Key Notes:

  • The first exemptive order permitting a non-traded BDC to issue multiple classes of shares is expected to be granted on or before February 24, 2020, unless the SEC orders a hearing to discuss such matter.
  • Assuming the exemptive relief is granted, it would be the culmination of a nearly 5-year effort and could signal a new phase in the evolution of non-traded BDCs.
  • Sponsors that are considering non-traded BDCs but have hesitated because of the historical inability of non-traded BDCs to offer multiple share classes, should take note of these developments and be ready to take advantage of this option once it becomes available.

SEC Considers Granting Exemptive Relief

Nearly a year ago, we provided an update regarding what appeared to be progress by FS Investments in obtaining exemptive relief from the Securities and Exchange Commission (“SEC”) for relief that would permit its non-traded business development companies (“BDCs”) to issue multiple classes of shares. On January 29, 2020, the SEC issued a public notice that the requested relief will be granted on or about February 24, 2020, unless the SEC orders a hearing to discuss such matter. The public notice provides a mechanism for interested persons to request a hearing from the SEC. Ordinarily, no such requests are made and an exemptive order is issued on or around the date listed in the notice.

Assuming the exemptive relief is granted, it could serve as precedent for future exemptive orders for other non-traded BDCs wishing to offer multiple classes of shares. The availability of multi-class exemptive relief for BDCs would be an historic and long awaited development as the relief would provide non-traded BDCs the flexibility that continuously offered closed-end funds (“CEFs”), including interval funds, as well as real estate investment trusts (“REITs”) and mutual funds have previously enjoyed in being able to offer multiple classes of shares tailored to different distribution channels.

I. Background

Section 18 of the 1940 Act generally prohibits funds from issuing multiple classes of equity. (Section 61(a) of the 1940 Act makes Section 18 applicable to BDCs for this purpose.) A share of stock or beneficial interest is considered a separate “class” if it receives different allocations of income or expenses or has unequal voting rights compared to other shares. Funds with multiple share classes have class-specific expenses allocated to the appropriate class, which results in unequal dividend payments, and restrict voting on class-specific matters to the relevant class. Unlike mutual funds that can rely on an exemptive rule under the 1940 Act (Rule 18f-3), unlisted continuously offered CEFs with discretionary or mandatory repurchase features typically receive individualized exemptive relief to offer multiple share classes based on the rationale that such funds are sufficiently comparable to mutual funds to have such relief. CEF relief is typically conditioned upon the CEF’s compliance with Rule 18f-3 as if they were mutual funds.

Non-traded BDCs are considered by FINRA to be “direct participation programs” (“DPPs”) and their public offerings are, therefore, regulated under FINRA Rule 2310. FINRA Rule 2310 caps the amount of (i) organization and offering expenses at 15% of gross proceeds and (ii) all items of compensation from whatever source payable to underwriters, broker-dealers and affiliates at 10% of gross proceeds.

II. Highlights of the Application

FS Investment Corporation IV (“FSIC IV”) initially filed the application for exemptive relief in 2014, but after the merger of FSIC IV with other affiliated funds, the Application was amended to instead list FS Energy and Power Fund as the primary applicant, along with its investment adviser, FS/EIG Advisor, LLC (“Adviser”). FS Energy and Power Fund is a non-traded BDC that is not currently selling shares through a public offering but, according to the Application, may decide to re-commence its public offering in the future and would likely do so using multiple share classes, assuming the requested order is obtained. The Application further requests relief for any current or future unlisted continuously offered closed-end management investment company that elects to be regulated as a BDC, for which the Adviser or any entity controlling, controlled by, or under common control with the Adviser, acts as investment adviser and which periodically offers to repurchase its shares pursuant to Rule 13e-4 under the Securities Exchange Act of 1934, as amended, and Section 23(c)(2) of the 1940 Act (“Funds”). Like the multi-class application precedents for continuously offered CEFs that came before it, the Application makes the case for treating each Fund the same way mutual funds are treated for this purpose as a Fund would comply with Rule 18f-3 as if it were a mutual fund and its shareholders stand to benefit from increased economies of scale as a result of the Fund’s ability to raise capital through multiple distribution channels. By making periodic repurchase offers, a Fund would give its shareholders liquidity opportunities that are similar to, though not as extensive as, mutual fund shareholders’ redemption rights.

As noted above, unlike other CEFs, including interval funds, public offerings conducted by non-traded BDCs are regulated under FINRA Rule 2310. As a result, the Application would not require the Funds to comply with FINRA Rule 2341, which by its terms only apply to mutual funds and interval funds. Instead, in order to comply with FINRA Rule 2310, any share issued by a Fund that is subject to asset-based service or distribution fees would be required to convert to a share class with no asset-based service or distribution fee upon such share reaching the applicable sales charge cap determined in accordance with FINRA Rule 2310. While the underwriting compensation limits set forth in FINRA Rule 2310 relate to the entire offering, we assume that this provision would cap the sales load (including distribution and service fees) to 10% of the purchase price of such share. We further note that this strongly resembles the “track, cap and convert” model developed by non-traded REITs.

Finally, the Application represents that if a share class of a non-traded BDC is listed on an exchange, all other then-existing classes of Shares of the listing Fund will be converted into Shares of the class to be listed.

III. Conclusion

If the exemptive relief is granted and becomes precedent for future exemptive relief from the SEC for other non-traded BDCs, it would represent a significant step in the evolution of non-traded BDCs from a niche DPP product to a product that more closely resembles continuously offered CEFs. Sponsors that are considering non-traded BDCs but have hesitated because of the historical inability of non-traded BDCs to offer multiple share classes, should take note of these developments and be ready to take advantage of this option once it becomes available.