On March 23, 2018, the President signed the Consolidated Appropriations Act of 2018 into law. This legislation includes the Small Business Credit Availability Act (“SBCAA”), which contains several changes to regulations under the federal securities laws that impact Business Development Companies (“BDCs”).
BDCs are 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.
The SBCAA impacts BDCs in two essential ways. First, it significantly increases the ability of BDCs to increase their BDC leverage caps to two times equity. Second, it directs the SEC to implement regulations enabling BDCs to follow the more lenient reporting requirements and communications restrictions under the Securities Act and the Securities Exchange Act applicable to traditional public operating companies.
More leverage allows for more investment options
BDCs have always been limited to 1:1 debt-to-equity ratio, meaning they were only able to borrow $1 for every $1 in equity capital on the balance sheet. This leverage limit is much lower than limits on other financial institutions, which can leverage themselves by 10 times or more.
Section 802 of the SBCAA lowers these 200% asset coverage requirements to 150% (a 2:1 debt-to-equity leverage ratio) for BDCs that meet certain criteria. Traditionally, to generate returns with low leverage, BDCs were limited to investing in the riskiest, highest-yielding debt.
Generally, BDCs provide financing that traditional banks won’t, issuing loans to companies that are struggling to grow or are at risk. As a result, BDCs typically charge interest rates that are much higher than banks.
The new leverage standard provides more flexibility for BDCs to leverage investments in small and midsize companies, and potentially invest in more liquid, but lower-yielding, investments; thus triggering economic growth by increasing BDCs’ ability to provide capital.
Registration and Regulatory Uniformity
Section 803 of the SBCAA requires the SEC, not later than one year after the date of enactment, to revise Form N-2, the registration form used by BDCs, as well as numerous rules under the Securities Act, Exchange Act and Regulation FD to allow BDCs to take advantage of securities offering-related accommodations that have been reserved for the largest public companies, and to use the proxy rules that are available to other reporting issuers.
The law requires the SEC to revise the following rules, among others:
- Permit certain BDCs to qualify as well-known seasoned issuers and file automatically effective shelf registration statements. Currently, BDCs are required to wait for SEC staff review and to respond to the staff’s comments before commencing an offering.
- Allow certain qualifying BDCs to forward-incorporate future Exchange Act filings by reference, thereby eliminating the need to amend any shelf registration statements each time they file new financial statements. Form N-2 currently does not allow incorporation by reference of past or future periodic filings.
- Allow BDCs to file a prospectus “supplement” that will reflect substantive changes or additions to effective registration statements, rather than require them to file a new post-effective amendment, which will be consistent with the flexibility in Rule 424(b) that is available to non-investment companies.
The objective of Section 803 is to extend the rules created to streamline the registration and offering process for larger publicly traded operating companies to BDCs. The SBCAA provides that if the SEC does not complete the required rule and form amendments within a year following the date of the enactment of the SBCAA, a BDC may deem those required amendments as having been completed in accordance with the actions required of the SEC under the SBCAA.
This change in law may have significant and long-lasting impacts on the BDC industry as a whole. Specifically, the lowering of the asset coverage requirement will allow BDCs to potentially utilize greater leverage, which may encourage new and existing BDCs to invest in more liquid — but lower yielding — debt investments.
In addition, the rules should also meaningfully streamline the public debt and equity offering process going forward, once the SEC has fully implemented the mandated changes.
Neither the reduced asset coverage requirement, nor the offering reform amendments are automatically effective. BDCs will require board or shareholder approval on the asset coverage front, and will require SEC rulemaking on offering reform.
Both existing and new BDCs should, however, be mindful of the impact of these reforms on existing and planned operations and related public disclosure moving forward.