The real cost of reform

Ares, Apollo, FS and other BDCs have spent millions since 2011 getting the BDC bill passed.

Business development companies (BDCs) spent millions over the better part of a decade trying to get legislation through the US Congress and onto the President’s desk that “modernises” the industry’s regulations, as supporters of the measures claim.

Six BDCs have spent at least $8.23 million on lobbying since 2011 on various incarnations of legislation or other measures affecting the investment vehicles, according to the Center for Responsive Politics and US federal lobbying reports.

In March, the money managers won a victory when President Donald Trump signed a massive appropriations bill into law that included the Small Business Credit Availability Act (SBCAA).

While the new law tackles reporting requirements, such as the ability to register and issue securities with less paperwork, much of the attention has been centered on the loosening of leverage limitations. The maximum debt-to-equity ratio for BDCs was increased from 1:1 to 2:1; some also describe it as lowering a BDC’s asset coverage ratio from 200 percent to 150 percent.

Following the money

The trio of firms driving the effort were FS Investments, Ares Management and Apollo Investment Management. Each operate BDCs that are among the seven largest publicly traded BDCs by total assets. The three biggest spenders on lobbying were also among the first to come out in support of upping their leverage capacity.

FS, which operates FS Investment Corporation (FSIC), spent $3 million; Ares Capital Corporation (ARCC), indirectly owned by Ares Management, outlaid $2.32 million; and Apollo, which operates Apollo Investment Corporation (AINV), expended $2.25 million on lobbying from 2012-2018.

The remaining costs came from Main Street Capital at $390,000 and The Carlyle Group, which operates TCG BDC (TCBD), at $60,000. American Capital spent $90,000 in lobbying in 2011 before ARCC acquired it in 2017.

“It’s not uncommon to see firms engage in lobbying on specific things, individual specific rules or bills where they might think lobbying could be more effective,” says Maxwell Palmer, an assistant professor at Boston University who studies Congress and corporate governance. “The smaller bills get less attention, and it might be easier to have a say on those.”

The totals exclude the various industry associations and lobbying groups, suggesting maybe millions more could have been spent over the years getting the SBCAA passed. Federal regulations only require lobbying costs to be disclosed in the aggregate, meaning those reporting don’t need to provide line-item costs for each issue they advocate for or oppose.

Those organisations range from the smaller ones – like the Alternative Investment Management Association, the Coalition for Small Business Growth and the Small Business Investor Alliance – to the larger ones such as the National Federation of Independent Businesses and the US Chamber of Commerce.

The same serves true for Credit Suisse Group, which operated the Credit Suisse Park View BDC until the Swiss investment bank sold it to CION Investment Corporation in 2016. Credit Suisse lobbied for the bill in 2014. The large range of issues Credit Suisse weighed in on precluded a reasonable estimate for the financial institution’s expenditure on BDC-related matters.

“The more limited the issue is in scope, you’d expect to see a few firms or entities lobbying,” Palmer says. “Outside groups represent bigger constituencies. It’s really hard to coordinate these efforts across firms. It shouldn’t necessarily be surprising there were few parties lobbying [on the BDC reforms].”

Money reveals firm priorities

Is $8.23 million across six managers (minus Credit Suisse) a lot of money? It can be hard to judge on niche issues, but one way to look at it is to compare the amount spent on a specific issue against the firm’s total outlays.

“Any amount spent would be relative to what [the BDC managers] spent on other things,” Palmer says. “This is indicative of what’s important [to the firm].”

AINV’s indirect advisor, Apollo Global Management, spent over $1.5 million in 2015-17, some of it related to issues that might affect their portfolio companies. Apollo Investment Management has spent $360,000 annually from 2012-2017. The firm did not respond to request for comment.

Notably though, Ares Management, which reported ARCC as a subsidiary for lobbying-cost reporting purposes, spent $2.82 million since 2012, with the $2.32 million spent by ARCC being the bulk of its lobbying expenditures. The remaining $500,000 dealt with the taxation of carried interest. Using that metric as a proxy for importance, the future of BDC reform matters significantly more to Ares, which declined to comment, than Apollo.

FS Investments dropped almost all $3 million on BDC reform, though it should be noted FS’s platform is not as expansive, and BDCs make up a larger portion of its business.

Unlike Ares and Apollo, the firm does not have a dedicated private equity arm and has a relatively small presence in real estate, as FS operates a real estate investment trust that invests in real estate credit. Alongside its five BDCs, the firm also runs several interval funds and a mutual fund.

FS was “actively involved” in the process of crafting the legislation, according to a source familiar with the situation. In terms of recording lobbying costs, this person says the firm, which declined to comment, uses an expansive definition of lobbying, adding FS “is in the spirit of being over-inclusive in reporting”.

“The legislation is good for the industry and good for investors, so it’s something FS wanted to explore,” the source explains. Before revoking its plans to take on extra debt, FS’s request for board approval was meant to start the clock and the evaluation process around a one-year cooling off period.

For its part, The Carlyle Group lobbied little on the legislation, the federal records show, recording lobbying costs for it only this year. Carlyle has had a BDC since 2013, though it went public only last year. The firm received approval from its board and its shareholders, which voted on the measure in June.

“Overall, BDCs provide important capital to small businesses, which in turn help businesses expand and create jobs. We are pleased Congress came together to modernise the rules for BDCs,” said a Carlyle spokeswoman in an email.

Main Street, which did not respond to request for comment, has lobbied for BDC reform for years, the issue being its main lobbying expenditure. The firm said on its call it did not plan on putting any formal request before either its board or its stockholders to request the ability to increase its leverage. The BDC is one of Main Street’s principal investment products.

Stepping up to the plate

FSIC, ARCC and AINV were among the first managers to come out and publicly support the increased borrowing capacity.

Firms can seek approval to take on additional leverage in two ways: through a board vote or a shareholder vote. If the firm wins approval from its board, there is a 12-month “cooling-off” period before the BDC can utilise the extra borrowing capacity. If shareholders approve the measure, the BDC can access the additional leverage the next day.

“There is another factor that serves as a hurdle: If I am a board member, I have to decide if the board should increase it unilaterally or if the matter should be put to a vote to the shareholders,” says Dechert partner Jay Alicandri, who represents BDCs. “If shareholders say ‘no’, does the board approve it anyway?”

He adds: “The question for a board that approves the reduced asset coverage ratio without input from the shareholders or over a no vote, is what will happen to that board when it is up for re-election the next year.”

AINV has proceeded implementing the new standards, explaining on its first-quarter earnings call it would aim to operate with a debt-to-equity ratio of 1.25x-1.4x, an increase from its former target range of 0.65x-0.75x and above the former 1:1 limit. Increasing that figure from 0.7x to 1.4x would result in an extra $900 million-$1 billion in assets, chief executive Howard Widra noted on the call.

In addition, the New York-based alternative lender decreased its management fees, adopting a tiered structure under which any assets up to a 1:1 debt-to-equity ratio would be charged at 1.5 percent and any assets over 1:1 would be exacted at 1 percent. It also instituted a three-year lookback.

In April, AINV announced its board of directors had approved a measure allowing the BDC to up its leverage. In response, global ratings agency Standard & Poor’s cut AINV’s credit rating from BBB- to BB+, giving the firm a junk credit rating.

“While we’re disappointed in S&P’s actions, which we believe is rooted in their view of the industry and not AINV specifically, we do not believe that their action is an impediment to our successful execution of our go forward strategy,” chief financial officer Gregory Hunt said on the firm’s first-quarter earnings call.

Ratings agencies take a dim view

Many BDC managers assert the new rules will make it easier for them to invest in lower-risk assets, though there may be some caveats to that.

“People may invest in less risky assets, or possibly go after the assets they’ve already been chasing, in either case with the ability to offer more attractive pricing for the borrower,” says Paul Hastings partner Bill Brady, who is also head of its alternative lender and private credit group.

S&P has taken a decidedly different view.

“We believe the potential for increased leverage, in an already competitive environment, increases credit risk in the BDC industry,” the ratings agency said on a conference call in which it discussed the new law. “Relative to other finance companies BDCs’ creditworthiness has benefitted from a stronger institutional framework, including leverage constraints.”

Prospect Capital Corporation’s board approved the higher leverage guidelines in late March, with FSIC following suit four days later. S&P put the two BDCs on credit watch negative, signaling the potential for a downgrade. In response, both boards rescinded their decision to utilise the expanded borrowing capacity.

On its first-quarter earnings call, FSIC chairman and CEO Michael Forman responded to a question from Wells Fargo analyst Jonathan Bock about the board’s swift approval of the leverage increase only to recant it.

“We were quite involved in the process – the legislative process,” he says. “And I think we all believe it’s very important to the industry. We think it will take a little bit of time to sort itself out.”

In addition, S&P put ARCC, which has expressed support for adopting the 2:1 limit, on credit watch negative. The industry’s largest BDC has not laid out a concrete plan on how it will procure approval to increase its leverage.

The firm has “no formal action” before its board, chief executive Kipp deVeer said in the firm’s first-quarter earnings call.

GOVERNANCE AND SIDE EFFECTS

Who gets to decide whether leverage can be increased, and what are the consequences?

The BDCs have received pressure to let their shareholders decide, coming from myriad parties. Bock succinctly summarised the issue in his quarterly BDC report.

“We see the prospect for meaningful differentiation among BDC boards on this issue as some BDCs choose to actively engage with shareholders in a discussion on leverage (via a vote),” he wrote, “and others pass leverage through independent board member means and then simply say to shareholders, ‘if you don’t like the increased risks, you can do business elsewhere’.”

The providers of the leverage facilities aren’t necessarily as excited about the change though.

“Lenders to BDCs aren’t as overly optimistic about it,” Dechert’s Alicandri says. “[For the BDC], it’s not that simple to just be able to go out and do it.”

Myriad hurdles face BDCs that want to up their leverage profile, he says. For example, the providers of leverage to BDCs in certain cases have contractual asset coverage tests at 200 percent and, as a result, their consent will lower that figure to 150 percent.

In addition, many BDCs must deal with the ratings agencies. How the agencies respond to the BDC’s decision to increase its leverage can affect a BDC’s ability to tap the capital markets.”

Source: Center for Responsive Politics, US regulatory filings