April 15, 2020
In the current environment, business development companies (BDCs) are facing unique challenges. The Securities and Exchange Commission has announced temporary and conditional relief for BDCs to allow them to manage through the COVID-19 crisis. The relief allows BDCs to more easily meet their asset coverage test and co-invest with affiliated funds.
BDCs were created to provide capital to small and medium-sized U.S. businesses that otherwise might have difficultly accessing capital. Generally speaking, BDCs make investments in private companies in the form of debt. In the current economic environment, many of these companies have operations affected by COVID-19 and may have trouble making their debt payments.
In these difficult times, BDCs face regulatory challenges in providing capital to these companies. A BDC may not be able to meet asset coverage requirements under the Investment Company Act of 1940, or 1940 Act, due to temporary markdowns in the value of existing loans, and certain of the BDC’s affiliates may be prohibited from participating in additional investments due to restrictions in the BDC’s current exemptive relief order permitting co-investments.
Recognizing this, on April 8, 2020, the SEC provided temporary and conditional relief granting BDCs additional flexibility to issue and sell senior securities (in other words, to lever their portfolio) and to co-invest with affiliates in order to provide capital to existing portfolio companies. The relief is available from April 8, 2020 until the earlier of December 31, 2020 or the date on which the BDC ceases to rely on the relief.
The SEC has announced relief that essentially allows BDCs to look to pre-COVID-19 crisis valuations done for December 31, 2019 financial statements when attempting to comply with the asset coverage ratio at the time of issuance of senior securities (or borrowing more money to invest in portfolio companies and other operations).
Normally, when determining whether it may issue senior securities, the 1940 Act requires a BDC to determine asset coverage based on values calculated within 48 hours. The SEC’s temporary relief allows a BDC to instead use a more favorable “adjusted portfolio value” to calculate an “adjusted asset coverage ratio” if certain conditions are met.
The “adjusted portfolio value” is calculated using values as of December 31, 2019 for portfolio company holdings that the BDC held on December 31, 2019, continues to hold at the time of the proposed issuance of senior securities, and for which the BDC is not recognizing a realized loss.
The “adjusted asset coverage ratio” is a more complicated calculation meant to allow the BDC to depend on an asset coverage ratio calculated using “adjusted portfolio value” but modified slightly to reflect current portfolio company valuations.
Specifically, the BDC first calculates an asset coverage ratio using the “adjusted portfolio value” (in other words, generally using portfolio company values from December 31, 2019). That calculated ratio is then further adjusted by calculating the asset coverage ratio using the traditional method (in other words, using portfolio company values within 48 hours of the issuance of the senior securities), determining the difference between the two calculated ratios (the asset coverage ratio calculated using December 31, 2019 values minus the asset coverage ratio calculated using the traditional approach), and subtracting 25% of that difference from the asset coverage ratio calculated using December 31, 2019 values to find the “adjusted asset coverage ratio.”
For example, consider a BDC that has an asset coverage ratio of 250% as of December 31, 2019. Based on recent market conditions, its asset coverage ratio (under Section 18(b)) has declined to 180% on March 31, 2019. Using the adjusted portfolio value, the BDC calculates its asset coverage ratio as 220%. Therefore, the BDC would have an adjusted asset coverage ratio of 210% (220% minus 10% (25% of the difference between 220% and 180%)).
The adjusted asset coverage ratio provides relief only to issue or sell senior securities representing indebtedness or that are stock; the SEC is not providing relief in connection with the declaration or payment of a dividend or other distribution.
To utilize the SEC’s relief for the issuance and sale of senior securities, a BDC must comply with several conditions:
The SEC also expanded exemptive relief available to BDCs with existing co-investment orders. During the relief period, any BDC with an existing exemptive relief order permitting co-investment transactions in portfolio companies with certain affiliated persons may participate in a follow-on investment with one or more regulated funds and/or affiliated funds. If the participant is a “regulated fund,” it must have previously participated in a co-investment transaction with the BDC with respect to the issuer. If the participant is an “affiliated fund,” it must have either previously participated in a co-investment transaction with the BDC with respect to the issuer or not be invested in the issuer. The effect of the new relief granted by the SEC is to permit affiliated funds that are not already invested in the issuer to participate in follow-on investments with the BDC.
This relief is available if any such co-investment transaction is otherwise effected in accordance with the terms of the existing co-investment order, and certain board oversight requirements are met. For non-negotiated follow-on investments, prior approval by the board is not required. However, they are subject to the periodic reporting requirements in the co-investment order. For other follow-on investments, in connection with making the findings required under the co-investment order, the board of directors, and a required majority, must review the proposed follow-on investment on both a stand-alone basis and in relation to the total economic exposure of the BDC to the issuer.
Nelson Mullins attorneys have broad experience in advising business development companies and closed-end investment companies regarding their compliance with the SEC’s requirements. For more information regarding the SEC adopting offering reforms for business development companies and closed-end investment companies, contact one of the experienced Nelson Mullins attorneys listed.
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