Ownership rule changes fall short for BDC market

By David Brooke

NEW YORK, Oct 22 (LPC) - The US Security and Exchange Commission's (SEC) decision to increase ownership limits on acquiring funds including business development companies (BDC), may be insufficient to boost growth.

Under the latest change, published October 7, regulated funds can now own 10% of a BDC's stock with full voting rights, albeit at the BDC manager's discretion. Previously if a regulated fund, either a BDC or an activist fund, invested more than 3% in a BDC's stock, its voting rights would remain at 3%. The limited voting right disincentivized investors because it prevented them from exerting influence over the BDC manager.

Many investors in BDCs believe that the previous 3% limit stymied institutional investment into the BDC market by clipping voting rights, specifically as it deterred activist funds from investing in BDCs and pushing managers for more discipline and better protections. Activist fund tactics traditionally involve demanding the removal of members of a BDC's board or a sale of the unit if the BDC is underperforming.

"Our view is that the change in the 3% rule could help support effective governance across the BDC space," said Chelsea Richardson, an analyst at Fitch Ratings.

"I'm not sure we expect it to have an overly meaningful impact on the sector, but we do believe there is the potential that this could help facilitate activism for firms that consistently underperform," she added.

Despite hurdles, activists can claim several successes in challenging underperforming BDCs in recent years.

In the BDC market, activist funds have driven the sale of Alcentra's BDC to Crescent Capital Group, announced in August 2019, and recently pushed Garrison Capital's BDC into the arms of Portman Ridge Finance Corp, according to a press statement.

Barings is set to buy MVC Capital's BDC, while Golub Capital acquired a portfolio of loans from Medley Capital Corp. All the BDCs subject to sales were put under pressure by activist funds, according a number of press statements and filings with the SEC.

"An uptick in activism stems from a confluence of buyside firms familiar with the industry, and more BDCs failing to deliver shareholder and managerial economics. This backdrop is likely more important than any technical rule change," said Finian O'Shea, a senior analyst at Wells Fargo.

Since the rule change applies to all regulated funds – such as mutual funds and other institutional investors – the 3% rule amendment could bring more capital and influence into the broader BDC market that would go beyond that of activist funds.

Larger institutional investors can provide a constructive influence on BDC governance structures.

"Outside of activists, larger institutional investors have the potential to engage with management and have a constructive influence. It may be helpful for the industry to have this type of capital in their BDC," said William Bielefeld, partner at law firm Dechert.

BIGGER SNAG

Though the ownership rule change is progress for the asset class, market participants agree that the biggest hurdle for further growth in the BDC asset class is the Acquired Fund Fees and Expenses (AFFE) disclosure requirements.

The AFFE requirement in shareholder prospectuses makes mutual funds invested in BDCs report higher expense ratios than other funds. BDCs typically have higher expenses than passive funds, such as real estate investment trusts, due to the active management of its investments.

The AFFE requirement led to the removal of BDCs from fund indexes, such as the Russell 2000, MSCI, and S&P 500, in 2014. The impact was depressed share prices and less institutional investment in the BDC market. In August, the SEC announced proposals that relaxed the AFFE requirements but did not entirely remove them.

"We view this new (ownership) rule positively for the space," said Robert Dodd, an analyst at research firm Raymond James, in a report. "We do not believe it will have any tangible impact on BDC shares until the key issue limiting institutional involvement in the space – which is, in our view, AFFE – is resolved."

The fear is that the amended ownership rules instead "codify the AFFE" by requiring BDCs to make disclosures to the SEC regarding the increased ownership of stock by regulated funds akin to AFFE requirements, according to Casey Alexander, an analyst at research firm Compass Point.

Such a development will not be a boon for the market and could keep BDCs off the indexes and deter institutional investment.

"These rulings, as they are construed, are some form of ownership of BDCs that the indexes are not going to allow. And the problem is that an institutional investor is not likely to go outside of a benchmark in order to invest in BDCs," said Alexander. (Reporting by David Brooke. Editing by Michelle Sierra and Kristen Haunss.)