What is a Business Development Company?
Business Development Companies (“BDCs”) are a type of publicly-traded closed-end fund that are registered under the Investment Company Act of 1940 (the “1940 Act”). BDCs are designed to facilitate the raising of capital by small, developing, and financially troubled companies that historically lacked access to the public capital markets. A BDC is required to make available “significant managerial assistance” to the companies in which it invests including management and operational assistance. As such, BDCs are not intended to be passive investment vehicles. BDCs make investments in the form of long-term debt or equity capital with the goal of generating capital appreciation and/or current income. In recent years, a number of private equity managers have also launched BDCs as a means of accessing public capital.
BDCs are preferable to other investment funds for a number of reasons:
- Unlike mutual funds and other open-end funds, BDCs provide the same liquidity to investors as other publicly traded investments.
- BDC investors are not limited to “qualified purchasers” and investors need not meet income and net worth requirements.
- BDC managers have access to permanent capital that is not subject to shareholder redemption.
- Unlike other registered fund managers, BDC managers may charge performance fees (e.g. “2 and 20” incentive fees).
BDCs are subject to a number of restrictions and limitations including the following:
- BDCs must maintain low leverage – total debt may not exceed total equity.
- BDCs are restricted in their ability to enter into transactions with affiliates.
- BDCs must adopt and implement policies and procedures designed to prevent violations of the federal securities laws and must appoint a chief compliance officer to administer these policies and procedures.
- No single BDC investment can account for more than 25% of total holdings and 70% of all assets must be invested within a limited number of categories.
- BDCs must distribute at least 90% of their taxable earnings quarterly.
Section 55 of the 1940 Act requires that a BDC invest at least 70% of its total assets in the following:
- Privately issued securities purchased from issuers that are “eligible portfolio companies;”
- Securities of eligible portfolio companies that are controlled by a BDC and of which an affiliated person of the BDC is a director;
- Privately issued securities of companies subject to a bankruptcy proceeding, reorganization, insolvency or similar proceeding or otherwise unable to meet their obligations without material assistance;
- Cash, cash items, government securities or high quality debt securities maturing in one year or less; and
- Office furniture and equipment, interests in real estate and other similar non-investment assets incidental to the BDC’s operations.
BDCs are typically organized as limited partnerships or Subchapter M regulated investment companies in order to obtain pass-through tax treatment. Distributions to shareholders are taxable as either ordinary income or capital gains in the same manner as distributions from mutual funds.
To become a BDC, a company must file Form N-6 with the SEC (intent to file a notification of election). Then, a company must file a notice on Form N-54A indicating that it elects to be regulated as a BDC under the 1940 Act. In order to elect to be regulated as a BDC, a company must register its equity securities under Section 12 of Securities Exchange Act of 1934. This registration requires BDCs to periodically file Form 10-K, 10-Q and 8-K as well as proxy statements with the SEC. A BDC must also register its securities under the Securities Act of 1933 by preparing and filing a Form N-2 registration statement which describes essential information about the BDC to help investors make informed investment decisions. The registration statement must disclose (i) the terms of the offering including number of shares and price, (ii) the intended use of the proceeds, (iii) investment objectives and strategies, (iv) risks associated with the investment, and (v) a description of the BDC’s management.
Cole-Frieman & Mallon LLP, an investment management law firm which provides legal services to the hedge fund industry. Bart Mallon can be reached directly at 415-868-5345.