Shedding new light on business development companies.

In the 1970s, a perceived crisis in the capital markets led Congress to enact the Small Business Investment Incentive Act of 1980 (1980 Amendments). The genesis of the crisis stemmed from the limitation set forth in the "small private investment company" exemption contained in Section 3(c)(1) of the Investment Company Act of 1940 (1940 Act). In essence, private equity and venture capital firms believed that their capacity to provide financing to small, growing business was being stymied by their inability to raise equity capital due to the limitation in Section 3(c)(1) that their securities not be beneficially owned by more than 100 persons. Because these firms were unwilling to subject themselves to the 1940 Act, they urged Congress to ameliorate the situation before the spigot of capital to small, growing businesses was closed shut. (1) Congress responded to such concerns by enacting the 1980 Amendments.

The 1980 Amendments amended the 1940 Act and the Investment Advisers Act of 1940 (the Advisers Act) to add a new category of closed-end investment company known as a business development company (BDC). (2) BDCs are publicly traded closed-end funds that make investments in private or thinly-traded public companies in the form of long-term debt or equity capital, with the goal of generating capital appreciation and/or current income. Specifically, the 1980 Amendments were designed to encourage the establishment of public vehicles that invest in private equity in order to increase the flow of capital to small, growing businesses. The 1980 Amendments sought to achieve this goal by lessening some of the restrictions under the 1940 Act that were believed to discourage private equity managers from participating in the regulated portion of the investment management industry, most notably restrictions relating to compensation and borrowing.

Congress believed that BDCs would become a widely used investment vehicle from the outset. (3) However, the anticipated popularity of BDCs did not catch on quite as quickly as anticipated by the proponents of the 1980 Amendments. (4) Although there are approximately 30 active BDCs that manage in excess of $9.5 billion of assets, until very recently, these vehicles operated in relative anonymity, barely scratching the surface of the financial press and were generally the subject of less regulatory guidance than larger, more financially significant industries, such as the mutual fund industry, by the Securities and Exchange Commission (SEC).

Recently, the BDC industry has been thrust into the limelight. A spate of more than 10 filings for initial public offerings (IPOs) by would-be BDCs sponsored by high-profile private money managers, followed by a highly magnified level of SEC regulatory scrutiny likely spurred on by intense negative media coverage of these BDCs, has brought a fundamental change to the landscape. Notwithstanding such change, it remains to be seen whether BDCs will gain widespread acceptance by the marketplace.

Regulatory Structure

When Congress adopted the 1980 Amendments, it made the provisions of the 1980 Amendments immediately effective. As a result, the staff of the SEC's Division of investment Management (Staff) had to scramble to revise the SEC's rules and forms to accommodate BDCs. (5) Many of the changes made to these rules and forms have never been revisited by the SEC or the Staff. Thus, counsel advising promoters of BDCs have to use care to ensure that their clients are aware of the unique attributes of the BDC regulatory structure.

The BDC regulatory structure can best be described as a patchwork of rules woven into the fabric of the 1940 Act. The 1980 Amendments provide a general exemption for BDCs from the provisions of the 1940 Act and make them subject to Sections 54 through 65 of the 1940 Act, which were added specifically to regulate BDCs (BDC Sections). Notwithstanding the general exemption for BDCs from the 1940 Act, Section 59 of the 1940 Act provides that "Sections 1, 2, 3, 4, 5, 6, 9, 10(f), 15(a), (c), and (f), 16(b), 17(f) through (j), 19(a), 20(b), 32(a) and (c), 33 through 47, and 49 through 53 of this title shall apply to a business development company to the same extent as if it were a registered closed-end investment company."

BDCs are not "registered" investment companies, but instead are closed-end investment companies that "elect" to be treated as a BDC under the 1940 Act by filing a notice to that effect with the SEC. As a pre-requisite to making a BDC election, a company must have a class of its equity securities registered under the Securities Exchange Act of 1934 (the 1934 Act). As a result, BDCs must file periodic and current reports (i.e., Forms 10-Q, 10-K and 8-K) as well as proxy statements with the SEC pursuant to the 1934 Act like those filed by public operating companies. Therefore, a BDC can best be thought of as a hybrid between a closed-end fund and an operating company.

BDCs may be operated as internally managed investment companies or externally managed investment companies. To date, the internally managed structure has predominated. An internally managed BDC does not have an investment adviser and is managed by its executive officers under the supervision of its board of directors. As a result, an internally managed BDC does not pay investment advisory fees, but instead pays the operating costs associated with employing investment management professionals.

BDCs issue a fixed number of shares to the public through public offerings, after which the shares are bought and sold on a national securities exchange or association. BDCs are not obligated to issue new shares or redeem outstanding shares as open-end funds are required to do. The price of a share in a BDC is determined entirely by market demand, so shares can either trade below their net asset value (at a discount) or above it (at a premium). BDCs use equity capital raised through public offerings and debt capital from various sources to make their investments.

Portfolio Investments

Consistent with the Congressional purpose behind the 1980 Amendments (i.e., increasing the flow of capital to small, growing businesses), a BDC is, in effect, required …