Business development companies (BDCs) won greater flexibility to leverage their loans to small and midsize businesses when President Trump signed the $1.3 trillion government spending bill on March 22, 2018. The 2,148 page Consolidated Appropriations Act of 2018 (the “Budget Act”) increases BDC leverage caps to two times equity. The law also eases offering, proxy and reporting requirements that previously applied only to operating companies. These revised requirements are, together, expected to help BDCs raise capital.
BDC Leverage Limits Expanded
Section 61(a) of the Investment Company Act of 1940, as amended (the “1940 Act”) applies the asset coverage requirements of Section 18(a)(1)(A) to BDCs. Under prior law, BDCs must maintain asset coverage of 200 percent when they obtain leverage.
The new law, which amends Section 61(a), lowers the “asset coverage” requirements to 150 percent from 200 percent. This means that, under the new rules, a BDC with $100 in equity can now borrow $200 if it complies with the new conditions, described below. Under current rules, a BDC that has $100 in equity can borrow $100.
The 150 percent leverage limitation is available only if:
- The BDC amends its public disclosures in securities filings (typically, on Form 8-K) and on its website within five days of adopting the new standard;
- A publicly traded BDC includes disclosures in its period filings (e.g., Form 10-K and Form 10-Q) that are “reasonably designed to ensure shareholders” are informed of
- the amount of the BDC’s indebtedness and asset coverage ratio as of the BDC’s most recent financial statements and
- the principal risks associated with the indebtedness;
- A “required majority” of the BDC’s independent directors approve the new asset coverage level, which can take effect one year after date of approval, OR, at least 50 percent of the votes cast at a shareholder meeting approve the new standard to become effective immediately; and
- A non-listed BDC must agree to repurchase 25 percent of its shares in each of the four quarters following the approval date.
The new leverage standard provides more flexibility for BDCs to leverage investments in small and midsize companies, thus increasing their ability to provide capital. But the additional flexibility may come at a cost for non-listed BDCs: in theory, they may be required to repurchase all of their outstanding shares in the coming year.
Offering and Proxy Rule Parity
The Budget Act also directs the Securities and Exchange Commission to amend its rules and forms within one year after the date of enactment of the Budget Act to allow BDCs to take advantage of securities offering-related accommodations that have been reserved for the largest public companies and to use the proxy rules that are available to other reporting issuers. In addition, the law requires the SEC to revise the following rules, among others:
- WKSI status. BDCs will be able to qualify as “well-known seasoned issuers” (WKSIs), which would allow qualifying BDCs to take advantage of streamlined offering rules and more flexible communications rules. Specifically, pending SEC rulemaking, BDCs would benefit from the following:
- Automatic effectiveness. BDCs that qualify as WKSIs will be able to file shelf registration statements that automatically become effective upon filing on EDGAR, without SEC staff review. Currently, BDCs are required to wait for SEC staff review and to respond to the staff’s comments before commencing an offering.
- Free writing prospectuses. A BDC that qualifies as a WKSI will have greater flexibility to make communications prior to filing a registration statement through the use of free writing prospectuses. A free writing prospectus generally is a written communication that is deemed to be an offer to sell a security that precedes or accompanies a prospectus.
- Oral and written offers. A BDC that qualifies as a WKSI may rely on Rule 163 safe harbors for certain communications that would otherwise be considered “gun jumping,” which would be an illegal offer of securities. For example, BDCs would be able to rely on safe harbors for ordinary business communications.
- Prospectus supplements. Rule 497 will be amended to allow BDCs to file a prospectus “supplement” (that is, a definitive form of prospectus) that will reflect substantive changes or additions to effective registration statements, rather than require them to file a new post-effective amendment, which will be consistent with the flexibility in Rule 424(b) that is available to non-investment companies.
- Incorporation by reference. The SEC will be required to amend Form N-2 to permit BDCs that qualify for Form S-3 to incorporate future SEC filings by reference, which eliminates the need to amend shelf registration statements when new period reports are filed with the SEC. Form N-2 currently does not allow incorporation by reference of past or future periodic filings.
- Access equals delivery. BDCs will be able to rely on Rule 172, which exempts issuers or broker-dealers from the requirement to deliver a prospectus in connection with an offering, so long as the issuer files the final prospectus with the SEC. BDCs will also be able to rely on Rule 173, which allows underwriters or dealers participating in an offering to provide a copy of a final prospectus to a purchaser, or send a notice that the final sale was made pursuant to a registration statement, within two days following the completion of the sale. The rules eliminate the requirement for BDCs to deliver paper or electronic copies of prospectuses. Currently, BDCs cannot rely on Rules 172 or 173.
The Budget Act specifically provides that BDCs can rely on the offering and proxy parity provisions within one year of the Budget Act if the SEC does not adopt final rules.
Impact of the Leverage and Offering Reforms
These reforms are likely to increase the ability of BDCs to raise capital, both through the ability to use more leverage and to reduce regulatory burdens that slowed the registration process and increased costs. BDCs should review their current disclosures to determine how and the extent to which these new provisions will affect their portfolios and their ability to raise capital. Moreover, BDCs that take advantage of these new provisions, particularly the new leverage rules, should review their risk disclosures. And, BDC directors should evaluate how the new rules will affect their oversight responsibilities.