After years of intense regulatory and legislative efforts, the business development company (“BDC”) industry earned a potentially significant win in the form of the Small Business Credit Availability Act (“SBCAA”), which was included as part of the Consolidated Appropriations Act, 2018 (“Omnibus Spending Bill”) passed by Congress on March 23, 2018. The SBCAA enacts a number of meaningful legislative reforms with respect to BDCs — closed-end investment companies regulated under the Investment Company Act of 1940 (“1940 Act”), that generally invest in the debt, and to a lesser extent equity, of primarily U.S.-based, nonpublic middle-market issuers.
Specifically, the SBCAA impacts BDCs in two fundamental ways. First, it significantly increases the ability of BDCs to utilize leverage to acquire investments by modifying the asset coverage requirements applicable to BDCs under the 1940 Act (“Leverage Reform Provisions”). Second, it directs the SEC to implement regulations enabling BDCs to follow the more lenient reporting requirements and communications restrictions under the Securities Act of 1933, as amended (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”) applicable to traditional public operating companies, including with respect to incorporation by reference and the use of free writing prospectuses (collectively, “Securities Offering Reform Provisions”).
These changes will likely have a significant impact on BDCs going forward, though the impact may differ materially between existing publicly traded BDCs and newly formed non-traded BDC structures, including the increasingly popular “private” BDC structure, which mimics a traditional private credit fund capital call model but utilizes a 1940 Act-regulated BDC vehicle. In particular, as a result of certain conditions that must be met under the Leverage Reform Provisions, existing BDCs — particularly publicly traded ones — will likely face some headwinds in taking advantage of the looser leverage limits under the 1940 Act. However, newly formed BDCs, as well as private BDCs that may only have a relatively small number of stockholders, may more easily meet the requirements to permit a reduction in the required asset coverage ratio under the 1940 Act. In contrast, many of the most useful sections of the Securities Offering Reform Provisions, including with respect to incorporation by reference and automatic effectiveness of shelf registration statements, will only apply to publicly traded BDCs.
Under the 1940 Act, BDCs must generally meet certain levels of asset coverage with respect to their outstanding “senior securities,” which typically consist of outstanding borrowings under credit facilities and other debt instruments, including publicly and privately offered notes. “Asset coverage,” as defined under the 1940 Act, generally refers to the ratio of a BDC’s total assets compared to its aggregate amount of outstanding senior securities.1 Prior to the passage of the SBCAA, the 1940 Act required that a BDC have asset coverage of at least 200 percent, representing approximately a 1-to-1 debt-to-equity ratio, at the time of any borrowings or other issuances of senior securities.2 Under the Leverage Reform Provisions of the SBCAA, BDCs that meet certain specified conditions may elect to decrease their effective asset coverage requirement to 150 percent, representing approximately a 2-to-1 debt-to-equity ratio, which substantially increases their ability to deploy leverage to acquire investments.3 A BDC may elect to be subject to the lower asset coverage requirement in two ways.
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