SEC co-investment guidance offers boon to BDCs

The SEC’s latest guidance eases the regulatory burden associated with using co-investments as an alternative to raising capital by issuing new shares. The change is particularly meaningful for publicly traded BDCs whose shares trade below net asset value per share, former THL Credit Chief Executive Jim Hunt said. When that happens, shareholders must approve any issuance of new shares, further diluting their value, which the BDC then uses to fund new investments.

“It’s very tough for a responsible BDC to grow right now because you don’t want to issue stock when you’re below NAV,” Hunt said.

The guidance is timely, as BDCs have diminished in the eyes of the public market over the last several months, with the S&P’s index of 38 publicly traded BDCs falling from $88.12 in mid January to $75.85 as of Dec. 10.

The SEC’s latest guidance on co-investments is mostly relevant to BDCs managed by firms that also offer private investment funds, which would include vehicles offered by firms such as Ares Management, The Carlyle Group and TPG Capital. Private equity funds are structured as partnerships, rather than public offerings. The regulator viewed fund LPs that held stakes in other vehicles managed by the same firm as “close affiliates” of that firm’s BDC because of the distinction.

The law that governs BDCs prohibits close affiliates from co-investing, which forced private fund LPs to get an SEC approved exemption to co-invest alongside the firms’ BDCs. Obtaining an exemption was “a long process, so the new guidance solves a big problem, particularly when BDC stocks are in the tank,” said Hunt.

“Previously, the SEC was not willing to grant relief for transactions involving these types of affiliates,” said Steven Boehm, a partner at Sutherland Asbill & Brennan who specializes in regulatory issues pertaining to BDCs. “Now you don’t need relief, because the SEC says this kind of relationship does not require relief.”

The guidance does not extend to all LPs, however. Investors that provide more than 25 percent of a private fund’s investment capital will still need SEC approval to co-invest, as will investors that manage or hold other stakes in the private fund’s management company.

“What this really addresses is a situation where there really is no connection between the limited partner and the advisor, other than them being a limited partner. When you get into other situations and other facts, you have to do the analysis all over again,” said a regulator who asked not to be named.

The Small Business Investor Alliance, a trade organization that lobbies on behalf of many BDCs, applauded the SEC’s latest guidance.

“The ability to co-invest gives BDCs more flexibility,” said SBIA President Brett Palmer. “It’s something where the SEC has listened to the industry and made a change, which is something the SEC hasn’t always been prone to do.” 

Palmer added that the SEC’s latest action was a welcome development as the SBIA pushes for other changes to regulations that govern BDCs, including asset coverage limits that prevent the vehicles from taking on too much debt.

“This was not the highest-order problem that the industry was facing, but it was a legitimate problem that has a clear fix, and that’s beneficial,” Palmer said.