NEW YORK, July 11 (LPC) – The US Securities and Exchange Commission’s (SEC) fund of funds proposals potentially open the door to a shakeup in the Business Development Company (BDC) market.
Under the existing guidelines, regulated funds are prohibited from owning more than 3% of another fund’s outstanding voting securities, a limitation that has restricted activist funds from having a big influence on the sector.
“If you can’t own more than 3% in a BDC then you don’t have the natural consequences of activism that improves governance,” said one fund manager. “Activism is capitalism doing its job.”
As a result, some have argued that the relaxation of the 3% rule to attract more institutional capital into the sector is best placed to put pressure on underperforming BDCs and improve the overall governance across the market.
“The limitation on funds investing in other funds reflects a long-held concern over pyramiding of investment funds, although the historic 3% limitation in the statute is arguably an arbitrary standard,” said Steve Boehm, partner at Eversheds Sutherland.
Across the BDC market, return on average equity (ROAE) continues to drop, according to data from Fitch. Last year, the ROAE across a composite of structures was 5.6%, down from 6.5% and 7.3% in 2017 and 2016, respectively. It is less than half the 11.6% ROAE in 2013, Fitch data shows.
TPG, a middle market lender that has a history of investing in other BDCs, has been vocal in its support of extending the 3% limit to 10%, outlined in its submission to the regulatory body in May.
The SEC has proposed that voting rights can go above 3% with the caveat that firms operate pass-through or mirror-voting procedures, a guideline that TPG argued in its submission would be a “practical burden” that will act as a disincentive for acquiring funds to go above 3%.
BDCs in the last 12 months have been engaged in conflict with activists. Medley Management has been involved in battles with shareholders since it proposed the merger of its externally managed BDCs, Medley Capital and Sierra Income Corporation, last year.
Alcentra’s BDC has been the target of activist investor Stilwell, which in April argued for the sale or liquidation of the vehicle.
Some in the industry have championed greater protections for BDCs against activist shareholders seeking short-term gains at the expense of long-term shareholders.
Law firm Skadden said in its submission to the SEC that hedge funds frequently seek a liquidity event through pushing for directors to be replaced or through proxy contests.
“The activist and its shareholders then profit from the difference between the discounted price at which the closed-end fund shares are purchased and the price at which the liquidity event occurs,” the law firm said. “This perhaps is good for the short-term interests of the activist and its investors, but these types of coerced actions can impose substantial harm on the fund and its long-term shareholders.”
A growing market in private BDCs means a number of firms are able to avoid the attention of activists. Historically, many started off private to generate momentum, but increasingly it is the preferred choice for some in the market.
“Private BDCs have become very popular and they don’t need to worry about activist investors,” Boehm said. “The first private BDCs used their non-public period as a runway to going public, but now, many have no intention of going public.” (Reporting by David Brooke. Editing by Leela Parker Deo and Jon Methven)