The shifting sands of the BDC market

The march into CLOs and action against the AFFE rule are developments that Andrew Hedlund believes will change the shape of the BDC market in 2019.

Business development companies have had an eventful 2018, with some major movement within the industry. Barings entered the space by purchasing Triangle Capital Corporation’s management contract, while FS Investments formally parted ways with sub-advisor GSO Capital Partners in favour of a partnership with KKR. Bain is set to go public, while GSO plans to raise billions for its new BDC.

The industry also saw the largest change in recent years, if not ever, when US Congress passed the Small Credit Availability Act, which allowed BDCs to double their leverage capacity from a 1:1 debt-to-equity ratio to 2:1. Each respective BDC management team has taken their own approach to upping their leverage capability, but it often included a reduction on management fees for assets above the previous 1:1 limit.

However, it could be two developments in the latter half of the year that provide BDC watchers with interesting fodder for 2019.

BDCs get permission from SEC to issue on-balance-sheet CLOs

In September, Golub Capital BDC received a no-action letter from the Securities and Exchange Commission concerning plans to issue a collateralised loan obligation for financing purposes. The mid-market lender had done so twice before risk-retention rules took effect, once in 2010 and again in 2014.

GBDC, externally managed by GC Advisors, priced Golub Capital BDC CLO III, a $602.4 million term debt securitisation, in early November. The BDC will retain all of the $38.8 million of Class C-2 notes, $42 million of Class D notes and $113.4 million of subordinated notes.

The firm will use the proceeds to repay the revolving credit facility provided by Morgan Stanley to GBDC, which was increased to $450 million from the initial $300 million in conjunction with the deal. The BDC will use the extra funds on its credit facility to acquire additional assets before the CLO closes and the loan is repaid.

GBDC declined to comment on the deal.

Speaking with PDI earlier this year, GBDC chief executive David Golub emphasised the importance of fund managers having the correct mix of liabilities.

“You ought to want diversification amongst your sources of borrowings,” he said. “You don’t want to be overly reliant on any one counterparty. The huge benefits associated with getting liabilities right are going to pay off during the next downturn.”

Golub first issued what would become a $350 million CLO in 2010, which in July was refinanced into the Morgan Stanley credit facility GBDC will use to pay off proceeds from the November CLO. In 2014, the firm issued a second CLO for $402 million that was repriced in March this year.

Since Golub received the SEC no-action letter, Bain Capital Specialty Finance, Bain Capital’s private BDC, closed its BCC Middle Market CLO 2018-1, a $451.15 million deal in September. It was secured by 69 first-lien and second-lien loans. Bain retained 5 percent of the deal’s $85.45 million membership interests. The firm used a portion of the proceeds to prepay its revolving credit facility.

In addition, Garrison Capital has refinanced one of the mid-market CLOs it executed before risk-retention rules took effect. The firm priced a $420 million CLO in September that refinanced a $300 million September 2016 CLO.

At issue here was whether a BDC can be a CLO manager and hold a portion of the CLO to satisfy risk-retention rules that were enacted in December 2016, or if the retention interest must be held by the BDC’s external advisor.

“When risk retention took effect, we had identified an issue with externally managed BDCs and these types of CLOs,” says one advisor. “A BDC that is externally managed cannot fall within any exemptions for risk retention.”

To execute the deal, the BDC would sell the collateral loans to the special purpose entity created to issue the CLO, but those loans went through the external advisor first. The CLO issuer then sold the portion of the deal it would retain to the BDC, though it also went through the advisor.

“The upshot of the discussions was there was no appetite for trying to modify risk-retention rules or reinterpret these rules,” the advisor says. “One of the ideas was that the sponsor be involved in each investment that went into the CLO.”

One of those exceptions is the sponsor rule, the advisor explained, noting that SEC’s Division of Corporate Finance decided an externally managed BDC could not qualify as a sponsor though an internally managed vehicle could.

While the no-action letter gave BDCs the green light to finance themselves with term debt securitisations, some wondered whether it had even been necessary.

Two partners at law firm Mayer Brown pondered the question: “While the adopting release for the [risk-retention] rule was reasonably clear that ‘sponsors’ must be active participants in the related origination and initiation activities critical to the determination that an entity is a ‘sponsor’, why is it the case that this must be the advisor for a BDC that is externally managed rather than the BDC itself?”

Some of the risk-retention rules were tossed out by the District of Columbia Circuit Court of Appeals earlier this year in a lawsuit brought by the Loan Syndication & Trading Association. Those were only for loans purchased on the secondary market though rather than CLOs with originated loans, as is the case with GBDC.

“Putting the court’s reasoning in the LSTA decision together with the [SEC Division of Corporate Finance’s] staff position that the BDC is not itself a [risk retention] ‘sponsor’, is any party in a [mid-market] CLO involving an externally managed BDC required to retain risk?”

Apollo, Ares petition SEC on AFFE

Another issue to watch in 2019 is an SEC rule known as Acquired Fund Fees and Expenses. Advisors to Ares Capital Corporation and Apollo Investment Corporation submitted an application to the SEC in September, a move that one credit manager says was done at the regulatory agency’s behest.

The rather arcane statute requires other investment companies like mutual funds that acquire BDC stock to calculate the BDC’s 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.

One potential fix would involve the SEC handing down an exemptive class order, which would exclude all publicly listed BDCs from the AFFE rules, a person with knowledge of the situation says. The federal agency acknowledged receipt of the application, but the two firms have yet to receive any comments back, the source adds.

The Vanguard Group explains AFFE 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.”

This results in the reporting of inflated costs, the advisors to ARCC and AINV noted in their application.

“Reflecting these expenses again under the AFFE rule results in double-counting a BDC’s expenses,” the application reads, “and hence the AFFE rule disclosure requirements will result in significantly overstating acquiring fund expense ratios. Such disclosure provides misleading and inaccurate information to investors.”

Both firms declined to comment.

AINV and Prospect Capital Corporation were in the S&P Dow Jones Indices until they were taken out in 2014, causing their stock prices to slump at the time, according to Barron’s coverage of the removal. Then the Russell Indices also dropped BDCs –33 at the time – according to a Fitch Ratings note.

There’s been “good engagement” on the part of the SEC, one large credit manager says, declining to specify any potential time frame for action on AFFE because federal policy matters are inherently hard to predict.

Another source is hopeful for action, even though fixing the AFFE statute has been on BDC managers’ radars for years. The space, this person observed, has “grown up a lot” and “learned to consolidate [the industry’s] views”, with the key figures presenting a unified front rather than each investment firm or disparate groups of investment firms taking a go-it-alone approach.

Revoking the AFFE rule for BDCs could result in the BDCs being put back into indices, which could result in greater ownership among institutions, among both active and passive managers, the large credit manager says – passive managers because they buy into indices, active managers because they try to beat indices.

“At a high level, people are pretty hopeful” that BDCs will be removed from AFFE, another source familiar with the situation said. AFFE wouldn’t really change the fundamentals of the business, this person explains, noting institutions will still look at performance and the relative value of the BDC sector.

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 channel is certainly important and firms have been making inroads among that constituency recently, it can also mean a less engaged and less sophisticated shareholder base.

With passage of the Small Business Credit Availability Act, 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; institutional investors are likely more engaged, theoretically holding independent directors more accountable than a retail shareholder would.