Business development companies (“BDCs”) are regulated investment companies that provide capital and, from time to time, managerial assistance, to American small businesses.BDCs elect to be taxed advantageously for their investors, as permitted by the Investment Company Act of 1940.
The non-bank lending industry has worked together, with the help of the Small Business Investor Alliance (“SBIA”), to educate lawmakers of the positive impact BDCs have on small business growth, and to recommend changes that will enhance access to capital and market efficiency.Below is a summary of those recommendations.
Offering Reforms: Conform the rules that apply to BDCs to those applying to publicly traded operating companies, including “incorporation by reference” into current registration statements, the filing of automatic shelf registrations statements, and reliance on communication safe harbors, among other streamlining changes.These offering reforms were included as part of the Small Business Credit Availability Act, passed in 2018.
Additional Leverage: The total amount of leverage available to BDCs has increased to 2:1 (debt to equity), up from the 1:1 limitation in place since 1980.Allowing a modest increase in the leverage enables BDCs to provide significantly more capital in support of small businesses.In addition, the modest increase in leverage may reduce risk in BDC portfolios, as BDCs can invest in lower-yielding, lower-risk investments, while still generating appropriate returns for shareholders. Increased leverage was included as part of the Small Business Credit Availability Act.
Exempt BDCs from Disadvantageous Fee and Expense Disclosures: Acquired Fund Fees and Expenses (“AFFE”) is a template disclosure item pertaining to funds that invest in other funds, including BDCs.It requires the acquiring fund to include a separate line item showing its share of the acquired fund’s expenses.It then adds this share of the BDCs expenses to the acquiring fund’s overall expense ratio.In the case of BDCs, this results in the misperception that the acquiring fund’s expenses are higher than they are.In 2014, the AFFE rule had the unintended consequence of causing S&P, Russell, and other public equity indices to disqualify BDCs from inclusion.As a result, many institutional investors liquidated their BDC holdings and exited the sector to avoid the distortive disclosure requirement.This exemption has not been approved, though the industry, along with SBIA, is actively working towards a positive outcome.
Tax Parity for BDCs: Since their creation by Congress in 1980, BDCs, like Real Estate Investment Trusts (“REITs”), have been taxed as pass-through entities.Due to what the industry and other observers believe to be an oversight in the Tax Cuts and Jobs Act, BDCs are now taxed differently than REITs, despite their structural similarities and historically comparable treatment.Under the new law, shareholders of most pass-through entities, including REITs, are able to deduct 20% of their qualified business income.However, BDC shareholders are not afforded this deduction and are instead taxed at the individual rate.The industry, led by SBIA, is working with Congress to restore equitable tax treatment and ensure that BDC investors are eligible for the 20% pass-through deduction.
Amend Fund of Funds Limitation: Current rules prohibit a mutual fund, registered closed-end fund (“CEF”), or BDC from (1) acquiring more than 3% of the outstanding voting securities of another mutual fund, CEF, or BDC; (2) investing more than 5% of its total assets in any one mutual fund, CEF, or BDC; or (3) investing more than 10% of its total assets in mutual funds, CEFs, or BDCs.The industry, led by SBIA, is actively working with the SEC to enact rules that would permit a fund to acquire shares of another fund in excess of current limits.
It is imperative that the BDC, non-bank lending and small business investment community continue to educate lawmakers, individual and institutional investors, and the public on the importance of our industry to the growth of small businesses.We have successfully obtained certain regulatory changes (offering reforms, increased leverage), and continue to seek additional reforms (AFFE, tax parity, 3% rule).
Steve Arnall is Chief Financial Officer of Capitala Finance Corp. and Chief Operating Officer of Capitala Group.Capitala Group is a $2.7 billion asset management firm providing capital to lower middle market companies throughout North America since 1998.