BDCs: Dodd-Frank is just the beginning

 A cliché heard in the finance industry and media these days is that the only predictable thing about the Trump administration and Congress is unpredictability. But that doesn’t seem to dampen the optimism many mid-market lenders have about potential regulatory rollbacks.

While tax and Dodd-Frank reforms get the lion’s share of attention in the private credit world today, there are three other provisions regulating business development companies that could be game-changers if rolled back: acquired fund fees and expenses (AFFE); the 3 percent proprietary limit; and the one-to-one leverage ratio.  

On the face of it, the provisions appear not to have hindered BDCs much. In fact, but for a slight dip in stock prices and net asset values early last year, BDC performance has continued its upward trend since the global financial crisis. 

The average BDC market price has spiked more than 12 percent, while NAV has jumped by 18.5 percent over the same period, according to the Cliffwater BDC Index. Over a three-year period BDC market prices have increased by nearly 17.5 percent and NAV has gone up 17.3 percent.

However, that success may be masking future problems. Non-traded and public BDCs have increased the amount of capital they are raising, meaning more and more players are chasing fewer deals in the lower to-mid-market, said Ted Koenig, chief executive of Monroe Capital, on the fund manager’s earnings call in March. “New managers putting money to work and existing BDCs replacing run off due to M&A activity has caused a supply and demand imbalance,” he said.

Adapting these provisions, enforced through the US Securities and Exchange Commission but mandated by Congressional law, could help BDCs in an increasingly competitive lending environment.

Manuel Henriquez, chairman and chief executive at Hercules Capital, said on an earnings call that modifying the likes of AFFE would have a “profound, meaningful impact to the business development company industry and specifically Hercules Capital”.

Henriquez tells PDI the AFFE rules – which require open-ended funds to incorporate all operating expenses of any BDC they manage into their own overall operating costs they list on market indices – render BDCs invisible to potential investors because they remove them from crucial lists like the S&P and Russell 2000.

Also, the AFFE guidelines, adopted by the SEC in 2006, have inflated the perceived operating cost of a BDC’s fund manager, Henriquez adds. The AFFE makes the fund look like it is incurring higher expenses than its peers simply because it has purchased shares in a BDC. 

“That is just not right,” Henriquez says. “Since BDCs are active fund managers, it inadvertently elevates the funds’ operating expenses. In short, it distorts the reality of the mutual fund buyer.”

Staff at the SEC, Congress and the institutional investor community have generally favoured changing the AFFE rules, Henriquez notes. He is hopeful that lawmakers could start by removing the exemption of real estate investment trusts from the AFFE rules, which, he believes, give REITs an unfair advantage over the similarly-structured BDCs. However, road blocks remain. 

He doesn’t anticipate the SEC will take action over AFFE until a replacement for former chairwoman Mary Jo White is sworn in. And though the new Congress is receptive to changes, some members see them as new regulations, clashing with President Donald Trump’s desire to remove two old rules for every new one.

Lift the limit

Another provision being targeted is the rule limiting institutional investors from owning more than 3 percent of a BDC’s outstanding shares.

Henriquez supports getting rid of this limitation, which stems from the 1980 bill establishing BDCs, because increased institutional ownership could lead to better alignment between fees and shareholders for all BDCs, he says. 

But the BDC community is divided. Many view any changes as a threat to their existing business models. Specifically, BDCs currently trading below NAV or low-cap BDCs see any changes to the ownership restrictions as opening the floodgates to activist shareholders to force lower fees or consolidation.  

“Unfortunately, the subject is complicated and deserves an open discourse as to the merits of considering changes to the limits of 3 percent,” says Henriquez. “We do not have a single voice uniting the BDCs on the subject.”


When BDCs were created by Congress nearly 40 years ago to spur capital access for US mid-market businesses, the debt-to-equity ratio was locked in at 1:1. But a bill, which passed a US House committee last autumn and is likely go to a second vote this year, would increase the leverage limit to 2:1. Though details are not yet publicly available, the main proponent of the Financial Choices Act 2.0, chairman of the House Financial Services Committee, Jeb Hensarling, a Republican from Texas, is already “poised to unveil” the bill, The Wall Street Journal reported in February. 

Boosting leverage to 2:1 will have a “profound positive impact for BDCs”, Henriquez says. 

This could allow them to extend credit at lower costs, while still fulfilling the typical BDC shareholder’s expected return of 10-12 percent. 

But the bill’s importance goes beyond shareholder returns, he adds. This increased leverage could help each BDC be a better “economic engine to the US economy and in providing growth capital to small and medium business to stimulate economic growth”. 

Though the new Republican-controlled government has larger campaign promises to fulfill, the new act could pass more quickly than other initiatives. The Republican Party’s proposed tax reforms, including lower corporate tax rates, will not go to a Congressional vote before August, says the new Treasury Secretary Steven Mnuchin, while the review process of potential changes to Dodd-Frank, which President Trump ordered in February, will not wrap up before June. 

Meanwhile, Henriquez says the Financial Choices Act 2.0 seems to have the wind in its sails with several representatives supportive of it. The bill’s previous critics, such as a faction led by Democratic Senator Elizabeth Warren that had opposed the bill because it would threaten the post-crisis regulations of Dodd Frank and give BDCs an unfair benefit, have been silent.

“I’m encouraged that this ‘2:1 change’ has been attached to a bill that has momentum and remain hopeful that we may see passage later in 2017,” Henriquez says. 

Henriquez is optimistic that other changes will follow. 

“I have walked and met with the prior session of senators and House of Representatives about the many different pending BDC regulatory and legislative changes,” he says. 

“[The new Congress] certainly appears to be more sensitive to the fact that
BDCs are probably one of the best vehicles to enhance capital flows to small businesses and jump start jobs and economic growth.”

Perhaps the industry will be soon be able to predict the end of the unpredictability.