Tax-related excerpts from Dechert's “Riding the BDC Consolidation Wave” webinar.

Background

Jeffrey Sion, Dechert partner, joined with other members of Dechert’s leading Permanent Capital Practice to present a webinar to discuss the legal and technical aspects of consolidations involving business development companies (BDCs). During the webinar, “Riding the BDC Consolidation Wave,” he highlighted a number of important tax considerations related to various transaction scenarios. 

Key tax-related webinar takeaways

  • Interest in consolidating Business Development Companies (BDCs) has been significant attention during the past several quarters. Some reasons for such interest include: a continued low interest rate environment, which impacts yield; limited organic growth, with many BDCs trading below NAV; the impact of increased AUM on cost structure; and it might be a lower-cost option for asset managers considering a BDC launch.
  • Any or all of these diverse factors make acquisition of additional assets through consolidation potentially appealing. Still, careful analysis of the tax impact of such deals on the acquired BDC, the acquiring BDC and their respective shareholders is both absolutely necessary and critical. Business leaders can pursue several strategic options, each of which involves distinct tax dynamics and consequences. A number of the considerations typically examined under each of the following structural alternatives are outlined below:

Alternative 1: Acquiring an entity for cash

  • A cash-based transaction generally represents a taxable event for the target BDC. 
  • This transaction is also taxable event for the target’s shareholders, because they are receiving something different from what they currently possess, i.e., they are receiving cash for their stock.
  • The target entity terminates, along with its tax attributes. These tax attributes no longer are usable by the successor acquiring entity.
  • The acquiring entity generally will acquire target’s assets at their fair market value, which demands rigorous analysis of how those assets impact the acquirer’s ultimate Regulated Investment Company (RIC) status, particularly as it impacts the RIC asset composition test.
  • Acquirers also must factor in the impact of other non-standard assets, such as pass-through entities, which would require a case-by-case analysis to assess their specific tax consequences.

Alternative 2: Acquiring an entity for stock

  • BDCs most commonly use stock in connection with these types of acquisitions.
  • The transaction generally will be treated as a tax-free event to the acquiring BDC, the acquired BDC, and their respective shareholders.
  • However, any boot – cash or other non-security assets paid in consideration of the transaction – generally would represent a taxable portion of the transaction.
  • Attributes in stock-based transactions are generally subject to carryover.
  • Of particular significance, if the acquired BDC has historical losses that are eligible to be carried over, such as capital losses, the use of these losses by the acquiring BDC may be limited under certain tax principles.
  • This makes it critically important to consider tax implications when determining which entity should be the acquiring entity and which should be the acquired entity.
  • Another critical consideration is whether the transaction causes a taxable recognition event for the shareholders of the acquired BDC.
  • The potential impact on the acquired BDC’s shareholders can be significant, particularly if there are built-in losses. Depending how structured, such losses could be carried over and impact the acquired shareholders’ tax basis in their shares.

Alternative 3: Acquire the entity’s investment adviser

  • When acquiring an entity’s investment advisor, the structure and order of events leading up to the ultimate consummation of the deal are very important.
  • For corporate-level transactions, evaluate whether the acquisition will be accomplished inside or outside of the acquirer’s consolidated group. 
  • For such transactions, you generally will not see the step-ups in basis that typically occur in partnership transitions. When weighing potential elective step-ups, carefully consider the impact of making such elections on the shareholders of the acquirer.
  • With partnership transactions, you have to be very mindful of the impact on the tax distribution provisions and other carry-over provisions that are typically included in the governing transactional documents.

Alternative 4: Enter into a new investment management agreement

  • With a new agreement, costs will be incurred by both parties involved.
  • The critical step for tax purposes is to evaluate whether those costs are either deductible or subject to capitalization.
  • If subject to capitalization, it would then be important to determine whether such costs may be amortized over their anticipated useful life or must they be permanently added to the basis of certain acquired assets.
  • Recently, regulations promulgated by Section 197 of the Internal Revenue Code permit a 15-year amortization period as an available default mechanism.
  • With these considerations in mind, leaders evaluating these types of transactions should carefully assess costs incurred in these transactions to evaluate whether they would be subject to capitalization, amortization or whether such costs could be fully deductible.