On April 8, 2020, the staff of the Division of Investment Management of the US Securities and Exchange Commission (Commission) issued an exemptive order (the Order) under the Investment Company Act of 1940 (1940 Act) that will provide immediate temporary flexibility for business development companies (BDCs) to issue and sell senior securities and to participate in certain joint transactions that are otherwise prohibited under the 1940 Act. In light of the continuing impact of the COVID-19 pandemic on the economy and the financial markets, the Commission’s stated purpose for providing the temporary conditional exemptive relief under the Order is to assist BDCs in fulfilling their statutory purpose of providing capital to small and medium-sized domestic companies by easing certain regulatory restrictions that may otherwise hinder those efforts.
The Order is intended to help BDCs and their affiliates provide capital to BDCs’ existing portfolio companies that are impacted by COVID-19 by addressing two issues that may otherwise limit the BDC’s and/or its affiliates’ ability to deploy capital: (i) a BDC’s inability to issue senior securities as a result of exceeding its minimum asset coverage requirements under the 1940 Act due to temporary mark-downs in the value of the loans to its portfolio companies, and (ii) restrictions under a BDC’s co-investment exemptive order that prohibit certain of the BDC’s affiliates from participating in additional investments in the BDC’s portfolio companies.
The relief provided by the Order is described in greater detail below. All relief provided by the Order is temporary, and only available from the date of the Order (April 8, 2020) to the earlier of December 31, 2020, or the date by which a BDC ceases to rely on the Order (the Exemption Period).
Asset Coverage – Issuance and Sale of Senior Securities
Adjusted Asset Coverage Ratio
Under the Order, a BDC may elect to apply an “Adjusted Asset Coverage Ratio” for purposes of determining whether it may issue additional senior securities that represent indebtedness (e.g., a note) or that are equity (e.g., preferred stock, and together, covered senior securities). Specifically, a BDC electing to use the Adjusted Asset Coverage Ratio may calculate its asset coverage ratio by using the values of certain portfolio assets as of December 31, 2019, rather than by calculating the value of such assets within forty-eight hours of the issuance or sale of covered senior securities as required by Section 18(b) of the 1940 Act. Under the Order, the assets that may be valued as of December 31, 2019 include only portfolio holdings that:
- The BDC held at December 31, 2019;
- The BDC continues to hold at the time of the issuance or sale of covered senior securities; and
- For which the BDC is not recognizing a realized loss (e.g., assets that are not permanently impaired).
Portfolio holdings that do not meet the above-listed criteria must continue to be valued pursuant to Section 18(b) of the 1940 Act. The sum total of the assets so calculated is referred to as the “Adjusted Portfolio Value.”
To calculate the Adjusted Asset Coverage Ratio, the Order provides that a BDC must calculate its asset coverage ratio twice – once using the Adjusted Portfolio Value (the Adjusted Ratio), and once pursuant to Section 18(b) of the 1940 Act (the Actual Ratio). The BDC must then reduce the Adjusted Ratio by an amount equal to twenty-five percent of the difference between the Adjusted Ratio and the Actual Ratio. The Calculation may be expressed mathematically as follows:
Adjusted Asset Coverage Ratio =Adjusted Ratio-25%×(Actual Ratio-Adjusted Ratio)
Items Excluded from the Order
The Order does not provide relief from the prohibition on declaring and paying dividends or other distributions that may be applicable to a BDC under Section 18(a) of the 1940 Act. In that regard, BDCs that issue covered senior securities pursuant to the Order should ensure that they remain in compliance with such provisions before declaring any dividends or other distributions. Additionally, the Order noted that BDCs may not use the Adjusted Portfolio Value for any purpose other than calculating the Adjusted Asset Coverage Ratio, and that BDCs must continue to use US generally accepted accounting principles for purposes of financial reporting.
Election Mechanics and Compliance with the Relief
To rely on the Order, a majority of the BDC’s board of directors, and a majority of directors who are not “interested persons” for purposes of the 1940 Act (a Required Majority), must determine that the issuance or sale of a covered senior securities is permitted by the Order and that such issuance or sale is in the best interests of the BDC and its shareholders. Following the board of directors’ approval, the BDC must elect to apply the Order by filing a current report on Form 8-K, which election may be similarly withdrawn by filing a current report on Form 8-K.
Additionally, upon each issuance or sale of a covered senior security, a Required Majority of a BDC’s board of directors must determine such issuance or sale is in the best interest of the BDC and its shareholders. To make this determination, the Order requires the BDC’s board of directors to obtain and consider: (1) a certification from the BDC’s investment adviser that the issuance of covered senior securities is in the best interest of shareholders (including the investment adviser’s recommendation, the reasons for the recommendation and information regarding whether the investment adviser considered reasonable alternatives), and (2) advice from an independent valuation expert regarding the reasonableness of the terms and conditions of such proposed issuance or sale of a covered security.
Additionally, the BDC’s board of directors must receive, on at least a monthly basis, reports prepared by the investment adviser discussing the investment adviser’s efforts to regain compliance with the BDC’s assets coverage requirements under the 1940 Act. If, by the expiration of the Exemption Period, a BDC that has elected to use the Adjusted Asset Coverage Ratio is not in compliance with its minimum asset coverage requirements under the 1940 Act, the BDC will be required to file a current report on Form 8-K, which shall include: (1) the BDC’s current asset coverage ratio, (2) the reasons why the BDC was unable to comply with the applicable minimum asset coverage ratio required by the 1940 Act, (3) the timeframe within which the BDC expects to come into compliance with the applicable minimum asset coverage requirements under the 1940 Act, and (4) the specific steps the BDC will take to regain compliance.
Limitations Under the Order
New Investments
A BDC electing to use the Adjusted Asset Coverage Ratio may not make new investments in a portfolio company unless either: (1) the investment is a follow-on investment in a portfolio company in which the BDC has an existing investment, or (2) the BDC’s Actual Ratio at the time of investment is at least 200% (or 150%, as applicable), as required under the 1940 Act.
Affiliate Compensation
If a BDC has elected to issue a covered senior security in reliance on the Order, generally no affiliated person of the BDC nor any affiliated person of such person (i.e., the BDC’s investment adviser or any of its affiliates), will be permitted to receive any transaction fees (including break-up, structuring, monitoring or commitment fees) or other remuneration from an issuer in which the BDC invests during the Exemption Period. However, such affiliates may receive: (i) a commission, fee or other remuneration that complies with Section 57(k) of the 1940 Act for acting as a broker in connection with the sale of securities to or by the BDC (generally one percent of the purchase or sale price), or (ii) payments or distributions made by an issuer to all holders of the issuer’s securities.
Notably, the Order made clear that the foregoing condition does not apply to the investment adviser’s receipt of investment advisory fees under an investment management agreement. As a result, the Order does not prohibit an investment adviser from receiving an advisory fee on the proceeds raised in connection with any issuance of covered senior securities (subject to the terms of the investment advisory agreement).
Affiliate Transactions – Expansion of Relief for BDCs with Existing Co-Investment Orders
Under the Order, at any time during the Exemption Period, a BDC that has an effective co-investment order may participate in a Follow-On Investment1 with an Affiliated Fund2 that is not already invested in the issuer. Without the Order, a BDC generally is only permitted to complete Follow-On Investments under its existing co-investment order with Affiliated Funds and Regulated Funds3 that acquired securities of the issuer in a co-investment transaction with the BDC.
The Order expands the sources of capital available to a BDC’s portfolio company by permitting Affiliated Funds that are not already invested in the issuer to participate in Follow-On Investments with the BDC. Any such Follow-On Investment must otherwise be completed in compliance with the conditions of the BDC’s existing co-investment order. In addition to the general requirement that a BDC’s board of directors approve a Follow-On Investment, the Order requires the BDC board, including a Required Majority, to review the proposed Follow-On Investment both on a stand-alone basis and in relation to the total economic exposure of the BDC to the issuer. Notwithstanding the foregoing, a Follow-On Investment made pursuant to the Order will not require BDC board approval if no terms other than price are negotiated.
Unlike the application of the Adjusted Asset Coverage Ratio, the Order provides automatic relief to effective co-investment orders, and a BDC is not required to elect to apply for such relief with a Form 8-K filing. Moreover, the Order does not specify additional recordkeeping or other compliance-related requirements that will apply if a BDC makes investments pursuant to the co-investment relief granted under the Order.
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1 The term “Follow-On Investment” generally means an additional investment in the same issuer, including, but not limited to, through the exercise of warrants, conversion privileges or other rights to purchase securities of the issuer.
2 The term “Affiliated Fund” has the meaning ascribed in each BDC’s specific co-investment order, but generally refers to a private fund under common control with the BDC that would be an investment company but for Sections 3(c)(1) or 3(c)(7) of the 1940 Act.
3 The term “Regulated Fund” generally means a BDC and/or investment company registered under the 1940 Act that is under common control with the BDC.
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