Business Development Companies

Business Development Companies (“BDCs”) are special investment vehicles designed to facilitate capital formation for small to medium sized middle-market companies. As closed-end investment companies, BDCs are regulated by the SEC and subject to securities laws. However, BDCs are exempt from many of the regulatory constraints imposed by the Investment Company Act of 1940 (’40 Act). BDCs originated in 1980, when the U.S. Congress enacted the Small Business Investment Incentive Act (“SBIIA”) in an effort to help stimulate the economy by providing smaller, privately owned companies with credit solutions. The stated purpose of the SBIIA is to facilitate the activities of BDCs and to encourage the mobilization of capital for new, small and medium-sized, and independent businesses.

Whereas larger and more established companies have historically been able to raise capital through securing bank financing or the issuance of securities to the public, smaller developing companies generally have not shared similar access to attractive financing or the capital markets. Accordingly, passage of the SBIIA ushered in the creation of BDCs to address the capital needs of smaller companies, while simultaneously creating a market for retail investors to participate in private equity type investing.

As of May 2018, there are approximately 50 publicly traded BDCs. As publicly listed investment vehicles, these BDCs can readily be sold and resold on deep and liquid national securities exchanges. However, in addition to the many publicly traded BDCs that provide an important source of capital for smaller American businesses, there are also numerous publicly registered non-traded BDCs. Unlike their exchange traded counterparts, these non-traded financial products carry certain additional risks, as more fully discussed below.

In practical terms for investors, BDC status means that the investment vehicle is:

• Regulated by the ’40 Act;
• Unique because a BDC’s focus is on investing in smaller, private companies:
  • In fact, BDCs are required to invest at least 70% of their assets in private or public U.S. companies with market values of less than $250 million;
• Required to report to shareholders like traditional operating companies and to file regular quarterly and annual reports with the SEC;
• Required to make significant managerial assistance to their portfolio companies.

Pursuant to Section 55(a) of the ’40 Act, a BDC must generally have at least 70% of its total assets in the following investments:

• privately issued securities purchased from issuers that are “eligible portfolio companies” (or from certain affiliated persons);
• securities of eligible portfolio companies that are controlled by a BDC and of which an affiliated person of the BDC is a director (a controlling interest is presumed if the BDC owns more than 25% of a portfolio company’s voting securities);
• privately issued securities of companies subject to a bankruptcy proceeding, reorganization, insolvency or similar proceeding or otherwise unable to meet their obligations without material assistance;
• cash, cash items, government securities or high-quality debt securities maturing in one year or less;
• office furniture and equipment, interests in real estate and leasehold improvements and facilities maintained to conduct the business of the BDC.

Put simply, an “eligible portfolio company” means a domestic issuer that either (i) does not have any class of securities listed on a national exchange, or in the alternative, (ii) has a class of securities listed on a national exchange, but has an aggregate market value of outstanding voting and non-voting common equity of less than $250 million.

Investing in non-traded BDCs may pose considerable risks, including but not limited to the following:

• Illiquid Nature: similar to other non-traded securities, including non-traded REITs, non-traded BDCs do not trade on national securities exchange. Unfortunately, uninformed retail investors often discover too late that they are unable to readily sell out of some or all of their investment position, because there is no public market for trading in these securities. In addition, due to their illiquid nature, many non-traded BDCs suffer from valuation complexities, as it is a difficult and imprecise exercise to assign a value to the shares of a non-traded BDC;
• Excessive Fees Associated with many Non-Traded BDCs: many non-traded BDCs charge investors extremely high commissions and fees, as high as 15% in some instances. Such high fees and commission act as an immediate “drag” on the investment performance of the underlying vehicle;
• Distributions are not guaranteed: the decision to pay distributions is at the discretion of the Board of Directors in the exercise of its fiduciary duty. In certain instances, a non-traded BDC’s Board will elect to suspend its distribution for a period of time, or altogether halt distributions to investors, many of whom purchased the security for its enhanced yield;
• Blind Pool Structure: many non-traded BDCs are structured as blind pools, meaning they have not yet specified the investments they intend to make. As a general rule, investors are better served when they have access to information concerning the investment portfolio of a BDC and its make-up, including types of investments, interest rates assigned to various portfolio investments, and the like;
• Early Redemption is Often Restrictive: investors should be cautioned that most non-traded BDCs will place restrictions on the amount of shares that can be redeemed prior to a future liquidation event that may take many years to materialize. In some instances, redemption provisions can be as restrictive as a small percentage (e.g., 3%) of the weighted average number of shares outstanding during the prior year. Furthermore, redemption programs may be terminated or adjusted, at the distraction of the Board, so investors should not count on them as a viable option, even as an emergency exit strategy. And even where redemption is available, the redemption price offered by the sponsor is typically much lower than the purchase price.
• FINRA Guidance: through its 2017 Annual Regulatory and Examination Priorities Letter, FINRA had this to say about the risks associated with certain non-traded investment products including unlisted REITs and BDCs: “While these products may be appropriate for some customers, certain non-traded REITs and unlisted BDCs, for example, may have high commissions and fees, be illiquid, have distributions that may include return of principal, have limited operating history, or present material credit risk arising from unrated or below investment grade products. Given these concerns, firms should make sure that they perform and supervise customer-specific suitability determinations.”

The attorneys at Law Office of Christopher J. Gray, P.C. have significant experience in representing investors who have lost money due to financial fraud and related misconduct. In particular, the firm has represented numerous investors in connection with non-traded securities products, including unlisted BDCs.

Investors in non-traded BDCs other non-conventional investments may be able to recover losses in FINRA arbitration if the investments were sold pursuant to a misleading sales presentation or a financial advisor’s recommendation to purchase the investments lacked a reasonable basis. Investors may contact a securities arbitration attorney at Law Office of Christopher J. Gray, P.C. by telephone at (866) 966-9598, or by e-mail at newcases@investorlawyers.net for a no-cost, confidential consultation.