May 30, 2024 - As a source of permanent capital for alternative asset managers, Business Development Companies (BDCs) have proved to be very popular structures and BDC AUM represents a significant share of the private credit landscape. According to LSEG LPC, BDC AUM reached a new high of $343 billion at the end of 1Q2024 – representing an 8% increase from 4Q23 and a 23% gain year over year. Despite the popularity of BDCs – and the transparency BDCs afford – these vehicles are not well understood.

We have prepared a primer series on BDCs that unpacks the lessons in the “Nuts and Bolts of BDCs” webcast. Part 1 introduced the three types: publicly-traded BDCs, non-traded BDCs and private BDCs. Part 2 surveyed the applicable reporting requirements under the ’34 Exchange Act.  This Part 3 looks at the key restrictions and limitations on BDCs pursuant to the ’40 Act as well as tax considerations for BDCs that elect to be treated as Registered Investment Companies.

• Registration Requirements: As a closed-end investment company, BDCs must register with the SEC by filing a Form N-2, which includes detailed information about the company, its management, and its investment strategy.

• Asset Coverage Requirements: One of the attractive features of BDCs is that they can take on more leverage than a mutual fund. However, leverage is still capped. Under the ’40 Act BDCs must have 200% asset coverage (total assets/total debt). However, in 2018, the rules changed to allow a BDC to maintain an asset coverage ratio of 150% (i.e., 2x leverage) if approved by the BDC’s board and certain conditions are met. In practice, BDC leverage runs well short of maximum capacity. LSEG LPC calculated average leverage of 1.04X across all BDCs in 1Q2024 (and 1.0x for the universe of BDCs with assets over $500 million).

• Portfolio Composition Requirements: At least 70% of a BDC’s assets must be invested in qualifying assets or “eligible portfolio companies.” Qualifying assets generally include debt or equity investments in U.S. companies that are not an investment company or a private fund and are privately owned or is a public company with an aggregate market cap of less than $250 million. BDCs are restricted from investing more than 30% of their assets in non-qualifying investments. Some BDCs take full advantage of the flexibility of the non-qualifying asset bucket (e.g., JVs, investments in non-U.S. companies) while others may not. If a BDC’s non-qualifying asset investments exceed 30% of its total assets, then no more non-qualifying investments can be made until this is cured and the event is reported in the next 10-Q filing. 

• Limitations on Transactions with Affiliates: Perhaps the limitation that catches most new BDC managers off guard – the ’40 Act limits a BDC’s ability to transact with affiliates. While the limitations are not as restrictive as those for registered investment companies, depending on the nature of the proposed transaction, transactions involving a BDC and one or more of its affiliates requires either authorization by the required majority of the board of directors and of independent directors, or an exemptive order by the SEC. As an example, co-investments in affiliated funds typically require SEC exemptive relief. The restriction is designed to avoid conflicts of interest, e.g., where a manager may have investments in different parts of a company’s capital structure across its platform. Generally, this will be considered when a BDC is being formed, but the exemptive relief process may take six to nine months.

• Asset Valuation: Section 2(a)(41) of the ’40 Act requires a fund to value all of the investments in its portfolio for which market quotations are readily available at their market value, and all other securities and assets must be valued at their “fair value as determined in good faith by the [fund’s] board of directors.” Rule 2a-5 sets forth the framework for fund valuation practices. See Part 2 of this Series for reporting.

Most BDCs elect to be treated as Registered Investment Companies (RICs) for US taxation purposes meaning they are not subject to federal corporate income tax on income and capital gains distributed to shareholders. For this reason, BDCs can be useful vehicles for attracting foreign investors. Nothing in life is free, however, and this tax election comes at a high compliance cost. In addition to reporting and recordkeeping obligations, to maintain RIC status:

• Dividend Distribution Requirements:BDCs must distribute at least 90% of their taxable investment company income (ex net capital gains) to shareholders annually to avoid taxation at the corporate level. Additionally, a BDC must distribute 98% of its investment income to avoid excise tax.

• Source-of-Income Test: At least 90% of a BDC’s annual gross income must be “good income”, i.e., derived from dividends, interest, and gains and some types of fees.

• Asset Diversification Test:Tested on a quarterly basis, 1) at least 50% of the value of the BDC’s total assets must be represented by cash, government securities, RIC securities, and “other” securities, which cannot be more than 5% of a RIC’s total assets or more than 10% of an issuer’s voting stock and 2) no more than 25% of a RIC’s assets may be invested in any one issuer (or in similar businesses if the RIC controls).

For more information, please watch our Dechert-led webcast replay. Part 4 – the final in our series – will look at operational, management and governance considerations for BDCs as well as a look at BDC finance trends.