January 2020

January 15, 2020 – The emergence of Business Development Companies (“BDCs”) over the last decade is not a surprise. BDCs are well-established as an essential provider of debt capital to small and medium-sized U.S. businesses. Since the peak of the financial crisis, the number of publicly-listed BDCs has more than doubled, and the number of private or non-traded BDCs has exponentially increased, as asset management firms increasingly add private credit and direct lending to their investment strategies, and investors (whether retail, institutional or non-U.S. institutional) seek exposure to the ever-maturing market for U.S. middle market credit. BDCs are an attractive destination for non-U.S. investors, particularly due to their tax advantages. They are an attractive product for asset managers because of the complement they offer other formats that attract capital to direct lending strategies. These advantages notwithstanding, BDCs present complex capital structure, balance sheet management, regulatory compliance and corporate governance challenges for asset managers that other formats (like commingled funds and SMAs) do not pose. Professional advisors and consultants well-versed in these intricacies can help fund sponsors and debt and equity capital sources unlock the numerous opportunities presented by BDCs.

Leaving the “Banking System” … to Return 

One widely-known tailwind for this growth has been the transplantation of most of the smaller-end and much of the middle market’s leveraged finance holdings off depository institutions’ balance sheets and onto private funds, SMAs and – yes – BDCs’ (we’ll refer to them collectively as the “New Lenders”) balance sheets. It’s not that big banks have entirely left the chat, however, as they are vitally important to the New Lenders. The New Lenders rely on the big banks for some deal flow, treasury management and fund administration, but most importantly, for massive amounts of financing. The New Lenders to “main street” take on many forms. Still, most rely on at least one meaningful credit facility from a big bank, for liquidity and additional capital to make these investments, and as a key source of financing that reduces the overall cost of capital for the New Lenders, which enhances the gross- and net-level returns.

Even though there are noteworthy differences among BDC structures and terms, management teams, strategies and performance, there are legal and regulatory boundaries, and in some cases barriers, that BDC managers – and their lenders, professional advisers and investors – should be prepared to neutralize.

Leverage Limitations for BDCs are a Special Consideration 

As with all funds, governing documents may set limitations on leverage (among other areas). BDCs, however, are subject to additional limitations. First, all BDCs, whether exchange-listed, private or non-traded, are Regulated Investment Companies (each, a “RIC”) under the Investment Company Act of 1940 (the “40 Act”). The 40 Act restricts BDCs’ ability to utilize leverage; the regulatory consequence of violating the incurrence-tested restriction is the BDC’s inability to incur additional indebtedness. Until late 2018, BDCs were permitted to incur debt up to a 1:1 ratio to the fair market value of their respective portfolios. Following years’ worth of lobbying efforts led by the Small Business Investor Alliance, industry leaders and advisers, BDCs may now incur debt up to a 2:1 ratio to their portfolio’s FMV, so long as the BDC’s board or shareholders, as the case may be, permit such incremental leverage.

What the 2018 BDC Leverage Increase Means for BDCs, Lenders and Investors

A breach of the 40 Act leverage limit generally prohibits the BDC from accessing any additional debt capital until such BDC is back in compliance. For publicly listed BDCs, the research and public equity investment community would also respond harshly to such financial and liquidity degradation. The most important practical consideration for public or private BDCs with credit facilities, outstanding bonds or convertible notes is to appreciate the extra-regulatory consequences of the BDC’s prevailing leverage limit.

Most, if not all, BDC credit facilities and debt securities are accompanied by maintenance covenants that would trigger an event of default if the BDC is out of regulatory compliance with the 40 Act’s leverage limit, or the BDC exceeds a 1:1 ratio of debt to assets.

BDCs that are considering – or that have received approval to – avail themselves of incremental leverage, and their lenders and advisers, must anticipate the interplay of existing credit facility and debt security covenant packages with any change to the BDC’s leverage profile.

The Market Responds to Scale, First … Others Follow

Although some BDCs chose the expedited method of shareholder approval for increased leverage, some of the largest BDCs have completed impressive expansions of their credit facilities. Other BDCs that sought board, rather than shareholder approval – whether due to their smaller scale or relative portfolio performance – are only now able to access this additional leverage, due to the year-long waiting period between board approval and effectiveness.

Beginning in early 2019, there was a backlog of requests from BDC managers for amendments to credit facilities and/or indentures, led by the largest BDCs with the most intricate capital structures. It just so happens that most of these BDCs are also part of larger platforms that are meaningful fee payers and counterparties to the banks lending to BDCs. Naturally, these institutions were at the front of the line.

In mid-to-late 2019, many more managers approached their lenders and bond underwriters for similar changes, to accommodate additional leverage. The underwrite by these lenders has been BDC-specific and very focused on asset-level performance, investment strategies and modeling the BDC’s ideal leverage scenarios. Many of these BDCs are still seeking the requisite amendments. Some have not yet begun the process.

If You’re Still in the Queue, it’s Not Too Late

If you’re a BDC manager that seeks additional leverage but suspects that you may have to nudge your lender or underwriter, consider isolating certain investments in specific borrowers or offering approval rights to lenders that are providing additional debt capital than is currently available. If you have any industry specialization within your portfolio, consider isolating those loans in an SPV and seeking financing from a lender with expertise and a long view of that industry. If specialty finance is one of your strategies, a typical BDC-level revolver may exclude those investments from your borrowing base; however, there may be lenders that have a more accommodating view of the same collateral.

In addition to optimizing asset composition and possibly expanding either the sources of debt capital or the types of credit facilities your BDC utilizes, BDC managers should be particular about the advisers they rely upon in connection with these amendments, refinancings or establishment of new credit facilities. There are many notable 40 Act lawyers with renowned BDC experience. Likewise, there are many thoughtful, driven fund finance lawyers with experience negotiating and documenting NAV facilities for credit funds and BDCs. It is not a foregone conclusion that those specializations universally reside within the same law firms.

If you’re considering any sort of asset reorganization or specialization, or segmentation of your BDC’s sources of credit, consider the breadth of regulatory, specialty finance and market knowledge that you have at your side.

What Fund Finance Partners Offers in the BDC Realm

  • FFP is the only dedicated advocate for BDC sponsors with experience establishing numerous corporate revolvers, SPV financing, total return swaps and other leverage solutions for public and private, traded and non-traded BDCs.
  • FFP is the only advisor whose leadership has substantial portfolio management, compliance and financial reporting experience specifically for BDCs to complement your CFO or capital markets desk, as well as regulatory experience to complement your 40 Act and fund finance counsel.
  • FFP uniquely has the market experience and relationships to elevate your BDC’s profile in the crowded neighborhood of New Lenders seeking financing, capital and brand recognition.
  • FFP appreciates the relationship between BDCs and other direct lending or investment vehicles on asset managers’ platforms, such as JVs, SMAs and other funds, and the opportunities and challenges that those assets present, and is equipped with creative product development, conflict recognition and mitigation and process-improvement solutions for BDC managers.