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Lenders, Private Equity

New BDC Rule Aims to Level Playing Field

At the end of March, President Trump signed a bill that gives business development companies (BDCs) access to additional capital for investment as well as simplified reporting requirements, making it less expensive and easier for BDCs to do business going forward. BDCs raise capital on the public stock markets and use that capital to invest debt and equity into private companies.

The new legislation, the Small Business Credit Availability Act, permits BDCs to now leverage up to two times total debt to equity. Additionally, the offering reform portion of the bill streamlines the Securities and Exchange Commission offering and registration processes. This is the first time amendments to the Investment Act have been made since the 1980s. Legislative efforts to make changes first began in 2012 and finally gained traction in late 2013. Supporters of the bill believe it will provide more capital for small-to mid-sized companies.

“This has been a lot of years in the making,” says Brett Palmer, president of the Washington, D.C.-based Small Business Investors Alliance. “On the leverage side, it gives BDCs more opportunity to structure deals they way they want to and offer a broader array of products to their shareholders while lowering risk and maintaining yield. Shareholders will be the beneficiaries of the change.”

Before the passage of this act leverage for BDCs was capped at a ratio of one-to-one total debt to equity. So in the past if a BDC had $10 million of equity, it could not borrow more than $10 million of debt to then use to do an investment. Now it will be able to borrow $20 million and thus do more investments. Proponents of the act believe the use of additional leverage will permit BDCs to pursue higher quality deals with less credit risk because the additional debt capacity will allow the BDCs to pursue more first lien positions and invest in more stable companies.

“BDCs provide several forms of capital to small businesses including debt and equity. If you use leverage appropriately you can augment returns and provide a lower risk strategy,” says Palmer.

Henri Steenkamp, chief financial officer with Saratoga Investment Corp. (NYSE: SAR), a BDC that has $650 million of assets under management and a Small Business Investment Company (SBIC) license, agrees that the change will allow BDCs to make less risky investments, but also notes that BDCs with SBIC licenses were already able to lend at the two-to-one ratio. The passage of the bill levels the playing field for all BDCs. “The one-to-one leverage rule was created in the 1980s and has remained unchanged since. With our SBIC license we have had a two-to-one leverage program and the SEC has historically recognized the value there. The bill is really aligning all BDCs with this government program,” says Steenkamp. “I would also argue that this gives BDCs the opportunity to have their leverage levels better aligned with other industries, but they are still under leveraged when you consider that banks leverage levels are at a nine-to-one ratio.”

Naysayers feel the act puts shareholders at risk of losing money if something goes wrong. If BDCs invest more into companies and those companies fail they may wind up with no returns for investors. But Palmer says the concerns aren’t valid. “The people who aren’t behind this are skeptical of finance in general. This is straightforward and had a lot of bipartisan support. It passed 58 to two in the House Finance Committee. It’s good for domestic small businesses,” he says.

The change is a welcome one for the BDCs. Accessing more capital will make BDCs more competitive with private equity firms and other lenders, which have raised record levels of capital during the bull market and are lending at record levels. As a result of the fierce competition, many BDCs have struggled to grow or meet quarterly expectations. “This is good for shareholders, the BDCs themselves, and small businesses. It’s good all around,” says Palmer.  

The offering reform portion of the bill is also welcomed. Prior to the passing, BDCs had additional expensive and time consuming reporting requirements that other public companies did not have. “Even though BDCs are well seasoned issuers there were reporting requirements putting them at a disadvantage. These changes are really just bringing BDCs in line with other public company peers,” says Steenkamp.

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