold on a national securities exchange, or non-traded, which means their shares are not traded on a national securities exchange and so have limited liquidity. This paper will review the characteristics that traded and non-traded BDCs share and explore the factors that broker-dealers and financial advisors should consider in analyzing non-traded BDCs as investment opportunities for clients. I. Basics of BDCs Business development companies (BDCs) are a type of closed-end investment company regulated under the Investment Company Act of 1940 (1940 Act) as modified by the Small Business Investment Incentive Act of The dual goals in authorizing the creation of this type of closed-end investment company are to: Encourage investment in thinly traded companies Attract public investors and money managers to BDCs BDCs typically elect to be treated as regulated investment companies (RICs) for tax purposes. If they distribute at least 90% of their investment company taxable income each year to their shareholders, and meet other source-of-income and asset diversification tests, they are exempt from federal corporate taxes. This annual distribution makes BDCs attractive to investors seeking regular income, though, of course, the income is not guaranteed. The offering price of a BDC must always be at least equal to its net asset value (NAV), after excluding selling commissions and discounts. As a result, an increase in the NAV will increase the offering price. The reverse is also true. If the NAV falls, the offering price is decreased. NAV is calculated by dividing the combined value of the portfolio assets minus fees and expenses by the number of the BDC s outstanding shares. Portfolio Construction Using Non-Traded BDCs 3

4 Regulatory and Compliance Issues The 1940 Act regulates various aspects of a BDC, including its business model, capital structure, and operations. A BDC must elect to be regulated as a business development company exempting it from certain provisions of the 1940 Act. A vote of shareholders is required to withdraw such election. The following are the most significant regulatory requirements that pertain to BDCs. Business Model Requirements To maintain their BDC designation, the companies are required to invest at least 70% of their assets in a portfolio of qualifying investments, specifically private US companies or thinly traded public US companies with a public float of less than $250 million. BDC investment portfolios may be internally or externally managed, provided that any external advisor is registered under the Investment Advisers Act of In addition, BDCs must offer to provide substantial managerial assistance to their portfolio companies if the companies request it. Managerial assistance may take the form of significant guidance and counseling concerning the management, operations or business objectives and policies of the portfolio company. In fact, a BDC may exercise a controlling influence over the management or policies of a portfolio company. For example, the BDC may arrange financing, recruit management personnel, and evaluate proposed acquisitions and divestitures. Capital Structure BDCs may issue debt and equity securities as well as derivative securities, including options, warrants, and rights that convert into voting securities. Any debt or senior security (as defined under the 1940 Act) issued by a BDC must have asset coverage of at least 200% immediately after it is issued or sold. That is, BDCs are generally subject to a cap on borrowing of 50% loan to value. A 50% LTV corresponds to a 200% asset coverage ratio and will be used interchangeably. In addition, a BDC cannot declare dividends on its common stock unless its debt and senior securities, if there are any, have asset coverage of at least 200%. Portfolio Construction Using Non-Traded BDCs 4

5 A BDC s board of directors must approve and its shareholders must authorize any issuance of derivative securities. In some cases the BDC may need to obtain exemptive relief from the SEC as well. Further, the number of voting securities that could result if all derivatives being issued were exercised cannot exceed 25% of the outstanding voting securities at the time of the proposed issuance. Operational Requirements The 1940 Act subjects BDCs to the following operational requirements: Composition of Board of Directors The majority of the directors of a BDC must be persons who are independent (i.e., not interested persons as defined under the 1940 Act) of the BDC and its investment advisor. Additionally, directors, rather than shareholders, can fill a vacancy on the board if, after the vacancy has been filled, at least two-thirds (2/3) of the directors then holding office have been elected by shareholders. Under the 1940 Act, the board of directors of a BDC is tasked with approving any investment advisory agreement, underwriting agreement, valuation policies, and compliance policies. Valuation A BDC is required to value the BDC s portfolio assets on a quarterly basis in connection with filing certain required periodic reports. Those assets must be valued based on market value if a trading market exists; and in the absence of a readily ascertainable market value for an asset, the board of directors must determine the fair value of the asset in good faith. Fair value is generally determined through the cooperation of the BDC s management and board of directors and often involves the participation of internal auditors and third party valuation firms or pricing services. Fair value is a judgment made in light of the specific facts and circumstances surrounding each portfolio investment through consistently applied valuation processes developed by the BDC. Each debt and equity security is separately valued and disclosed on a Schedule of Investments contained in the financial statements included in quarterly and annual reports filed with the SEC. Portfolio Construction Using Non-Traded BDCs 5

6 Compliance Procedures and Chief Compliance Officer Additionally, under the 1940 Act, a BDC must adopt and implement policies and procedures reasonably designed to prevent violations of the federal securities laws and must designate a chief compliance officer ( CCO ) to oversee the administration of these policies and procedures. The BDC s compliance procedures must address, at a minimum, the following areas: (i) portfolio management processes; (ii) trading practices; (iii) accuracy of disclosures; (iv) safeguards on client assets from advisory personnel; (v) accurate creation of records; (vi) valuation of portfolio holdings; (vii) identification of affiliated persons; (viii) protection of non-public information; and (ix) compliance with the various governance requirements. The compliance procedures must be approved by the BDC s board of directors, including a majority of the independent directors. Annually, the board of directors is required to review the compliance policies and procedures to ensure the ongoing effectiveness of such policies and procedures and the CCO is required to provide a report of the BDC s compliance policies and procedures to the board of directors. Code of Ethics Officers and directors of a BDC are subject to general fiduciary duties with respect to their conduct as they impact the BDC. In order to address such fiduciary duties, the 1940 Act requires that a BDC adopt a code of ethics and institute procedures reasonably necessary to ensure that its employees and certain affiliates adhere to such code. The code of ethics must require periodic reporting by access persons, who generally include any director, officer, or employee of the BDC or its investment advisor or of any company in a control relationship to the BDC or its investment advisor, and impose recordkeeping requirements on the BDC and its investment advisor, as applicable. Fidelity Bond Further, a BDC must provide and maintain a bond issued by a reputable fidelity insurance company to protect the company against larceny and embezzlement. The bond must cover each officer and employee with access to securities and funds of the company and generally cannot include a deductible amount. The amount of coverage is prescribed by the rules promulgated under the 1940 Act and is tied to the amount of the BDC s assets. Portfolio Construction Using Non-Traded BDCs 6

7 Custody Furthermore, all securities of the BDC must be held under a custody agreement by a custodian meeting certain requirements under the 1940 Act, either through bank custody or a safekeeping arrangement. There are certain annual requirements to ensure that appropriate custody is maintained. Indemnification A BDC can enter into an indemnification arrangement with its officers and directors but 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. Reporting A BDC is required to have a class of securities registered under the Securities Exchange Act of 1934 (the Exchange Act ) and meet the reporting and disclosure requirements under the Exchange Act. Under the Exchange Act, issuers must file with the SEC periodic (e.g., Forms 10-Q and 10-K) and other (e.g., Form 8-K) reports in order to provide current information about the BDC and its securities to the public. Management also must report their purchases and sales of the BDC s equity securities and are restricted from obtaining short swing profits from trading in such equity securities within any six-month period pursuant to Section 16(b) of the Exchange Act. In addition, a BDC must maintain a system of disclosure controls and procedures, disclose whether such controls and procedures are effective, and must maintain adequate control over financial reporting. Transactions with Affiliates Generally, a BDC is prohibited from effecting or participating in certain transactions with affiliates (as defined under the 1940 Act) unless certain procedures are satisfied, such as obtaining SEC exemptive relief and/or receiving board approval for a transaction. Portfolio Construction Using Non-Traded BDCs 7

8 Regulatory Examinations The SEC has the authority under Section 31(a) of the 1940 Act to inspect the books and records of a BDC and, under Section 204 of the Advisers Act, to enter the offices of a BDC s investment advisor to inspect the books and records of the BDC. The 1940 Act requires that every BDC maintain and preserve records, such as documents relating to its financial statements, the purchase or sale of securities, financial ledgers, corporate charter, brokerage orders and a list of persons or groups authorized to transact in securities, as prescribed under the rules adopted by the SEC. Additionally, the Investment Advisers Act of 1940, under which investment advisors are regulated, requires that the advisor of an externally managed BDC must register with the SEC and update its registration annually. Further, any arrangement with an external advisor must be approved initially by the board of directors and the BDC shareholders and reapproved annually by either the board or the shareholders. An investment advisor to a BDC must also maintain certain conflict of interest and allocation policies in addition to a 1940 Act code of ethics. An investment advisor must maintain similar compliance policies and procedures. The Advisers Act also regulates the fee structure paid to an investment advisor of a non-traded BDC. Advisors to externally managed BDCs can receive management fees and incentive fees, which are typically structured as follows: Base management fee, which is typically equal to 1.5% to 2.0% of gross assets, depending on the BDC s investment objective Incentive fee on ordinary income, which is typically equal to 20% of pre-incentive fee net investment income, often subject to a hurdle ; and Incentive fee on net capital gains, which is typically equal to 20% of net realized capital gains. The fee structure discussed above is specific to externally managed non-traded BDCs and is not applicable to internally managed non-traded BDCs. There are also certain other regulatory requirements involving investment advisory agreements, including that any investment advisory agreement must be terminable, without the payment of a Portfolio Construction Using Non-Traded BDCs 8

9 penalty, on not more than 60 days written notice by the board of directors of a BDC or its shareholders. NASAA Since offerings of non-traded BDCs are not covered securities as defined by Section 18 of the Securities Act of 1933, the offerings must be registered in all states or other jurisdictions in which sales of shares are made. In connection with the Blue Sky registration of non-traded BDC offerings, states have the ability to issue comments on the registration statement and governing documents of the BDC. NASAA has developed a number of statements of policy that pertain to various offering types, including non-traded REITs, commodity pools, and oil and gas programs. NASAA has not yet developed a statement of policy dedicated to BDCs. In the meantime, BDCs have been subject to the NASAA Omnibus Guidelines, which was initially developed to govern offerings by limited partnerships. Often, the comments from states center around provisions found in the NASAA Omnibus Guidelines or, on occasion, the NASAA REIT Guidelines. NASAA has indicated that it is in the process of developing a statement of policy dedicated to offerings conducted by non-traded BDCs. Characteristics of Non-Traded BDCs While non-traded BDCs share certain defining features with traded BDCs, they are different in significant ways. Beyond the distinction that traded BDC shares are liquid while non-traded BDC shares are essentially illiquid, the following features are also relevant: Non-traded BDC shares are available only to investors who meet suitability standards established by the state where they live. A number of non-traded BDCs utilize a sub-advisor, which is typically an affiliate of an established investment advisor to a BDC or other financial institution, to source or originate investment opportunities. To compensate a sub-advisor for its services, a portion of the management and incentive fees are generally paid by the investment advisor to the sub-advisor. Portfolio Construction Using Non-Traded BDCs 9

10 Non-traded BDC shares are sold in a continuous offering period through independent broker-dealers and financial advisors rather than on an exchange, permitting the BDC to continue to raise capital despite fluctuations in market environments. A non-traded BDC s performance may be measured by total return which includes the sum of cash distributions during the lifespan of the program plus any appreciation or depreciation of its share price up through the liquidity event. The 1940 Act requires that all BDC shares must be sold at a price at least equal to its net asset value (NAV), after excluding selling commissions and discounts. As a result, an increase in a BDC s NAV will require the BDC to increase its offering price and to disclose the new offering price publicly. Most non-traded BDCs have also adopted a policy that if the NAV declines by a certain percentage, the offering price will also be decreased. NAV is calculated by dividing the net assets of the BDC by the number of the BDC s outstanding shares. A non-traded BDC is designed to have a limited offering and operational period, often up to ten years although sometimes longer, before ending in a liquidity event, such as a listing, a merger, or a sale of its assets. The return of a non-traded BDC may display limited correlation with the return of exchange-listed investments. The up-front fees of a non-traded BDC may be up to 11.5% to 15%, which includes the sales load paid in connection with the purchase of shares and organization and offering expenses borne by the BDC. II. Portfolio Construction A BDC identifies the investment objective it will strive to achieve and the strategy it will adopt to accomplish its investment objective. Among the choices it must make as it positions itself in the universe of non-traded business development companies, are: Whether it will focus on debt or equity securities or both Which types of securities within an asset class it will emphasize Where it will position itself along the spectrum of risk Portfolio Construction Using Non-Traded BDCs 10

11 Whether it will invest in companies within a particular industry or diversify more broadly How the BDC investment portfolio will be managed and by whom Types of BDCs Non-traded BDCs can generally be classified into two broad categories: debt and equity. Of the two, debt BDCs are much more common than equity BDCs, which seek capital appreciation. Sometimes, however, a BDC makes significant investments in both debt and equity securities rather than focusing on one or the other. Investors in a non-traded BDC often measure the success of the program by its total return. Total return is the sum of the distributions they receive, any capital appreciation, and the profit or loss from the liquidity event, measured by the extent to which the amount differs from the original purchase price. Debt BDCs A debt BDC invests primarily in the debt securities of eligible portfolio companies, ranging from senior secured debt at the top of a company s capital structure to unsecured mezzanine debt and debt that may incorporate derivatives such as warrants or rights that may be converted to equity at lower levels of the capital structure. They may also purchase a company s preferred stock, which is sometimes described as a hybrid of debt and equity, or convertible bonds. A debt BDC generally makes investments that it expects will provide regular interest and perhaps dividend income, allowing it to make regular distributions to its shareholders. Investors in debt BDCs may also receive cash distributions from the sale or disposition of securities in the BDC portfolio. Return of principal from early repayments may be used to make new investments. If a debt BDC concentrates its investments on senior secured debt at the top of a portfolio company s capital structure, its investment risk profile is lower but typically earns interest at a lower rate than it would if it concentrated on subordinated debt with a risk profile that is greater but typically offers a higher interest rate. However, additional income from higher-rate loans comes with greater risk that the borrower will be unable to cover its interest payments. Portfolio Construction Using Non-Traded BDCs 11

12 What a BDC that concentrates on debt investments sacrifices is the potential to benefit from the possible capital appreciation of a portfolio company, since growth in value does not increase the interest the company owes or the amount of principal that must be returned. Equity BDCs An equity BDC invests principally in equity securities of eligible portfolio companies, including venture capital-backed emerging and pre-ipo companies and publicly traded companies with market capitalizations of less than $250 million. Equity BDCs focus primarily on seeking capital appreciation and few, if any, of their portfolio companies pay distributions. As a result, equity BDCs are less likely than debt BDCs to make income distributions on a regular schedule, if at all. Rather, investors anticipate cash distributions of net realized gains from the sale or other disposition of the underlying portfolio investments and eventual capital gains from the liquidity event. Equity BDCs may be considered riskier than debt BDCs because of the relative risk of the equity investment. Because common stock occupies the lowest rung in the capital structure, stockholders rarely recover the full value of their investment if the portfolio company declares bankruptcy. Instead, the remaining assets are shared among lenders, with holders of senior secured debt having priority. Further, since the qualifying companies in which a BDC must invest are, by definition, small private or thinly traded public companies, they may have a greater risk of failure during economic downturns. Industry Focus Whether a non-traded BDC invests primarily in debt or equity, it may focus its portfolio in a particular industry, such as energy, technology, or healthcare, or on companies that meet certain financial criteria, such as micro-cap companies. In contrast, some BDCs establish broader investment criteria and diversify across industries in companies of all sizes within the qualifying range. While industry focus is an important consideration in evaluating a non-traded BDC, it s not necessarily a predictor of performance success. A particular sub-type or sector can substantially outperform the broad market. But the opposite could also be equally true. Portfolio Construction Using Non-Traded BDCs 12

13 The more critical assessment that a financial professional must make is of the skill with which a nontraded BDC s investment managers have analyzed the capital markets and the economy in setting its unique strategy for meeting its investment objective. Investment Managers BDCs may be managed externally or internally. When a BDC is externally managed, it has an investment advisory agreement with an outside investment advisor. All the investment personnel are employed and compensated by the investment advisor rather than by the BDC. In contrast, when a BDC is internally managed, all the investment personnel are employees of the BDC. To date, all nontraded BDCs are externally managed, as are most traded BDCs. Some of the external investment advisors engaged by non-traded BDCs have engaged investment subadvisors to source investment opportunities and present them to the investment advisor for approval. When this is the case, the investment advisors generally pay a portion of the management and incentive fees they receive from the BDCs to the sub-advisors. Other external investment advisors have their own staffs of investment professionals to source transactions and do not use subadvisors. Evaluating Portfolio Construction When performing due diligence on a non-traded BDC, a retail broker-dealer or financial advisor will want to be comfortable with the answers to these questions: Is the investment objective and strategy presented in the BDC s prospectus logical and backed up by research and market data? Do the BDC s managers and investment advisors have the experience and necessary expertise to execute its proposed strategy and meet its investment objective? Do the current status of and future expectations for the capital markets and overall economy support the BDC s investment objective and strategy? Is the investment objective and strategy of the BDC appropriate and suitable for the specific investor? Portfolio Construction Using Non-Traded BDCs 13

14 III. Assessing the Investment Environment Investment markets move through recurring cycles, from expansion through contraction to recession and ultimately through recovery back to expansion. While the movement through these phases is predictable, the duration and magnitude of the phases and the triggers that move the cycle from one phase to the next are not. Because the managers of non-traded BDCs raise and invest capital over an extended period, they must be prepared for the market to evolve and develop appropriate strategies for different phases. It s relevant that debt and equity market cycles are often negatively correlated. In other words, when debt markets are outperforming, equity markets may be underperforming, and vice versa. Market Cycles Although it is impossible to predict when a market contraction will begin, how long the recessionary period that follows will last, and how severe the impact will be, there is ample historical evidence to support the likelihood that such a downturn will occur within the projected lifespan of a non-traded BDC. So it is appropriate for a financial advisor to consider the potential impact an economic downturn could have as part of evaluating whether to recommend a specific BDC. Since 1980, traded BDCs have performed in a number of different market conditions. Beginning in the third quarter of 2007, global credit and other financial markets suffered substantial stress, volatility, illiquidity, and disruption. These forces reached extraordinary levels in late 2008, resulting in the bankruptcy of, the acquisition of, or government intervention in the affairs of several major domestic and international financial institutions. In particular, the financial services sector was negatively impacted by significant write-offs as the value of the assets held by financial firms declined, impairing their capital positions and abilities to lend and invest. These declines in value compelled leveraged holders of financial assets to sell to meet margin requirements and maintain compliance with applicable capital standards. Such forced liquidations also impaired or eliminated many investors and investment vehicles, leading to a decline in the supply of capital for investment and depressed pricing levels for many assets. These events significantly diminished overall confidence in the debt and equity markets, engendered unprecedented declines in the values of Portfolio Construction Using Non-Traded BDCs 14

15 certain assets, and caused extreme economic uncertainty. Since the recession officially ended, economic growth remains subdued and unemployment rates have not declined significantly. Despite this, many sectors of the capital markets have largely recovered from their depths during the credit crisis. The effect of the credit crisis on traded BDCs was that many traded at substantial discounts to their published net asset values for prolonged periods of time, and the industry as a whole experienced consolidation through a series of mergers. Many traded BDCs were also forced to reduce the amount of distributions paid to shareholders as a result of generating less net investment income. As the markets recovered, however, distribution rates paid by traded BDCs were largely restored. Considering the depth of the credit crisis, the resurgence of traded BDCs illustrates the resiliency of the BDC model. Because the first non-traded BDC launched in January 2009, non-traded BDCs have not yet had to perform in a variety of different market conditions. However, non-traded BDCs generally purchase the same types of debt securities and have exposure to small and middle market private companies in the same manner as traded BDCs, so we would expect some correlation between traded and non-traded BDCs in this regard. Below is a general summary of how the traded and non-traded BDC structures are designed to operate in rising and declining market environments. The summary assumes that the investments held by the traded or non-traded BDC are performing as expected and are not in default. The ability of an investment advisor or investment personnel of a BDC to make sound investment decisions plays perhaps the largest role in the success or failure of a BDC, regardless of whether the BDC is traded or non-traded and regardless of whether the markets are rising or declining. However, there are other factors that may affect how traded and non-traded BDCs perform in rising and declining markets. For example, market prices of traded BDCs may be influenced by price movements in the markets as well as changes to the values of the investments they hold. Portfolio Construction Using Non-Traded BDCs 15

16 Rising Markets In rising markets, the market price of a traded BDC is more likely to be at or above the net asset value of the traded BDC which aids in the BDC being able to access the capital markets or obtain leverage on favorable terms. Non-traded BDCs are structured to be able to raise capital in either rising or declining markets at offering prices that are pegged to their net asset values. The portfolio companies in which traded and non-traded BDCs may be more financially sound in a rising market, but the ability to purchase debt securities at significant discounts may be limited. Declining Markets In declining markets, traded BDCs may have more difficulty raising capital because of the prohibition under the 1940 Act of selling shares at a price, after selling commissions and discounts, that is below net asset value, while non-traded BDCs are less likely to be affected since they have the ability to peg their offering prices, less selling commissions and dealer manager fees, to a multiple of net asset value. In declining markets, the values of many financial instruments, including senior debt securities that trade on the over-the-counter market for institutional loans, may trade at substantial discounts to par, but the loans may also carry greater risk. Investors who invested in certain of the better-performing traded BDCs during the credit crisis and held their investment to the present have seen appreciation in the value of their shares, enhanced by the fact that they were able to purchase shares at prices well below the net asset value of such BDCs. IV. Life Cycle of a Non-Traded BDC The life cycle of a non-traded BDC has three phases offering, operations, and liquidity event with the offering and operation phases typically overlapping. The full cycle may last up to ten years, though it could be extended. Phase 1. Offering A non-traded BDC s offering phase begins when the SEC issues a Notice of Effectiveness of the BDC s registration statement, the Financial Industry Regulatory Authority (FINRA) issues a no Portfolio Construction Using Non-Traded BDCs 16

17 objections letter, and the securities administrators of any states or other jurisdictions in which the non-traded BDC intends to sell its shares provide clearance for the sale. The North American Securities Administrators Association (NASAA) sets general suitability standards and has indicated it intends to draft a set of guidelines that will apply specifically to BDCs. A BDC may impose a minimum offering requirement, or escrow provision, that must be raised by purchasers not affiliated with the BDC or its investment advisor before any shares can be sold. Once the BDC has raised the minimum amount of capital, it will begin to sell shares in its extended public offering, which generally involves a dealer manager or a retail broker-dealer network, or both. Sales of shares in the offering will be made at an offering price that approximately reflects the sum of the net asset value per share plus any selling commissions and dealer manager fees payable by the investor. During the offering and operational stage, the BDC must value its assets at least quarterly, and, as a result of the 1940 Act prohibition against selling shares below net asset value, the offering price for its shares may be adjusted upward or downward. As the retail broker-dealers or financial advisors continue to sell the BDC s shares, the funds received are used to purchase the BDC s investments in portfolio companies according to the BDC s investment strategy. The initial public offering of a non-traded BDC can last from one year to three years and is generally extendible by the BDC s board of directors and management. Once the initial public offering is sold out or expires, a BDC may choose to conduct a follow-on offering, which would extend the amount of time before a liquidity event will be explored or consummated. Offering Phase Assessment Retail broker-dealers and financial advisors should be attuned to several important factors as they evaluate a non-traded BDC in its offering phase as a potential investment opportunity for their clients. The logical starting point is the viability of the BDC s investment objective and strategy, along with the experience and expertise of its management team, investment advisor, and subadvisors if any. Portfolio Construction Using Non-Traded BDCs 17

18 In addition, because a non-traded BDC invests over an extended period, it may make investments in different economic and capital market conditions. This means the quality and risk profile of its investments may change over time, for better or worse. At the same time, a longer investment period adds the potential benefits of greater diversification and dollar cost averaging. They should also bear in mind that the exact composition of the BDC s investment portfolio will be at least partially unknown as the offering begins but also that potential rates of return are determined by the composition of the overall portfolio. With these points in mind, due diligence should include: A review of the investments made to date and what investments are planned An assessment of whether the investment strategy seems reasonable in the current market environment and whether the BDC s investment objective and strategy is flexible enough to permit changes based on market conditions A comparison of the net investment income earned to the BDC s current distribution yield to ensure the coverage is adequate and sustainable A determination of whether the BDC intends to employ leverage, such as lines of credit, to make investments and how that leverage will affect the program Early Stage Risk Assessment In addition to the general risks of investing in a non-traded BDC, there may be risks that are especially relevant during the early stages of an offering: Since it may take time to raise sufficient capital, the BDC s portfolio may be overly concentrated initially in a specific industry, geographic region, or one or more individual investments. Since the BDC is under pressure to produce net investment income that can be paid to shareholders as cash distributions, it may invest in fairly liquid over-the-counter (OTC) syndicated loans to reduce the lag time between share purchase and distribution subject to the limitations of its investment objective and strategy. Portfolio Construction Using Non-Traded BDCs 18

19 Once the BDC has an established portfolio even a small one the question becomes whether the investments are consistent with the objective and strategy described in the prospectus. The answer may provide (1) an indication of how successful the BDC has been in executing its plan, and (2) a preview of its ability to continue to do so. Phase 2. Operations Once a non-traded BDC has raised significant capital, its investment team creates a mature portfolio that may differ at least to some extent from its earlier portfolio. For example, some more mature BDCs seek to originate loans directly to their portfolio companies, a different approach than successfully investing in syndicated loans that trade in the OTC market or in securities quoted in active markets. At the same time the BDC s managers expand their emphasis on operations, for example by taking steps to control or reduce expenses wherever practical. An experienced team seeks efficiency in managing the portfolio through the scale created by having additional assets under management. As a BDC s portfolio grows, it should be self-sufficient in covering capital expenditures and other large costs, and ideally it should be producing cash flow to cover its distributions. Operations Phase Assessment As the offering stage comes to an end, and the BDC shifts its focus from managing its continuous offering and its operations to effecting a liquidity event, retail broker-dealers and financial advisors should make: An assessment of the BDC s portfolio composition to determine the program s financial health, its ability to continue to make distributions, and the likelihood that it will support a liquidity event that benefits shareholders A determination of whether net investment income, net realized gains, or both, are sufficient to cover the cash distributions that are being paid Portfolio Construction Using Non-Traded BDCs 19

20 An evaluation of whether the BDC maintains sufficient levels of cash to fund unexpected expenses or defaults by its portfolio companies or to fund any share repurchases that it might make The key question is whether the BDC s investment portfolio offers the potential for capital appreciation through a future liquidity event. As part of determining their answer, the brokerdealers and financial advisors should consider the value of the investments in the portfolio, including whether any are at risk of default. Once the offering period ends which will occur before the operations phase ends and any subsequent follow-on offering is completed, no new capital will be available for investment unless the BDC uses additional sources of leverage, receives principal from debt repayment, or sells existing investments. Phase 3: Liquidity Event Non-traded BDCs are generally designed to be finite life entities that are expected to execute an exit strategy, generally described as a liquidity event, at a predetermined time or within a predetermined time frame detailed in the prospectus. Potential liquidity events include: 1. Listing on a national securities exchange 2. The sale or merger of the entire portfolio 3. The orderly sale of the underlying investments one-by-one or in small blocks Ultimately, the non-traded BDC s board of directors is responsible for approving the liquidity event or combination of strategies that best optimizes shareholder value while providing the required liquidity. It is often a best practice for a non-traded BDC to have the flexibility to delay a pre-timed liquidity event if market conditions are unstable or unfavorable. A retail broker-dealer, financial advisor, or other investment professional should be able to explain the various liquidity event options to potential investors as well as the expected timing of the event. Each alternative may have unique tax and other implications for shareholders and affect whether or not the BDC is a suitable investment. The possibility that a liquidity event may be delayed is similarly germane. Portfolio Construction Using Non-Traded BDCs 20

21 1. Listing on a National Securities Exchange In a listing, the non-traded BDC is issued a ticker symbol and listed as a traded BDC on a national securities exchange, such as the New York Stock Exchange (NYSE) or the NASDAQ Stock Market (NASDAQ). From that point, the BDC s shares trade continuously, as the shares of other listed companies do, at a price that is set by supply and demand, subject to external market forces, and likely to be at a premium or a discount to book value, expressed as NAV, of the BDC. A non-traded BDC s board of directors may decide the listing option is advantageous in these circumstances: If shares of traded BDCs are selling at premiums to NAV, which means that investors are paying more for BDC assets than the fair value of the assets as determined by the BDC s board of directors If continuing to operate the BDC has value for investors and ceasing operations would be value destroying If the BDC s investment portfolio is well understood by traded BDC analysts and other market participants If potential private buyers for either the entire portfolio or its individual assets are limited Sell or Hold? After the listing occurs, shareholders of the non-traded BDC have the option to (1) sell all or some of their shares and receive cash to reinvest or spend, or (2) continue to hold the shares and receive any cash distributions the newly traded BDC pays. Holding for the present provides the flexibility to sell at some point in the future. Retail broker-dealers or financial advisors should be prepared to assist their clients in evaluating the choice between selling and holding, based in large part on projections of future performance keyed to the financial information in the periodic reports the non-traded BDC has filed with the SEC and assessment of the investment climate. However, tax planning and portfolio rebalancing will be major factors in each investor s decision, so different clients may make different choices. Portfolio Construction Using Non-Traded BDCs 21

22 2. Sale or Merger of Entire Portfolio In choosing to sell or merge, a non-traded BDC s board attempts to complete a transfer of assets in a single transaction. If the assets are sold, shareholders receive a lump sum of cash at a predetermined closing date. If the non-traded BDC is merged with another fund, such as a publicly traded BDC, the shares of the non-traded entity may be converted into a combination of shares of the acquiring BDC and cash on the closing date. The board of directors may choose the sale or merger option if: A suitable acquirer or merger partner can be identified and the terms of the deal are advantageous to the non-traded BDC s shareholders Shares of traded BDCs are generally selling at a discount to NAV, which means investors are paying less than the fair value of BDC assets as determined by the BDC boards of directors A single transaction involves the lowest cost and the least amount of uncertainty If the payout is entirely in cash, the retail broker-dealer or financial advisor should review each investor s portfolio to provide guidance on reallocating assets and managing any tax payments that may be due. If the payout includes securities in a publicly traded BDC, the broker-dealer or advisor should additionally analyze the future performance potential of that BDC based on SEC filings and other information to help investors determine whether to sell the new shares immediately or hold them at least for the present. 3. Orderly Sale of Investments In an orderly sale, a non-traded BDC board liquidates its portfolio of investments either individually or in blocks. These transactions typically occur over several months and may take years to complete, depending on demand for the investments the BDC holds and the number of potential buyers. While the liquidation continues, the non-traded BDC s shareholders receive distributions that include net investment income from securities in the portfolio as well as any net realized gains Portfolio Construction Using Non-Traded BDCs 22

23 from the sales of investments as they occur, or at least on an annual basis. Of course, there is no guarantee that the sales will produce capital gains, and there could be capital losses. Once all investments are liquidated, the BDC issues a final liquidating distribution that returns any remaining capital to shareholders and ceases operations. The board of directors may choose the incremental sale option if: The individual investments are too heterogeneous to be sold to a single purchaser in a single transaction. The investments are difficult for publicly traded BDC analysts to understand and value appropriately. Shares of traded BDCs are selling at discounts to NAV, which means investors are paying less for BDC assets than the assets are intrinsically worth. Certain investments have either a high or low value and should be sold separately before other disposition decisions are made. It is easier, and so preferable, to dispose of smaller investments, especially syndicated loans that trade on the OTC secondary market, on an individual rather than a portfolio basis. For the retail broker-dealer or financial advisor, the considerations are similar to the considerations involved in the sale or merger of an entire portfolio. However, in an incremental sale, capital may be returned to shareholders in multiple payments of varying amounts rather than in a single lump sum. V. Basic BDC Accounting A significant part of conducting due diligence on a non-traded BDC investment involves analyzing its financial health and performance. Since the BDC s shares do not trade on public markets, a retail broker-dealer or financial advisor and an investor must rely on examining its financial statements to determine whether it is an appropriate investment. Portfolio Construction Using Non-Traded BDCs 23

24 Non-traded BDC financial statements are prepared in accordance with GAAP and SEC accounting regulations applied to investment companies and are significantly different from the financial statements of operating companies. This section highlights certain line items and concepts that are included in BDC financial statements, including the balance sheet and income statement, that may not be found in the financial statement of an operating company or even a specialty finance company. When looking at balance sheet or income statement entries, it is important to compare data on a year-over-year or quarter-over-quarter basis to assess whether a non-traded BDC s financial condition is improving or worsening. The increased use of leverage by a BDC, when combined with falling asset values, may signal a deteriorating financial condition. Similarly, increases in investment income represent growth in the BDC s operations. However, since a non-traded BDC raises capital over an extended period, it may not be enough to look for growth merely in total investment income. It is also necessary to take expense line items into account. Balance Sheet Among the key items to review on a non-traded BDC balance sheet are the aggregate fair value of its investments, its total liabilities, and its net asset value. Investments, At Fair Value The first line of a BDC balance sheet shows the aggregate fair value of the assets, or investments, in its portfolio at the end of the reporting period. Fair value is defined by the Financial Accounting Standards Board (FASB) as the amount that would be received to sell an asset in an orderly transaction between market participants at the measurement date. To arrive at the aggregate value, each asset in the portfolio must be valued separately before being included in the total. A BDC s board of directors is required to determine the fair value of each investment at least quarterly. Since most non-traded BDCs invest in illiquid debt securities, a significant number of Portfolio Construction Using Non-Traded BDCs 24

25 their investments are held at fair value. The fair value of an investment differs from its cost, which refers to the nominal or original cost of the investment. To the extent aggregate fair value exceeds aggregate cost, the difference is unrealized appreciation (gain) in the value of a BDC s investments. Similarly, to the extent that the fair value is less than the cost, the difference is unrealized depreciation (loss). Tracking the differences between aggregate fair value and aggregate cost over a number of reporting periods can provide useful information about potential trends in unrealized appreciation (gain) or depreciation (loss) of the portfolio. The first line of the balance sheet will also contain a breakdown of the portfolio into investment categories defined by the 1940 Act: Control investments, or portfolio companies in which the BDC owns more than 25% of the voting securities or fills more than 50% of the seats on the board Affiliate investments, or portfolio companies in which the BDC owns between 5% and 25% of the voting securities Investments that are neither control investments or affiliate investments Total Liabilities Total liabilities are often defined as the sum of short-term liabilities, long-term debt, and certain other liabilities of the BDC. The fair value of a liability is the amount it would cost to transfer the liability to a new obligor, not the amount that would be paid to settle the liability with the creditor. The amount of leverage a BDC can employ is limited under the 1940 Act. Specifically, a BDC may not issue a senior security unless its asset coverage is at least equal to 200% immediately following the issuance. For the purposes of the Act, a senior security includes any bond, debenture, note, or similar obligation or instrument that evidences indebtedness. This includes a class of preferred stock, for example, that has preference over the outstanding common stock. It is important for investors to know whether a BDC has incurred leverage and whether the BDC needs the leverage to maintain its current distribution rate. Disclosure of the sources of Portfolio Construction Using Non-Traded BDCs 25

26 distribution, including whether a portion of prior distributions came from leverage, is generally found in the BDC s prospectus or periodic reports, or both. Net Asset Value BDCs are required to publish their net asset value (NAV) per share in their periodic reports filed with the SEC. NAV per share is calculated by dividing the net assets as of the end of the period by the number of shares of common stock outstanding as of the end of the period. Net assets equals total assets minus total liabilities. It is useful for investors to be aware of the NAV of a non-traded BDC and compare it against prior periods as well as against the current public offering price. As explained earlier, a BDC is prohibited from selling its shares at a price, after excluding selling commissions and discounts, that is below NAV, so the correlation between NAV and public offering price is critical information. NAV shows what is commonly referred to as book value in the case of operating companies. Unlike an operating company, a BDC s NAV is a significant number to watch because of its correlation to fair value. Income Statement Some key items to review in a non-traded BDC income statement are total investment income, net investment income, realized gains/losses, and unrealized appreciation/depreciation. Total Investment Income A BDC s total investment income derives from three sources: interest (including payment-in-kind), dividends, and fees. The BDC s portfolio companies pay interest and dividends on the debt securities, including preferred stock, the BDC holds. Depending on the terms of a particular investment, all or a portion of these payments may be payment-in-kind (PIK) income. That is, the interest payments are made in something other than cash, including additional securities in the portfolio company. While investing in securities with a PIK feature is fairly common, holding a large number of these Portfolio Construction Using Non-Traded BDCs 26