Interest in BDCs Continues to Grow

Business Development Companies (“BDCs”), created by the Small Business Investment Incentive Act of 1980 to spur investment in smaller companies, are a type of closed-end fund that has exploded in popularity in recent years.BDCs generally make investments in private companies in the form of long-term debt or equity. Investments in thinly-traded small cap public companies are also permissible, consistent with the legislation’s objective of encouraging capital flows to companies that had traditionally been underserved by banks and the capital markets. Whether publicly-traded or private, internally managed or externally managed, the goal of a BDC is to generate current income and/or capital appreciation for its investors. BDCs often have dividend yields in excess of 7% or 8%.BDCs are typically structured as a pass-through entity, such as a registered investment company (“RIC”), for tax purposes. To qualify as a BDC, a BDC must:

1. Invest in eligible companies:
   • Principle place of business in the United States;
   • Private company, or a publicly-traded company with market capitalization of less than $250 million;
   • At least 70% of the BDC’s assets must be in eligible companies
2. Own a controlling position (>25% of the voting shares) or make managerial assistance available to the portfolio company.
3. Hold a diversified portfolio with no individual company’s securities representing more than 25% of the BDC’s total assets.
4. Ensure that 90% of the BDC’s gross annual income is derived from dividends, interest, and realized capital gains of eligible companies.
5. If structured as a RIC, must pay out at least 90% of its gross annual income to investors.
6. Maintain a debt to equity ratio of less than 1.

Although asset management companies were slow to embrace the new structure in the 1980’s and 90’s, BDCs became popular in the early 2000’s as retail interest in alternative asset classes increased and investment companies realized they could charge performance fees in addition to a flat management fee on assets under management under the BDC structure. After a difficult period from 2007 to 2009, the pace of new BDC formation has accelerated post financial crisis. Today, there are approximately 80 BDCs, of which in excess of 50 are publicly-traded – and nearly half of those have IPO’d in the last five years.

For private equity (“PE”) or venture capital (“VC”) firms, the primary benefit of electing to be classified as a publicly-traded BDC is the access to public capital, a much deeper pool of capital to attract. The public company format also generally has a lower cost of capital. Although 90% of gross annual income must be returned to investors to maintain pass-through status, initial capital need not be returned to investors after a pre-determined period of time as with PE or VC funds. Historically, the main drawback of operating a BDC was the onerous regulatory burden; however, with the passage of the Dodd-Frank Act in 2010, the advantage that PE and VC firms previously enjoyed in this area has been dramatically eroded. This, coupled with investors’ voracious appetite for yield in the current low interest rate economic environment, has driven interest in BDCs.

Although BDC stocks often trade at a premium or discount to net asset value (“NAV”), the NAV is a key determinant of the stock price of a publicly-traded BDC. BDCs are required to disclose the values of their investments on a quarterly basis. Where market prices are available, they should be used; however, given the types of companies in which BDCs usually invest, market prices are often not available. Historically, many BDCs had performed valuations of their investments internally, but with increased investor, lender, and regulator scrutiny, many BDCs are hiring third-party valuation firms to perform this critical function. Independent valuation is also widely-recognized as best practices by sophisticated investors.

Houlihan Capital can provide much-needed valuation information to funds, including their directors and administrators by rendering an independent valuation opinion, which can supply the necessary support and documentation to stand up to regulatory and investor scrutiny. Houlihan Capital provides clients with independent valuations and has a history of working closely with clients’ management, directors, regulators, auditors, legal counsel, and investors on financial reporting and tax compliance matters.

For further information on independent third-party valuation services, please contact Paul Clark (pclark@houlihancapital.com) at 312-450-8656 or visit www.houlihancapital.com.

Houlihan Capital is a leading, solutions-driven valuation, financial advisory, and boutique investment banking firm committed to delivering superior client value and thought leadership in an ever-changing landscape. The firm has extensive experience in providing fairness and solvency opinions, and objective, independent and defensible opinions of value that meet accounting and regulatory requirements. Our clients include some of the largest asset managers, private equity funds, ’40 Act funds, hedge funds, fund administrators, and both public and private operating companies, which benefit from Houlihan Capital’s comprehensive valuation and financial advisory services. Houlihan Capital is a Financial Industry Regulatory Authority (FINRA) and SIPC member, and is SOC-compliant. In short: Value. Added.