January 15, 2020 – The emergence of Business Development Companies (“BDCs”) over the last decade is not a surprise. BDCs are well-established as an essential provider of debt capital to small and medium-sized U.S. businesses. Since the peak of the financial crisis, the number of publicly-listed BDCs has more than doubled, and the number of private or non-traded BDCs has exponentially increased, as asset management firms increasingly add private credit and direct lending to their investment strategies, and investors (whether retail, institutional or non-U.S. institutional) seek exposure to the ever-maturing market for U.S. middle market credit. BDCs are an attractive destination for non-U.S. investors, particularly due to their tax advantages. They are an attractive product for asset managers because of the complement they offer other formats that attract capital to direct lending strategies. These advantages notwithstanding, BDCs present complex capital structure, balance sheet management, regulatory compliance and corporate governance challenges for asset managers that other formats (like commingled funds and SMAs) do not pose. Professional advisors and consultants well-versed in these intricacies can help fund sponsors and debt and equity capital sources unlock the numerous opportunities presented by BDCs.  

Leaving the “Banking System” … to Return 

One widely-known tailwind for this growth has been the transplantation of most of the smaller-end and much of the middle market’s leveraged finance holdings off depository institutions’ balance sheets and onto private funds, SMAs and – yes – BDCs’ (we’ll refer to them collectively as the “New Lenders”) balance sheets. It’s not that big banks have entirely left the chat, however, as they are vitally important to the New Lenders. The New Lenders rely on the big banks for some deal flow, treasury management and fund administration, but most importantly, for massive amounts of financing. The New Lenders to “main street” take on many forms. Still, most rely on at least one meaningful credit facility from a big bank, for liquidity and additional capital to make these investments, and as a key source of financing that reduces the overall cost of capital for the New Lenders, which enhances the gross- and net-level returns. 

Even though there are noteworthy differences among BDC structures and terms, management teams, strategies and performance, there are legal and regulatory boundaries, and in some cases barriers, that BDC managers – and their lenders, professional advisers and investors – should be prepared to neutralize. 

Leverage Limitations for BDCs are a Special Consideration 

As with all funds, governing documents may set limitations on leverage (among other areas). BDCs, however, are subject to additional limitations. First, all BDCs, whether exchange-listed, private or non-traded, are Regulated Investment Companies (each, a “RIC”) under the Investment Company Act of 1940 (the “40 Act”). The 40 Act restricts BDCs’ ability to utilize leverage; the regulatory consequence of violating the incurrence-tested restriction is the BDC’s inability to incur additional indebtedness. Until late 2018, BDCs were permitted to incur debt up to a 1:1 ratio to the fair market value of their respective portfolios. Following years’ worth of lobbying efforts led by the Small Business Investor Alliance, industry leaders and advisers, BDCs may now incur debt up to a 2:1 ratio to their portfolio’s FMV, so long as the BDC’s board or shareholders, as the case may be, permit such incremental leverage.

What the 2018 BDC Leverage Increase Means for BDCs, Lenders and Investors

A breach of the 40 Act leverage limit generally prohibits the BDC from accessing any additional debt capital until such BDC is back in compliance. For publicly listed BDCs, the research and public equity investment community would also respond harshly to such financial and liquidity degradation. The most important practical consideration for public or private BDCs with credit facilities, outstanding bonds or convertible notes is to appreciate the extra-regulatory consequences of the BDC’s prevailing leverage limit.

Most, if not all, BDC credit facilities and debt securities are accompanied by maintenance covenants that would trigger an event of default if the BDC is out of regulatory compliance with the 40 Act’s leverage limit, or the BDC exceeds a 1:1 ratio of debt to assets. 

BDCs that are considering – or that have received approval to – avail themselves of incremental leverage, and their lenders and advisers, must anticipate the interplay of existing credit facility and debt security covenant packages with any change to the BDC’s leverage profile.

The Market Responds to Scale, First … Others Follow

Although some BDCs chose the expedited method of shareholder approval for increased leverage, some of the largest BDCs have completed impressive expansions of their credit facilities. Other BDCs that sought board, rather than shareholder approval – whether due to their smaller scale or relative portfolio performance – are only now able to access this additional leverage, due to the year-long waiting period between board approval and effectiveness. 

Beginning in early 2019, there was a backlog of requests from BDC managers for amendments to credit facilities and/or indentures, led by the largest BDCs with the most intricate capital structures. It just so happens that most of these BDCs are also part of larger platforms that are meaningful fee payers and counterparties to the banks lending to BDCs. Naturally, these institutions were at the front of the line. 

In mid-to-late 2019, many more managers approached their lenders and bond underwriters for similar changes, to accommodate additional leverage. The underwrite by these lenders has been BDC-specific and very focused on asset-level performance, investment strategies and modeling the BDC’s ideal leverage scenarios. Many of these BDCs are still seeking the requisite amendments. Some have not yet begun the process.

If You’re Still in the Queue, it’s Not Too Late

If you’re a BDC manager that seeks additional leverage but suspects that you may have to nudge your lender or underwriter, consider isolating certain investments in specific borrowers or offering approval rights to lenders that are providing additional debt capital than is currently available. If you have any industry specialization within your portfolio, consider isolating those loans in an SPV and seeking financing from a lender with expertise and a long view of that industry. If specialty finance is one of your strategies, a typical BDC-level revolver may exclude those investments from your borrowing base; however, there may be lenders that have a more accommodating view of the same collateral. 

In addition to optimizing asset composition and possibly expanding either the sources of debt capital or the types of credit facilities your BDC utilizes, BDC managers should be particular about the advisers they rely upon in connection with these amendments, refinancings or establishment of new credit facilities. There are many notable 40 Act lawyers with renowned BDC experience. Likewise, there are many thoughtful, driven fund finance lawyers with experience negotiating and documenting NAV facilities for credit funds and BDCs. It is not a foregone conclusion that those specializations universally reside within the same law firms. 

If you’re considering any sort of asset reorganization or specialization, or segmentation of your BDC’s sources of credit, consider the breadth of regulatory, specialty finance and market knowledge that you have at your side. 

What Fund Finance Partners Offers in the BDC Realm

• FFP is the only dedicated advocate for BDC sponsors with experience establishing numerous corporate revolvers, SPV financing, total return swaps and other leverage solutions for public and private, traded and non-traded BDCs.
• FFP is the only advisor whose leadership has substantial portfolio management, compliance and financial reporting experience specifically for BDCs to complement your CFO or capital markets desk, as well as regulatory experience to complement your 40 Act and fund finance counsel.
• FFP uniquely has the market experience and relationships to elevate your BDC’s profile in the crowded neighborhood of New Lenders seeking financing, capital and brand recognition.
• FFP appreciates the relationship between BDCs and other direct lending or investment vehicles on asset managers’ platforms, such as JVs, SMAs and other funds, and the opportunities and challenges that those assets present, and is equipped with creative product development, conflict recognition and mitigation and process-improvement solutions for BDC managers.   

A child’s self-esteem is tied, in large part, to how they are treated, valued and cared for by their parents. If we spend too much time “giving time” to everything else in our lives ahead of our children, we are teaching them that they are less important to us — and therefore the greater world. Moreover, if parents don’t make the time to engage with their children the more apt they are to seek out other role models that may or may not have their best interests in mind.

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Private equity real estate funds have stepped up to be a major source of financing for the commercial real estate industry—and a bigger allocation for investors. However, fund managers may face a tougher road ahead for fundraising in the near term as capital flows to the sector slow.

Debt strategies have moved from the fringe to a more established and accepted part of the commercial real estate investment universe over the past several years. That shift has generated a significant wave of capital. According to London-based research firm Preqin, global private equity real estate debt funds have raised about $165.6 billion since 2013.

“Over the last three years in particular we’ve seen a massive amount of capital allocated to debt funds,” says Todd Sammann, executive managing director and head of credit strategies at CBRE Global Investors. The vast majority of that capital is targeting double-digit returns and is almost entirely allocated to closed-end funds. “The industry has seen fundraising trail off a little bit in 2019, which is not particularly surprising given the amount of capital that was formed,” says Sammann.

According to Preqin, the volume of capital raised by debt funds appears to have peaked at $33.7 billion in 2017. Fundraising edged lower to $29.4 billion in 2018 and has dropped more sharply in 2019, with fundraising through Nov. 7th totaling $15.6 billion.

That decline comes even as the broader private equity real estate fund market is enjoying robust capital flows. As of Nov. 7th, that global market had raised $138.2 billion year-to-date, which puts it on track to exceed the $146.1 billion raised in 2018 and likely to break the record of $147.5 billion raised in 2008, according to Preqin’s Q3 real estate report.

“There is no doubt that what Preqin is reporting, to a certain extent is true, that the appetite may not be there. But I also think that will rebound,” says Zac Barnett, co-founder of Fund Finance Partners, a debt advisory firm for private equity fund sponsors. “Private equity real estate debt doesn’t seem to be going anywhere. It fills a need, particularly when crossing over to the infrastructure space where there are very few banks that are able to play.”

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How does governance come into play for institutional asset managers. One key area is how leverage is managed, according to Richard Wheelahan, III, and Zac Barnett, the Co-Founders of Fund Finance Partners. Over the past decade Richard has advised fund sponsors and lenders, both as an adviser and as a principal at a $3 billion asset management firm. Zac has worked for twenty years as one of the leading attorneys the fund finance space; during this time he has represented investment banks and fund sponsors on some of the largest, most complex fund financings in the industry. The full interview with CorpGov is below:

CorpGov: In Asset Management, what is the role of corporate governance?

Messrs. Wheelahan and Barnett: All funds have governance standards which the asset management team must abide by.  Registered funds, like BDCs and REITs, are subject to the same corporate governance standards that public operating companies are, even though they aren’t operating companies in the traditional sense.  Private fund requirements are primarily negotiated by the fund sponsor with large investors and are usually also imposed by SEC regulations.

CorpGov: Can you talk about the use of leverage by private equity and other asset class funds, and how they are governed?

Messrs. Wheelahan and Barnett: While leverage is now more common than not, how the fund sponsor goes about obtaining and utilizing it must be permitted by the relevant regulatory limitations and the fund’s governing documents – its agreements with its investors. For Regulated Investment Companies (’40 Act funds), some of which are publicly traded, the limitations on leverage are prescribed by the Investment Company Act of 1940 (although this is subject to change as seen in the past year) as well as the Investment Company’s offering materials. Private funds’ use of leverage is potentially limited – or unlimited – by the private fund’s governing docs.

Whether managing a registered or a private fund, fund sponsors have a fiduciary duty to their investors to obtain the best terms, pricing and structure on any leverage they utilize. Relying on an unbiased intermediary – one which isn’t in the business of lending to funds but is solely engaged to optimize the funds’ borrowing terms to run a competitive process – is a good way to satisfy that fiduciary duty.

CorpGov: What are best practices in corporate governance for fund sponsors?

Messrs. Wheelahan and Barnett: Fund sponsors should be deliberate in their leverage strategy, especially early in the life cycle. Strategic leverage considerations and regulatory limitations should be communicated to the board in the case of a registered fund or considered carefully by the sponsor in consultation with the fund’s larger investors, and a private fund’s governing documents should provide for maximum flexibility.

These are deliberate decisions, and boards with oversight responsibility should be informed about both the strategy and specific tactical plan to accomplish these fiduciary responsibilities. Unless the fund sponsor has a robust debt capital markets and leveraged finance capability with the bandwidth to run a competitive process, fund sponsors and boards of directors should seriously consider engaging a professional intermediary.

CorpGov: What does your business, Fund Finance Partners, do for fund asset managers and fund sponsors?

Messrs. Wheelahan and Barnett: We believe that next to asset performance, leverage strategies are at the very heart of maximizing returns, and we provide innovative options that are lower-cost and more flexible for funds. As a sponsor’s strategy evolves we can help rethink or change how to efficiently pivot the fund sponsor’s approach to capitalizing these funds and maximizing the performance of the underlying collateral.

These shifts and pivots can trigger fund sponsor obligations in both the governing documents, as well as public disclosures and board involvement for registered funds. An advisory firm like ours which has experience with all types of fund leverage and all types of funds, including registered ones can provide valuable guidance in optimizing the fund’s leverage strategy. We do this while maintaining a constructive, risk-reducing dialogue with corporate governance constituencies.

Fund Finance Partners (“FFP”)is led by a team of finance and asset management professionals which has collectively executed more than 600 unique fund finance transactions. FFP is dedicated to innovation and growth of the market of debt capital solutions to fund sponsors and investors.  For further information go to https://fundfinancepartners.com/

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The Fund Finance market has been on an incredible run. We at FFP, like many of you reading this, want to see that success continue. We believe that the only way the market can maintain its staggering growth rate is to evolve, innovate and modernize its transaction processes.

As many of you know, the core subscription facility product has exploded over the last 10-15 years thanks to the hard work of so many, particularly industry’s leaders. Bankers have appropriately identified the fund sponsors’ need and have expertly refined their product offering to meet those needs. The attorneys have worked long and hard at erecting sound legal structures to ensure the reliability of the unfunded capital commitments and access to them via a proper capital call. This has resulted in profitability for so many deserved market players. However, now is not the time to pat each other on the back; we must re-invest and continue to innovate or else product and market stagnation will begin its eventual creep.

Despite the introduction of many new developments in technology, legal staffing, document review and the like, many if not most of these advancements have yet to penetrate the Fund Finance space. We believe that must and will change. Here at Fund Finance Partners, we have taken steps to help drive efficiency of lender selection, negotiation and legal document review.

By way of example, we’ll use the core Fund Finance product, a subscription financing, as the reference point for some of the streamlining methods we’ve been working on at Fund Finance Partners. Let’s take a quick peek at what we call Fund Finance 2.0 and how we hope to help us get there.

COORDINATION-THE LEFT AND RIGHT HAND

We’ve all seen deals significantly delayed or even crater due to improper coordination and planning on behalf of the fund sponsor. The attorneys and business folks forming the fund (right hand) don’t always keep the finance counsel and universe of lenders (left hand) appraised of various fund structure, Side Letter and LPA provision changes. We’ve seen the irreparable damage that can be caused by not properly identifying troublesome comments from tax, ERISA counsel, investor counsel, etc. during the fund formation process. If not addressed, these comments can, among other things, eviscerate the fund’s borrowing base or prevent access to creditworthy investor uncalled capital. The good news is that 9 times out of 10, these issues can be positively resolved with proper explanation to the party commenting. We at Fund Finance Partners have the experience to spot the potential problems and the blueprint for ensuring that the left hand is always aware of what the right hand is doing.

LEGAL DOCUMENTATION-THIS IS NOT ROCKET SCIENCE

A critical step toward achieving transaction time and cost efficiency is having the legal work accomplished at the appropriate level. Let’s take the document that the investor executes establishing its commitment to the fund (“the Subscription Agreement”) as an example. Traditionally, review of subscription agreements and related fund documentation would be executed by junior, mid-level or even more senior associates. This may have been appropriate 10-15 years ago when the product was less mature due to the differentiation of subscription agreement forms as well as the relative (as compared to present day) inexperience of each the lender and borrower-side counsel. There is no doubt that these documents need to be reviewed to confirm investor name, GP countersignature, LP commitment amounts, ERISA and other investor representation designations, etc. but an attorney certainly needn’t review every line of these documents. That said, we do recommend a senior attorney, perhaps even a partner review the fund’s form of subscription agreement to insure there is nothing out of the ordinary with respect to the proper representations / representations requested, compliance with law, etc.

COMMUNICATION-THERE IS PLENTY OF PIE

As mentioned above, a huge reason of the market’s success can be traced back to industry leaders particularly on the lender-side of the aisle. The most successful market participants have worked collegially with other lenders to make sure that their fund sponsor clients (and potential clients) needs are being met; whether or not they are taking part in the transaction. However, there remain all too many instances where short-term self-preservation instincts can play a role in client service and fund sponsors suffer as result. We’ve all seen or heard of fund sponsor’s being coerced into a product that is not right for them or left on the sidelines instead of being directed to a capital source that can fulfill its specific needs. FFP has the non-partisan platform, lender comparison checklists and product knowledge to ensure fund sponsors are connected with the proper lending source leaving them with a positive experience, increased faith in our markets and a willingness to enter into more fund finance transactions, thus growing the pie.