The Building Wave of Private BDCs
While the public markets remain closed to new business development companies, a growing queue of private BDCs underscores the draws of the structure for both managers and institutional investors
By Mark Emrich
Managing Director, Business Development
If three of something is a trend then the number of private business development companies, or private BDCs, currently in the works represents something far more than a passing fad.
Names such as Blackstone/GSO, First Eagle, BC Partners, and Kayne Anderson Capital have either submitted registration statements with the SEC to launch private BDCs or – based on exemptive relief applications – may opt to do so in the future. Recent conversations with industry participants also suggest the queue of new private BDCs could grow much larger over the next six to 12 months.
What’s notable is that this percolating activity comes as publicly held BDCs extend upon a protracted dry spell in which only two new names have accessed the public market in the past three years, while none have managed to float an IPO in the past 12 months. But the fact that so many are now gravitating to private BDCs speaks less to the challenges of going public than it does to the structure and its inherent benefits, particularly for U.S. tax-exempt organizations and offshore investors drawn to the tax advantages the private BDC structure affords to them.
Sponsors generally have three options as it relates to launching BDCs: publicly traded BDCs, non-traded vehicles, and private BDCs. While most should be familiar with the more traditional model, available to retail investors through public listings, non-traded BDCs generally conduct continuous offerings to accredited investors until a hard cap is met, whereas private BDCs are raised through private placements. Similar to more conventional private capital limited partnership funds, private BDCs will issue capital calls as new investments are sourced and funded.
To put the market and the prevailing trends in perspective, law firm Eversheds Sutherland has documented that there are currently over 90 BDCs in operation, nearly 60% of which are listed publicly. The balance is roughly split between non-traded and private BDCs. Over the past three years, though, the latter category has accounted for almost 80% of all new BDC formations.
In one sense, the move to the private BDC model is aligned to the ongoing migration of institutional investors into private debt. This, of course, is being driven by their ongoing hunt for yield. In 2018, according to data provider Preqin, asset owners had poured some $86 billion into private debt funds as of the end of the third quarter. While BDCs are not reflected in this data, it speaks to the global appetite among institutional investors and family offices to gain exposure to middle market private debt strategies.
As it relates specifically to BDCs, the Small Business Credit Availability Act, signed into law in March, added further momentum as the legislation trimmed the coverage requirements for BDCs to 150% from 200%. This allows BDCs to boost their debt-to-equity ratios to 2:1 total leverage, from 1:1. The overriding benefit so far has revolved around improved economics for investors in the form of reduced management fees. The added leverage also equips the BDCs to pursue more attractive risk-adjusted returns. It allows them to commit a higher proportion of their portfolios to senior-secured investments, higher up in the capital structure, that carry less risk than junior investments, which are more exposed during downturns.
These factors together help form a backdrop that supports the surge of interest in private BDCs. However, one of the more appealing aspects are the tax advantages of the structure. Like other BDCs, private BDCs can elect to be treated as a regulated investment company (RIC) under the IRS tax code. Meeting certain RIC requirements, such as asset diversification provisions, the election allows the entity to be treated as a pass-through for tax purposes whereby no tax is paid at the corporate level. In this way, the structure is similar to REITs and MLPs.
The tax advantages available to offshore investors and tax-exempt domestic institutions are equally attractive. For foreign investors, the RIC structure means that private BDCs are not subject to effectively connected income (or “ECI taxes”), a tax treatment that would otherwise be applied to income from trades or business sources within the U.S. Similarly, private BDCs also block unrelated business taxable income (or “UBTI taxes”), for domestic tax-exempt organizations. IRS rules on UBTI taxes generally create income-tax liability at the federal level on investments in pass-through entities or debt-financed deals.
For large, established asset managers, private BDCs represent another vehicle that will allow them to leverage their considerable fundraising resources and infrastructure. Importantly, though, the private BDC structure is also advantageous to fund managers when compared to other alternatives. For instance, private BDCs are generally easier to stand up and then manage than public BDCs, which require an initial public offering and heightened reporting demands. There is also less regulatory red tape than what is required for non-traded BDCs beholden to “blue sky” registration requirements. And from an investment perspective, the flexibility of the BDC platform is attractive to pursue different types of assets as the opportunity set evolves.
Managers also have several options as it relates to offering investors liquidity. A private BDC, like a traditional fund, will have an investment period that can range from three to four years. At the end of the investment period, liquidity can be achieved through either a public listing or a merger with a public BDC. This past spring, a third option emerged when the SEC’s Division of Investment Management issued an exemptive order to TCW Direct Lending LLC that allowed the BDC to transfer the assets of the private BDC to a split-off extension fund.
When the Carlyle Group successfully floated a public BDC in June of 2017, the IPO provided a glimmer of hope that the public markets would again open up for business development companies. Given the lack of IPO activity since, this hasn’t been the case. But given the factors that make private BDCs so appealing, the structure is fast becoming a first choice for managers and investors looking to access this portion of the market.