We have prepared a brief outline of the Business Development Company industry. Reviewed below is the historical origin of the 1980 regulations that established the industry, a précis of the main provisions of the law, and their impact on the business. We review how the internal and external managers of BDCs are compensated. It’s a little dry and collated from a number of sources (and we’re still updating this section when we have the time) , but if you want to know the basics about the BDC industry, read on.
HISTORY-HOW THE BDC INDUSTRY GOT STARTED
In the 1970s, a perceived crisis in the capital markets led Congress to enact the Small Business Investment Incentive Act of 1980 (1980 Amendments). The origin of the crisis was the limitation in the private investment company exemption in Section 3(c)(1) of the Investment Company Act of 1940 (1940 Act). Private equity and venture capital firms believed that their capacity to provide financing to small, growing businesses was being blocked because a limitation in the 1940 Act that stipulated that their securities could not be beneficially owned by more than 100 persons. That ruled out any kind of public company.
The financial firms urged Congress to ameliorate the situation , and the lawmakers responded by enacting the so-called 1980 Amendments. The stated objective was to encourage the establishment of public vehicles that would invest in private companies, and thereby increase the flow of capital to small, growing businesses. The upshot was that Congress created a new category of closed-end investment company known as a “business development company” (BDC). BDCs were envisioned as publicly traded closed-end funds that would make investments in private (or thinly-traded public companies) in the form of long-term debt or equity capital, with the goal of generating capital appreciation and/or current income. The 1980 Amendments sought to achieve this goal by lessening some of the restrictions under the 1940 Act that were believed to discourage “private equity” managers from participating in the regulated portion of the investment management industry, most notably restrictions relating to compensation and borrowing. The modern Business Development Company format was born, but as we shall see not much advantage was taken of the new format for the next twenty years.
Actually, until the turn of this decade, only a few public Business Development Companies were formed. Amongst the companies we track only three existed in 2000 (American Capital, Allied Capital and medallion Financial). However, things were about to change in a big way. Buoyed by the remarkable expansion of the Private Equity industry, which began in the 1980’s, and its ever increasing need for senior, subordinated and equity capital, a series of new BDCs were formed in the early years of the decade. In fact, in each of 2001 and 2002 a new BDC was launched (Gladstone Capital and MCGC). After a breather in 2003, no less than 4 new BDCs joined the ranks. By the end of 2008, there were 21 BDCs.
KEY DETAILS ON THE STRUCTURE OF BUSINESS DEVELOPMENT COMPANIES
BDCs are a unique kind of investment company in that they primarily focuson investing in or lending to private companies and making managerial assistance available to them. A BDC provides stockholders with the ability to retain the liquidity of a publicly traded stock, while sharing in the possible benefits of investing in emerging-growth or expansion-stage privately owned companies. The 1940 Act contains prohibitions and restrictions relating to transactions between BDCs and their directors and officers and principal underwriters and certain other related persons and requires that a majority of the directors be persons other than “interested persons,” as that term is defined in the 1940 Act. In addition, the 1940 Act provides that a BDC may not change the nature of its business so as to cease to be, or to withdraw its election as, a BDC unless approved by a majority of their outstanding voting securities. A majority of the outstanding voting securities of a company is defined under the 1940 Act as the lesser of (i) 67% or more of such company’s shares present at a meeting or represented by proxy if more than 50% of the outstanding shares of such company are present or represented by proxy or (ii) more than 50% of the outstanding shares of such company.
Under the 1940 Act, a BDC may not acquire any asset other than assets of the type listed in Section 55(a) of the 1940 Act, or “qualifying assets,” unless, at the time the acquisition is made, qualifying assets represent at least 70% of the company’s total assets. The principal categories of relevant qualifying assets are the following:
- Securities of an “eligible portfolio company” purchased in transactions not involving any public offering. An “eligible portfolio company” is defined in the 1940 Act as any issuer which:
- is organized under the laws of, and has its principal place of business in, the United States;
- is not an investment company (other than a small business investment company wholly-owned by the BDC) or a company that would be an investment company but for certain exclusions under the 1940 Act; and
- satisfies any of the following:
- does not have outstanding any class of securities with respect to which a broker or dealer may extend margin credit;
- is controlled by a BDC or a group of companies including a BDC and the BDC has an affiliated person who is a director of the eligible portfolio company;
- is a small and solvent company having total assets of not more than $4 million and capital and surplus of not less than $2 million; or
- does not have any class of securities listed on a national securities exchange.
- Securities of any eligible portfolio company that we control;
- Securities purchased in a private transaction from a U.S. issuer that is not an investment company and is in bankruptcy and subject to reorganization;
- Securities received in exchange for or distributed on or with respect to securities described above, or pursuant to the conversion of warrants or rights relating to such securities;
- Cash, cash equivalents, U.S. government securities or high-quality debt securities maturing in one year or less from the time of investment; and
- Under certain circumstances, securities of companies that were eligible portfolio companies at the time of the initial investment but that are not eligible portfolio companies at the time of the follow-on investment.
Generally, a BDC will elect to be treated as a regulated investment company (RIC) for tax purposes and thereby avoid corporate level taxation on ordinary income and capital gains distributed to its stockholders as dividends. A RIC is a domestic corporation that pools investments from more than one hundred persons for the purpose of investing in securities. RICs were established by the federal Investment Company Act of 1940 as a way for smaller investors to secure the benefits of professional management and a more diversified securities portfolio. A RIC is a pass-through entity that must distribute ninety percent or more of its income to shareholders. As a RIC, a BDC is required to distribute at least 90 per cent of its taxable ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses and to meet specified source-of-income and asset diversification requirements. Distributions out of capital gains to individual stockholders are generally eligible for favorable capital gain tax treatment.
GAAP Versus Taxable Income
Taxable income at a BDC generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation until realized. Dividends declared and paid by a BDC in a year generally differ from taxable income for that year as such dividends may include the distribution of current year taxable income or the distribution of prior year taxable income carried forward into and distributed in the current year. Distributions also may include returns of capital.
Significant Managerial Assistance
A BDC must have been organized and have its principal place of business in the United States and must be operated for the purpose of making investments in the types of securities described above. However, to count portfolio securities as qualifying assets for the purpose of the 70% test, the BDC must either control the issuer of the securities or must offer to make available to the issuer of the securities (other than small and solvent companies described above) significant managerial assistance; except that, where the BDC purchases such securities in conjunction with one or more other persons acting together, one of the other persons in the group may make available such managerial assistance. Making available significant managerial assistance means, among other things, any arrangement whereby the BDC, through its directors, officers or employees, offers to provide, and, if accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of a portfolio company through monitoring of portfolio company operations, selective participation in board and management meetings, consulting with and advising a portfolio company’s officers or other organizational or financial guidance.
Pending investment in other types of qualifying assets, as described above, a BDC’s investments may consist of cash, cash equivalents, U.S. government securities or high quality debt securities maturing in one year or less from the time of investment, or temporary investments, so that at least 70% of assets are qualifying assets. Typically, a BDC will invest in U.S. treasury bills or in repurchase agreements, provided that such agreements are fully collateralized by cash or securities issued by the U.S. government or its agencies.
Senior Securities; Coverage Ratio
A Business Development Company is permitted, under specified conditions, to issue multiple classes of indebtedness and one class of stock senior to their common stock if the asset coverage, as defined in the 1940 Act, is at least equal to 200% immediately after each such issuance. In addition, with respect to certain types of senior securities, the BDC must make provisions to prohibit any dividend distribution to stockholders or the repurchase of certain securities, unless they meet the applicable asset coverage ratios at the time of the dividend distribution or repurchase. A BDC may also borrow amounts up to 5% of the value of their total assets for temporary purposes.
B. COMPENSATION OF BDC FUND MANAGERS
Approximately half the BDCs in existence are managed by third party companies (“External Manager”). Our review of all the compensation agreements indicates that the compensation agreements between externally managed funds and their External Manager are almost identical. Compensation agreements usually contain four principal elements:
1. A Base Management fee: The base management fee is determined by taking the average value of a BDC’s gross assets, usually calculated at an annual rate of 1.75%-2.00%.
2. Hurdle Rate Fee. The BDC calculates pre-Base Management fee net investment income for the quarter as a percentage of average assets managed and compares the return against a pre-determined hurdle rate (usually 2% a quarter or 8% per annum).
(For this purpose, pre-Base Management fee net investment income means interest income, dividend income and any other income. Pre-incentive fee net investment income does not include any realized capital gains computed net of all realized capital losses and unrealized capital depreciation).
The BDC pays the External Manager a Hurdle Rate under certain conditions as follows: (i) no incentive fee in any calendar quarter in which the BDC’s pre-Base Management Fee net investment income does not exceed the hurdle rate;
(ii) 100% of the BDC’s ’s pre-Base Management fee net investment income with respect to that portion of such pre-incentive fee net investment income, if any, that exceeds the hurdle rate but is less than a pre-determined percentage (usually, the Hurdle Rate plus the Base Management Fee percentage).
(iii) 20% of the amount of pre-Base Management fee net investment income, if any, that exceeds the Hurdle Rate plus the Base Management Fee percentage in any calendar quarter.
These calculations are appropriately pro rated for any period of less than three months and adjusted for any share issuances or repurchases during the relevant quarter.
3. Net Capital Gains. The Fund will pay the External Manager 20% of its cumulative realized capital gains less cumulative realized capital losses, as well as unrealized capital depreciation (unrealized depreciation on a gross investment-by-investment basis at the end of each calendar year). Payments are usually made annually in arrears.
4. Administration Agreement. The BDC usually enters into an Administration Agreement with the External Manager or one of its affiliates under which the Administrator provides administrative services for the Fund. For providing these services, facilities and personnel, the BDC reimburses the Administrator for it’s allocable portion of overhead and other expenses incurred by the External Manager in performing its obligations under the Administration Agreement. In addition, the BDC reimburses the External Manager for all professional fees and other direct expenses incurred on its behalf.
BDCs that are internally managed have established different forms of compensation to attract and retain personnel. The varieties of compensation arrangements differ by company and include salaries, bonus arrangements, 401-K Plans, deferred compensation and stock option plans.