Business development companies (BDCs) were created by the Small Business Investment Incentive Act of 1980, which amended the Investment Company Act of 1940 (the 1940 Act). A BDC is a closed-end fund that is required to invest at least 70% of its assets in private or thinly traded public companies in the form of long-term debt and/or equity capital, with the goal of generating current income and/or capital gains.
BDCs may be internally managed, or they may be externally managed by a separate registered investment advisor. Over 90% of the BDCs operating today are externally managed, and nearly all newly filed BDCs are structured to be externally managed.
BDCs generally qualify to elect to be taxed as “regulated investment companies” under Subchapter M of the Internal Revenue Code for federal tax purposes, which regulates, among other things, the type of income the BDC may generate and the distribution of its net income to shareholders.
BDCs maintain a hybrid structure that captures elements of both funds and corporate registrants. Like all closed-end funds and mutual funds, BDCs are regulated by the Securities and Exchange Commission (SEC) under the 1940 Act, which requires, among other things, certain restrictions on the use of leverage and significant disclosure about the BDC’s investments, operations, and management, and prohibits many types of joint and affiliated transactions. Like traditional corporate registrants, BDCs file periodic reporting on 10-Qs, 10-Ks and current reports on 8-Ks with the SEC.
Generally, BDCs are either traded, non-traded or private. Both traded and non-traded BDCs offer securities in transactions that are registered under the Securities Act of 1933; however, traded BDCs list their securities on a national securities exchange and non-traded BDCs do not. Non-traded BDCs, a structure that non-traded REITs have used for years, permits the BDC to raise capital in a continuous private offering and eliminate price volatility, but this also limits liquidity and the retail investors to whom the BDC can market. Many non-traded structures provided mechanisms for liquidity after a certain hold period. Private BDCs do not list their securities on a national securities exchange and only offer their securities in transactions that are exempt from the registration requirements of the 1933 Act. The private BDC structure provides the additional advantages of optionality and efficiency.
Benefits of the BDC
One of the key benefits of all BDCs relative to private funds is the ability to access public retail investors, since private funds are generally restricted to marketing to only qualified or accredited investors. In exchange for access to this substantial pool of investing capital, BDCs are regulated by the SEC under the provisions of the 1940 Act. The 1940 Act provides important protections to retail investors, including restrictions on the use of leverage.
Retail investors control an important component of the public equity capital markets and can provide a “stickier” investor base, as compared to institutional investors, because retail investors tend to hold shares longer, appreciate current income from dividends, and can be less reactive to news (good or bad), which can provide some stability to the stock in volatile markets. A strong investor base has components of both institutional and retail investors.
In recent years, the majority of newly formed BDCs have been structured as private BDCs. From 2016 through 2022, 73 of the 87 BDCs that have been formed commenced operations as private BDCs. The process to launch a private BDC is potentially shorter than that to launch a traded or non-traded BDC, and there is no need to list the private BDC’s shares on an exchange or to complete the “blue sky” registration process applicable to non-traded BDCs conducting a continuous offering. The private placement process may be less costly because it does not involve underwriters, a roadshow or the "blue sky" process. In addition, the private BDC structure is also generally attractive to foreign investors and does not need to be formed with separate investment vehicles for onshore and offshore investors.
To learn more about BDCs, please view our "ABCs of BDCs" presentation.
A small business investment company (SBIC) is a privately owned and operated company that makes long-term investments in US-based small businesses and is licensed by the US Small Business Administration (SBA). The SBIC program was created in 1958 to fill the gap between the availability of venture capital and the needs of small businesses in start-up and growth situations. Historically, the SBIC program has granted licenses to existing fund structures, including business development companies (BDCs), and has granted SBIC licenses to a number of wholly owned subsidiaries of public BDCs.
The SBA presently provides financing to SBICs through the use of loans, or debentures. Debentures are issued by SBICs to the SBA that have interest payable semi-annually and ten-year maturities. The interest rate is established when issued and is based on the 10-year Treasury rate plus a market-driven spread. An SBIC may invest only in "small businesses," and must invest at least 25% of its invested funds in "smaller enterprises" as defined by the SBA.
In December 2015, Congress authorized SBA-guaranteed debentures that affiliated SBIC funds can have up to $350 million outstanding, subject to SBA approval. In 2018, the Small Business Investment Opportunity Act increased the maximum amount of leverage available to a single SBIC from $150 million to $175 million. In addition, The American Recovery and Reinvestment Act of 2009 allows for existing SBIC-licensed entities to obtain a second license and gain access to additional leverage of $75 million, for a maximum of $225 million combined SBIC leverage (subject to additional required capitalization of its second wholly owned SBIC subsidiary).
As Congress continues to seek ways to stimulate the American economy, additional increases in the available capital to SBICs continue to be discussed.
Special purpose vehicles (SPVs) are often established for the purpose of holding specific assets in connection with a secured financing transaction, or in other situations when certain assets are required to be segregated from other assets. These may be consolidated or not consolidated for GAAP purposes, depending on the facts and circ*mstances of the arrangement. Importantly, the SEC staff has looked closely at the leverage taken on at the SPV level by BDCs, particularly those that are not consolidated for GAAP purposes, and has suggested that some BDCs may be using these vehicles to permit additional leverage within the structure beyond the 1:1 debt-to-equity level, which might be considered a violation of Section 48 of the Investment Company Act of 1940. Issuers are cautioned to consult counsel on the formation, structure and control of SPVs within the BDC model.
Special purpose acquisition companies (SPACs) were originally developed as an alternative to traditional acquisition vehicles, due to their ability to raise capital through the public equity markets. SPACs are shell companies that have no operations but go public with the intention of merging with or acquiring a company using the proceeds of the SPAC's initial public offering (IPO). SPAC offerings are commonly sold in $8–10 units, which consist of one common share and one warrant and they trade as units and/or as separate common shares and warrants on a national exchange. The public currency is intended to enhance the position of the SPAC when negotiating a business combination with a potential merger or acquisition target, and also provides trading liquidity for its investors. SPACs are not subject to the Investment Company Act of 1940, so they have greater operational flexibility. Although SPACs have receded in popularity since 2021, the SPAC structure remains a potentially attractive vehicle for private equity managers to seek public capital for targeted acquisitions.
Registered Closed-End Investment Companies (CEFs) are a classification of investment companies registered under the Investment Company Act of 1940 (the 1940 Act). Unlike open-end funds, the securities issued by CEFs are not redeemable, meaning that they cannot be sold back to the fund upon the shareholder’s request. Nonetheless, CEFs may institute a share repurchase program and periodically offer to repurchase shares by conducting tender offers. In a number of instances, there are differences in the substantive regulation of CEFs and open-end funds. For example, CEFs are permitted to invest in a greater amount of “illiquid’ securities than open-end funds.
CEFs offer various distinct advantages to investors, such as:
- Investment advisers can manage a more stable asset base because CEFs generally raise a fixed amount of capital through their initial public offering, which allows the portfolio managers to more effectively accomplish their stated investment objectives without managing redemption requests;
- Greater flexibility to invest in less liquid securities compared to open-end funds because CEFs generally do not need to maintain liquidity to meet daily redemption; and
- More regulatory flexibility to leverage their investments by borrowing capital or issuing preferred stock compared to open-end funds.
Interval Funds are closed-end investment companies registered under the 1940 Act. Like all closed-end investment companies, the securities issued by interval funds are not redeemable; however, in order to operate as an interval fund, interval funds are required to adopt a fundamental policy to repurchase their shares, at a price equal to net asset value (NAV), from shareholders at periodic, pre-determined intervals in accordance with the 1940 Act (once per year, twice per year or four times per year). Each repurchase offer must be for no less than 5% and no more than 25% of the fund’s outstanding shares. It is this regulatory “guarantee” of liquidity, including with respect to the sale price (i.e., at NAV), that differentiates interval funds from other registered closed-end funds and business development companies.
Other key considerations in managing an interval fund include:
- Easier and more efficient distribution method of interval funds through electronic platforms (referred to as “point and click”) without the use of written subscription agreements;
- FINRA does not review the registration statement;
- Process for automatic effectiveness of subsequent registration statements and post-effective amendments; and
- NAV of interval funds, as a practical matter, must typically be determined daily because they are typically offering and selling their securities on a daily basis.
