FAQ’s about Business Development Company (BDC’s)
Part 4 of 6
Internal Versus External Management Issues
What are the advantages of internal management?
A BDC may be internally or externally managed. In some instances, the officers and directors of internally managed BDC’s supervise daily operations. In other instances, an internally managed BDC will establish a wholly owned subsidiary to conduct daily operations.
The officers, directors or wholly owned subsidiary of an internally managed BDC are not registered with the SEC as investment advisers. Internally managed BDC’s generally have lower expense ratios because the BDC pays the operating costs associated with employing investment management professionals as opposed to an investment advisory fee, which includes a profit margin. Internally managed BDC’s also have fewer conflicts between the interests of the manager and the owners of the BDC. However, an internally managed BDC must develop the infrastructure and hire employees or establish a subsidiary to manage the BDC and must address issues related to having custody of the portfolio assets.
What are the advantages of external management?
An externally managed BDC must contract with a third party to provide investment advisory services. An external investment adviser presumably already has the infrastructure, staff and expertise to satisfy the regulatory requirements applicable to BDC’s, including requirements relating to custody of assets. However, the investment advisory agreement memorializing the third party contract is subject to the requirements of the 1940 Act, which include, among other things, approval by the board of directors and shareholders of the BDC.
Certain inherent conflicts of interest may exist regarding the adviser’s allocation of investment opportunities between the BDC and the adviser’s other clients. Investment advisers to externally managed BDC’s also must be registered with the SEC. Therefore, if an adviser previously operated as an unregistered investment adviser, the adviser may be required to register with the SEC before serving as the BDC’s investment adviser.
Registration as an investment adviser also adds another layer of regulatory requirements, including, among other things, adoption of a compliance program, and an appointment of a chief compliance officer and adoption of a code of ethics for directors, officers and investment personnel governing personal investing activities.
What fees may be paid to an investment adviser?
Typically, an investment adviser is paid a management fee equal to an annual rate of 1.75% to 2.5% of the gross assets of the BDC’s portfolio (including any borrowings), paid quarterly in arrears. The Advisers Act permits an investment adviser of a BDC to also receive performance-based compensation, provided that it does not exceed 20% of the realized capital gains of the BDC, net of realized capital losses and unrealized capital appreciation over a specified time period or as of specified dates. The SEC staff has stated that the 20% limitation is the maximum performance fee, and not the maximum total compensation. Thus, the investment adviser can receive a management fee in addition to the performance fee. The performance fee is typically paid out as follows:
- 0% of all net investment income earned at or below a “hurdle rate” of 7%;
- 100% of all net investment income earned above the 7% hurdle rate but below a “catch-up rate” of8.75%; and
- 20% of all net investment income earned above the 8.75% “catch-up rate.”
- Finally, as is the case with traditional closed-end funds, brokers that sell BDC shares generally receive significant compensation from front-end sales loads charged to investors.
If a BDC elects to pay its investment adviser performance-based compensation, then the BDC cannot maintain an executive compensation plan that would otherwise be permitted under the 1940 Act.
The 1940 Act permits a BDC to issue to certain directors, officers and employees warrants, options and rights to purchase voting securities of the BDC pursuant to an executive compensation plan if, among other requirements:
- The issuance is approved by the partners and directors of the BDC (also requires SEC approval if issuance is to a director who is not also an officer or employee of the BDC);
- The exercise or conversion price of such warrants, options and rights is no less than the current market value or net asset value of the voting securities;
- The voting securities are non-transferable (except by gift, will or intestacy); and,
- The warrants, options and rights are not separately transferable (unless no class of such warrants, options or rights and the securities accompanying them have been publicly distributed).
How may a BDC compensate its management?
Internally managed BDC’s may compensate management through either:
- Performance-based compensation, including issuance of at-the-market options, warrants or rights under an executive compensation plan; or
- Through the maintenance of a profit-sharing plan. If an internally managed BDC elects not to adopt either of these options, they may compensate management through the use of cash compensation.
An externally managed BDC, which receives an incentive fee, cannot participate in any equity-based compensation plan.
To Be Continued …