AFFE: An alphabet soup that has spelled failure

A US regulation aimed at providing investors greater clarity has resulted in a less engaged BDC shareholder base. Moves to spark change are afoot.

Business development companies have suffered declining institutional ownership for years, an unwelcome phenomenon that may be on the verge of change.

Advisors to Ares Capital Corporation and Apollo Investment Corporation submitted an application to the Securities and Exchange Commission earlier this autumn asking the federal regulatory agency to reconsider its acquired fund fees and expenses rule, or AFFE for short.

The rather arcane statute requires other investment companies like mutual funds that acquire BDC stock to calculate the BDCs’ operating expenses when the acquiring fund is calculating its own fees. Multiple indices have since removed BDC stocks from consideration, resulting in lower institutional ownership.

The Vanguard Group explains it succinctly in a February fund prospectus: “Like an automaker, retailer, or any other operating company, many BDCs incur expenses such as employee salaries. These costs are not paid directly by a fund that owns shares in a BDC, just as the costs of labour and steel are not paid directly by a fund that owns shares in an automaker.”

What may have seemed like a rather mundane amendment to compliance protocol when enacted in 2006 has resulted in a retail-heavy shareholder base. While the retail channel is certainly important and firms have been making inroads among that constituency recently, it can also mean a less engaged and sophisticated shareholder base.

Though an important issue pre-Small Business Credit Availability Act – a US law that allows BDCs to increase their leverage from a 1:1 debt-to-equity ratio to 2:1 – now it is an even more pressing issue.

With passage of the SBCAA, BDCs had two different avenues to gain access to additional leverage. Management teams could put it to a vote to the shareholders or ask the BDCs’ boards to sign off on the increase. Corporate governance becomes crucial here; it’s imperative to ensure that BDCs, which can have un-shareholder-friendly fee structures, give their investors a fair shake.

BDCs’ C-suites have not tried to pull wool over shareholders’ eyes. Most management teams have telegraphed how they plan to utilise the additional leverage and adjusted management fees – which are often charged on levered funds as well – to shield stockholders from drastically increased management fees. Some have also instituted lookback provisions that cap incentive fees.

Still, an active and engaged shareholder base can hold independent directors – and management teams – accountable.

The world is very different from the one that existed 12 years ago when the AFFE rule was drafted. The BDC space has grown substantially; there are almost four dozen publicly traded BDCs now, which doesn’t even count the private and non-traded BDCs. US regulatory statutes should be altered to reflect the reality of the sector’s importance.

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