Why BDCs are warming to bonfire of the regulations

The Financial Choice Act has managers rubbing their hands at the prospect of more flexible financing options.

Among the various dramas enveloping the US administration, issues relating to the financing capabilities of business development companies may understandably be occurring below the radar.  

However, with the US House of Representatives one step closer to taking forward a bill that in part addresses BDC leverage limits, these mid-market lenders appear poised to notch a substantial policy victory in Washington DC. 

The House Financial Services Committee voted to recommend the Financial Choice Act be considered before the full House earlier this month, with all 34 Republicans voting in favour and all 26 Democrats voting against.

Passage of the bill would – among many other measures – mean BDCs could take advantage of double the debt-to-equity leverage ratio allowed under current statutes. The limit, which is 1:1 right now, would be pushed to 2:1 under the new legislation.

Of all potential laws introduced in the US House, only a quarter are advanced out of committee, according to GovTrack, which keeps tabs on legislation as it moves through Congress. Skopos Labs, a legislative analytics service, estimates the FCA has an 11 percent chance of becoming law based on historic precedents. 

The law must still pass the full House and make it through the US Senate, and has been criticized by a group of institutional investors including CalPERS and the New York State Teachers’ Retirement System, who have sent a letter urging House members to oppose it on the basis that it undercuts shareholder rights.    

However, the FCA’s chance of being enacted appears greater than the odds mentioned above. Rolling back “job-killing” regulations is a favourite line of the Republican Party, and measures such as this could help it to make good on its promises.

The provision allowing BDCs to take on a larger amount of debt is tucked into an almost 600-page bill, a sweeping proposal to change the way US financial infrastructure is regulated. Another provision in the legislation repeals the Volcker Rule, the statute advocated by former Federal Reserve chairman Paul Volcker that limits who can sponsor a private equity-style fund. The FCA is likely to be among the more important priorities for House Speaker Paul Ryan and his lieutenants. 

For BDCs, increased leverage could widen the gulf between firms that have a low cost of capital and those that do not. For those that can borrow on favourable terms, access to additional leverage might allow them to scale their operations more quickly. Moreover, those firms trading at or above net asset value per share can issue equity in a manner accretive to shareholders, expanding the denominator in their leverage ratio.

Clearly, the capability to utilise greater leverage will give BDCs additional capital to invest, marking a positive development for the industry as a whole. But whether it benefits a specific BDC manager could wholly depend on their access to credit markets. After all, firms that pay a premium for capital may have to write even bigger cheques toward servicing debt if they utilise the additional leverage, while firms that borrow at low rates could see total interest expense (the interest payable on borrowings) increase nominally by comparison.

It’s an open question how many BDCs would in fact utilise the additional borrowing capacity, but the legislation certainly holds potential for the further growth and maturity of the BDC industry. Many fund managers will have their fingers crossed that this is one bill able to defy the odds.