Goldman Sachs’ recent filing with the Securities and Exchange Commission (SEC) to launch a “business development company,” or BDC, should be of interest to financial services companies, particularly banking institutions structuring and restructuring their operations and product offerings to comply with the Volcker Rule’s prohibitions on investing in and sponsoring “covered funds.” A BDC is a closed-end investment company that elects to be regulated under the Investment Company Act of 1940 (1940 Act), and thus, like a 1940 Act closed-end fund or mutual fund, is not by definition a “covered fund,” which is defined generally as a vehicle that relies on the exception from the definition of investment company found in Section 3(c)(1) or Section 3(c)(7) of the 1940 Act. Below we discuss certain aspects of the operation and regulation of a BDC under the 1940 Act.
A BDC is not, as a technical matter, registered under the 1940 Act, but elects to be subject to regulation by the SEC under many of the provisions of the 1940 Act, including independence requirements for board members, valuation requirements and restrictions on investments in other investment companies. A BDC thus operates much like a typical closed-end 1940 Act fund but, unlike a 1940 Act fund, must invest its assets according to specific criteria set out in the 1940 Act that effectively require at least 70% of a BDC’s total assets to be invested generally in private securities acquired from “eligible portfolio companies” (generally, non-investment companies that are domestic unlisted companies or small cap companies subject to certain conditions), securities of eligible portfolio companies controlled by the BDC, private securities of companies subject to a bankruptcy, reorganization or insolvency proceeding, and certain cash items and short-term securities. A BDC is also required to offer “significant managerial assistance” to the eligible portfolio companies in which it invests. The remaining 30% of a BDC’s assets may be invested without regard to eligible portfolio companies but must be consistent with the overall purpose of the Small Business Investment Incentive Act of 1980 and applicable 1940 Act limitations, such as those regarding investments in other funds, in derivatives and in financial industry participants such as investment advisers and underwriters. While the “70% bucket” (and its effective requirement to originate loans), the requirement to offer managerial assistance and the leverage restrictions imposed on BDCs (discussed below) may prove difficult for sponsors interested in replicating true CLO strategies in a BDC, a BDC may be valuable as an origination platform for CLOs.
A BDC is not subject to all of the limitations and prohibitions of the 1940 Act applicable to typical 1940 Act funds, which could make it an attractive option to a money manager or sponsor seeking flexibility in a non “covered fund” format. A BDC generally can be marketed more freely, as BDC investors, unlike investors in private funds generally, are not required to be “qualified purchasers” or even “accredited investors” if the BDC is publicly offered and traded. A BDC may also be attractive to investors in that it can qualify for pass-through tax treatment under Subchapter M of the Internal Revenue Code. The 1940 Act (or, in the case of performance compensation, the Investment Advisers Act of 1940) also imposes fewer restrictions on operating a BDC, including the ability of the BDC manager to earn performance-based compensation (an internally managed BDC, in the alternative, may establish a stock option or profit-sharing plan for its investment professionals), and somewhat more relaxed affiliated transactions prohibitions and leverage limitations than those imposed on traditional 1940 Act funds. Certain direct and joint affiliated transactions involving a BDC, such as transferring assets among affiliates, co-investing with affiliates or participating with affiliates in allocations of security positions, however, will remain largely prohibited absent exemptive or interpretive relief from the SEC or its staff.