SEC Takes Targeted Action to Assist BDCs in Light of COVID-19 Coronavirus Pandemic

The Securities and Exchange Commission issued an order on April 8, 2020, providing relief to business development companies whose operations may be affected by the COVID-19 coronavirus outbreak (Order).¹ In the Order, the SEC acknowledges that, in the current environment, BDCs may face challenges as a result of certain requirements under the Investment Company Act of 1940 in providing much-needed capital to their existing portfolio companies that have been negatively impacted by the pandemic. In light of these concerns, the SEC afforded temporary, conditional relief from the 1940 Act’s asset coverage requirement and joint transaction prohibition, in order to assist BDCs and their affiliated private funds to provide additional capital to the affected portfolio companies.

Asset Coverage Requirement Relief

The Order permits a BDC that may not be able to satisfy the applicable 200%/150% asset coverage ratio under the 1940 Act to use an alternate asset coverage ratio (Adjusted Asset Coverage Ratio) when determining its asset coverage ratio prior to the issuance or sale of a “covered senior security.”² This relief is subject to satisfaction of a number of conditions, described below. The Adjusted Asset Coverage Ratio is to be calculated in the same manner that it is currently calculated under the 1940 Act, except that: (A) portfolio company holdings (i) that the BDC held at December 31, 2019, (ii) that the BDC continues to hold at the time of the issuance and sale of a senior security, and (iii) for which the BDC is “not recognizing a realized loss”³ would be valued at their December 31, 2019 valuations (Adjusted Portfolio Value); and (B) the BDC would be required to reduce the asset coverage ratio calculated using the Adjusted Portfolio Value by an amount equal to 25% of the difference between (i) the asset coverage ratio calculated using the Adjusted Portfolio Value and (ii) the asset coverage ratio calculated in the manner as currently required under the 1940 Act. The Order contains the following helpful example of the operation of the “25% of the difference” provision:

For example, a BDC has a 220% asset coverage ratio on December 31, 2019. Its asset coverage ratio declines to 160% on March 31, 2020, not using the Adjusted Portfolio Value, and 200% if it calculated the ratio (without the 25% decrease) using the Adjusted Portfolio Value. This BDC would have an Adjusted Asset Coverage Ratio of 190% (200% minus 10% (25% of the difference between 200% and 160%)).

A BDC that elects to rely on the asset coverage requirement relief must satisfy the following conditions:

• Election Form 8-K Filing – Prior to doing so, the BDC must file a Form 8-K disclosing the fact that it is electing to rely on the Order.
  
  
• Board Approval of Reliance on the Order – The BDC’s board of directors, including a majority of its independent directors, must approve the BDC’s reliance on the Order.
  
  
• Board Approval of Each Issuance of Senior Securities – Prior to the BDC issuing or selling a covered senior security under the Order, the BDC’s board of directors, including a majority of its independent directors, must determine that each such issuance is in the best interests of the BDC and its shareholders and permitted by the Order. In making such determination, the BDC’s board of directors must obtain and consider: (i) a certification from the BDC’s investment adviser that the issuance of the covered senior securities is in the best interests of the BDC and its shareholders, and that discloses the investment adviser’s recommendation and reasons therefor (specifically including whether the investment adviser has considered other alternatives to the issuance or sale of the covered senior security); and (ii) advice from an “Independent Evaluator”⁴ regarding whether the terms and conditions of the proposed issuance or sale of the covered senior security are fair and reasonable compared to similar issuances, if any, by unaffiliated third parties in light of current market conditions.
  
  
• Limitations on New Investments – The BDC may not, for 90 days following the date of such election, make an investment in a portfolio company in which the BDC was not already invested as of the date of the Order. Notwithstanding this restriction, a BDC may make an investment in a new portfolio company if, at the time of the investment the BDC complies with the asset coverage ratio under the 1940 Act (i.e., without applying the adjustments otherwise permitted by the Order).
  
  
• Monthly Board Reporting of Steps to Regain Compliance – The BDC’s board of directors must receive and review, no less frequently than monthly, reports prepared by the BDC’s investment adviser regarding and assessing the efforts the investment adviser has undertaken to achieve compliance with the asset coverage ratio under the 1940 Act.
  
  
• De-Election and Non-Compliance Form 8-K Filings – The BDC may withdraw its election to rely on the Order by filing a Form 8-K with the SEC, noting its decision to do so. In addition, if the BDC fails to regain compliance with the asset coverage ration under the 1940 Act before the expiration of the relief time period (see discussion below), the BDC must file a Form 8-K that includes the following information: (i) the BDC’s current asset coverage ratio; (ii) the reasons why the BDC was unable to comply with the asset coverage requirements; (iii) the time frame within which the BDC expects to come into compliance with the asset coverage requirements; and (iv) the specific steps the BDC will undertake to come into compliance with the asset coverage requirements.
  
  
• Recordkeeping – The BDC must maintain all board meeting minutes (including reports and documents furnished to board members) relating to the various determinations set forth above, for a period of not less than six years, the first two years in an easily accessible place.
  
  
• No Compensation or Remuneration of any Kind – Except (i) to the extent permitted by section 57(k) of the 1940 Act, or (ii) for payments or distributions made by an issuer to all holders of a security in accordance with the security’s terms, no affiliated person of the BDC, or any affiliated person of such a person, may receive any transaction fees (including break-up, structuring, monitoring or commitment fees) or other remuneration from an issuer in which the BDC invests, during the period in which the BDC is relying on this relief. However, this condition does not apply to the receipt of investment advisory fees by an investment adviser to the BDC under an investment management agreement.
  

Importantly, while the asset coverage requirement relief provides flexibility to issue covered senior securities, it explicitly “does not provide relief in connection with the declaration of any dividend or any other distribution” or the repurchase of capital stock, which may be limited when a BDC is not in compliance with the asset coverage ratio. Similarly, the benefits to BDCs from relying on the relief may be limited to the extent any existing credit facility or senior security contains stricter limitations than what is permitted by the 1940 Act, as modified by an order of the SEC.

Expansion of Joint Transaction Relief for BDCs with Existing Co-Investment Orders

The Order also expands the existing scope of co-investment relief that many BDCs have received, in order to permit certain affiliated private funds of a BDC that has a co-investment exemptive relief order to jointly invest in follow-on investments, even though conditions of such exemptive relief order might otherwise prohibit those affiliated private funds from doing so. In connection with negotiated follow-on investments completed in reliance on the Order, the BDC’s board of directors is required to review the proposed investment both on a stand-alone basis and in relation to the total economic exposure of the BDC to the issuer.

The expansion of the joint transaction relief is tied to the definitions used in the existing co-investment exemptive relief orders of BDCs, which should be considered carefully when relying on the relief.

Time Period for Relief

The relief provided by the Order is limited to the period from April 9, 2020 to the earlier of (i) December 31, 2020 and (ii) the date by which the BDC elects to no longer rely on the Order.

Key Take-Aways

We understand that the SEC staff has heard from a number of BDCs and industry groups over the last several weeks about the multiple challenges BDCs may confront as they seek to provide capital to their existing portfolio companies, many of which have been negatively impacted by the response to the COVID-19 coronavirus. These challenges include:

• The need for BDCs to raise additional capital in order to continue to support their existing portfolio companies;
  
  
• The potential inability to raise non-dilutive equity capital when BDC shares are trading below net asset value; and
  
  
• The potential inability to raise debt capital when the value of portfolio company investments has declined significantly due to COVID-19 coronavirus disruptions, which decline in turn makes it more difficult to satisfy the 1940 Act’s asset coverage requirement.
  

Conclusion

The SEC has crafted and approved two temporary, conditional and narrowly tailored sets of fixes to assist BDCs as they address these challenges. Although very much welcome, the narrow scope and related conditions suggest that the relief is not likely to have broad implications for the BDC market.

It is expected that BDCs and industry groups will continue to engage with the SEC with respect other possible relief that may assist BDCs as they seek to fulfil their statutory mandate. Dechert will continue to monitor developments in this area.

Footnotes

1) Order Under Sections 6(c), 17(d), 38(a), and 57(i) of the Investment Company Act of 1940 and Rule 17d-1 Thereunder Granting Exemptions from Specified Provisions of the Investment Company Act and Certain Rules Thereunder, Rel. No. IC-33837 (Apr. 8, 2020).

2) A “covered senior security” is defined for purposes of the relief as “a senior security that represents indebtedness or that is a stock.”

3) With respect to the “not recognizing a realized loss” prong, the Order states that “BDCs may not include a December 31, 2019, fair value measurement in their Adjusted Asset Coverage Ratio if the portfolio company is permanently impaired.” The Order notes that a “permanently impaired holding is a holding where a BDC recognized a realized loss subsequent to December 31, 2019, and the loss is not recoverable.”

4) The term “Independent Evaluator” means a person who has expertise in the valuation of securities and other financial assets and who is not an interested person (as defined in Section 2(a)(19) of the 1940 Act) of the BDC or any of its affiliates.