The Division of Investment Management (Division) of the Securities and Exchange Commission (SEC) recently published two Guidance Updates pertaining to business development companies (BDCs). First, under certain circumstances, a BDC may enter into a joint transaction with a “close affiliate” of the BDC without obtaining exemptive relief from the SEC.1 Second, a BDC with a wholly-owned subsidiary designed to act as an extension of the BDC’s investment operations should generally consolidate that subsidiary in its financial statements.2
Transactions with Certain Second-Tier Affiliates (December 2014 Guidance Update)
Under Section 57 of the Investment Company Act of 1940, as amended (1940 Act), an affiliated person of a BDC and affiliates of that affiliated person are generally prohibited from engaging in transactions with the BDC (Affiliate Transactions), including certain co-investment transactions in which the affiliate and the BDC are both participants. Section 57 distinguishes between transactions involving “close affiliates” and transactions involving “remote affiliates.” An Affiliate Transaction with a close affiliate of a BDC is only permitted upon receipt of an exemptive order by the SEC, whereas an Affiliate Transaction with a remote affiliate of a BDC is permitted upon approval by a majority of the BDC’s disinterested directors.
Many advisers to BDCs also manage private equity funds (PE Funds). Where a PE Fund and a BDC have the same investment adviser (or affiliated advisers), the PE Fund is a close affiliate of the BDC. If the PE Fund is organized as a partnership, every “partner,” and therefore, every investor in the PE Fund, would also be a close affiliate of the BDC. If the PE Fund were organized as a corporation, however, an investor owning more than 5% but less than 25% of the PE Fund would be a remote affiliate of the BDC. Thus, depending on whether a PE Fund is organized as a partnership or a corporation, an Affiliate Transaction with an investor in the PE Fund would require either an exemptive order or an approval by a majority of disinterested directors.
The Division acknowledged that it has previously recognized in other circumstances that limited partners and shareholders should be treated comparably, and expressed the view that where a limited partner in a private fund is a close affiliate of the BDC merely because the private fund is organized as a limited partnership, the limited partner may be treated as if it were a shareholder of the private fund for purposes of determining whether it is a close or a remote affiliate of the BDC.
Investment Company Consolidation
BDCs with Wholly-Owned Subsidiaries
Under Regulation S-X, when determining whether to consolidate its financial statements with the financial statements of a subsidiary, a registrant is expected to consider what presentation is most meaningful, and whether or not consolidation of financials will clearly exhibit the registrant’s financial position and operation. Also, under Regulation S-X, there is a presumption that consolidated statements are more meaningful than separate statements, and that consolidated statements are usually necessary for a fair presentation when one entity directly or indirectly has a controlling financial interest in another entity.
In the Guidance Update, the Division observed that a number of BDCs have wholly-owned subsidiaries formed to facilitate investment in a portfolio company, and that certain of these BDCs do not consolidate those subsidiaries. The Division generally suggests that a BDC consolidate a wholly-owned subsidiary if the purpose of the subsidiary (e.g., a holding company) is to act as an extension of the BDC’s investment operations and to facilitate the execution of the BDC’s investment strategy. The Division believes that consolidation in these instances would generally provide investors with the most meaningful presentation in the BDC’s financial statements.