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.

Issuance and Sale of Senior Securities – Adjusted Asset Coverage Ratio

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:

1. Board approval of reliance on relief. The board of directors, including a “required majority” of the board, as defined in Section 57(o) of the 1940 Act, must have determined that the issuance of senior securities is permitted by the SEC’s relief and is in the best interests of the BDC and its shareholders.
2. Form 8-K election. The BDC must affirmatively elect to rely on the relief by filing a Form 8-K.
3. Limitation on new investments. Once the BDC has elected to rely on the relief, for 90 days it cannot make an initial investment in any portfolio company in which it was not already invested, unless the investment would have been permitted under an un-adjusted asset coverage calculation.
4. Board approval of each issuance of senior securities. Prior to issuing or selling senior securities in reliance on the relief, the board of directors, including a required majority, must have determined that each such issuance is in the best interests of the BDC and its shareholders. Before it can make this determination, the board must have obtained and considered:
   1. Adviser certification. A certification from the BDC’s investment adviser that the adviser is recommending the issuance, the issuance is in the best interests of the BDC and its shareholders, the reasons for the adviser’s recommendation, and whether the adviser has considered other reasonable alternatives that do not involve issuing a senior security.
   2. Independent evaluation. Advice from an independent valuation expert regarding whether the terms of the proposed issuance are fair and reasonable compared to similar issuances by unaffiliated third parties in current market conditions.
5. Monthly board review. At least monthly, the board of directors must review reports prepared by the investment adviser discussing the efforts the adviser has undertaken, and the progress that has been made, towards achieving compliance with the usual asset coverage requirements by the end of the relief period.
6. Form 8-K upon failure to regain compliance by end of relief period. If the BDC reaches the end of the relief period and is not in compliance with the asset coverage requirements, it must immediately file a Form 8-K stating (i) its current asset coverage ratio, (ii) the reasons why it is unable to comply with asset coverage requirements, (iii) the time frame within which it expects to return to compliance and (iv) the specific steps it will take to bring itself into compliance.
7. Recordkeeping. For at least six years, the BDC must keep (i) minutes describing the board’s deliberations in connection with approval of each issuance of senior securities, including factors considered and all information, documents and reports provided to the board, and (ii) the reports and all other information provided to the board pursuant to the monthly reporting requirement. For two years, this information must be kept in an easily accessible place.
8. No compensation. No affiliated person of the BDC, or affiliated person of such a person, may receive any transaction fees (such as break-up, structuring, monitoring or commitment fees) or other remuneration from an issuer in which the BDC invests during the relief period, except for brokerage commissions permitted by Section 57(k) of the 1940 Act or payments made by an issuer to all holders of a security in accordance with its terms.

Expansion of Existing Co-Investment Exemptive Orders

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.