BDC Appeal To Amend AFFE Rule WithdrawnPremium Free
On January 15, 2020 the Coalition for Business Development (CBD)wrote to the SEC to withdraw its application to the agency regarding the appropriate application of the Acquired Fees And Expenses rules (AFFE).
According to the letter – which is attached – the CBD understood from a prior telephone conversation that the SEC had “determined not to move forward with any further consideration” of its request to reconsider how the AFFE rules are applied to public BDCs.
However, the CBD noted its understanding that the SEC might be “considering AFFE relief in a more global rulemaking context” which would involve not only public BDCs but “other exchanged-traded funds”.
The letter indicates that the CBD is disappointed by “this turn of events”:
“In January 2018, our representatives met with the staff who advised us to seek relief by filing an exemptive relief application. Senior staff at the meeting said they conferred with attorneys from the SEC’s Office of the General Counsel and said to our representatives that it was open to considering the relief we requested. At that meeting, we explained to the staff that we are aware of no credible distinction between BDCs and exchange-traded funds with respect to the relief; that is, AFFE disclosure equally harms BDCs and exchange-traded funds. Notwithstanding this, the staff counseled us to submit an exemptive relief application on behalf of the Coalition, which represents the interests of listed business development companies. We now understand a significant reason the SEC will not consider the Application further is this same issue we discussed with staff at the January 2018 meeting”
Nonetheless, the CBD remained hopeful that “the harm caused by AFFE disclosure can still be remedied in the final fund of funds rule.”
The CBD – as its letter indicates in a footnote – is “a member-driven, Washington-based trade association that advocates exclusively on behalf of BDCs to expand their ability to provide necessary growth capital to small- and middle-market Main Street businesses so they can expand, invest and create jobs”.
As further explained in the letter, the CBD represents the interest of “listed business development companies“.
Here is a link to the CBD’s website.
The correspondence noted above seems to put an end – for the moment – to one of the major objectives of the CBD: to reverse or amend the decision to require mutual funds “to disclose the fees and expenses it incurs indirectly from investing in shares of one or more acquired funds”.
The result of that rule was that the costs and expenses mutual funds were required to report ballooned as they included all the costs involved with their acquired fund investments, as well as their own.
In turn, the mutual fund industry decided to ban BDCs from their indexes, with material consequences for the BDC industry – amongst others – as explained below:
Worse, the effect has been to preclude investments from occurring. This is because the AFFE disclosure obligation led index providers to remove BDCs from their indices, causing a dramatic reduction in institutional ownership. As we note in our Application, the MSCI, Russell and S&P indices all removed BDCs from their respective indices in 2014, primarily because of the AFFE disclosure requirement. In all, the decisions by these index providers affected more than 30 BDCs at the time.
Here’s a much better explanation than ours of the entire AFFE debate from Eversheds Sutherland: click here.
For the past 6 years, various trade organizations like the CBD and the Small Business Investor Alliance (SBIA) have been lobbying to change the rules which has caused many funds to abandon investing in public BDCs altogether.
A recent key argument – made by the SBIA – is that real estate investment trusts have been exempted from the AFFE rules and public BDCs- which are very similar – should be too.
If the AFFE rules were to be overturned or – in some way- adapted to encourage mutual funds and the indexes to re-integrate BDCs into their portfolios, the BDCs hope this will cause greater transactional volume in their shares; a broader shareholder base and higher prices.
For the moment, though, the issue seems to be on hold but the CBD letter does suggest that the SEC is considering broader rule-making that might result in a satisfactory conclusion for the CBD and SBIA and their clients.
Into A Glass Darkly
Frankly, we’ve not tracked the twists and turns of this lobbying effort very closely since the new rules were implemented 6 years ago.
There have been multiple analytical and legislative articles written by the lobbyists as well as hearings, not to mention the direct dialog referenced in the above letter with the staff at the SEC.
For a non-Washington insider, it’s hard to evaluate what real progress is being made and what amounts to wheel spinning.
Legislative and regulatory changes coming out of Washington are something of a “black box” as demonstrated by the sudden passing of the Small Business Credit Availability Act in 2018, which seemed to surprise almost everyone, including many of the BDCs who had been most vociferous in lobbying for the higher leverage and looser rules.
Moreover, and writing from an investor’s perspective, the lobbying efforts are principally focused on benefiting BDC managers – who have the millions of dollars necessary to have an active voice in the corridors of power – rather than BDC shareholders.
We’re always a little uncomfortable when organizations like the CBD and the SBIA wrap themselves in the flag and claim that their objective is to help BDCs “expand their ability to provide necessary growth capital to small- and middle-market Main Street businesses so they can expand, invest and create jobs”.
This is neither their core objective nor even factually accurate any more as many BDCs have largely eschewed the supposedly under-banked lower and middle market to invest in very large transactions.
Just have a look at Advantage Data’s records to see how many billions of dollars BDCs have invested in large syndicated loans; high yield bonds to larger companies and direct originations to large-cap borrowers.
Very roughly – based on our own data – we estimate that over 80% of all public BDC assets are invested in the debt of companies with a market value in excess of a quarter of a billion dollars.
As someone who is both an owner of a private lower middle market companies and a lender to larger cap companies over the last thirty years, we know that there is a very large difference in the management depth; access to capital; valuation and about everything else between the different segments of the non investment grade market.
Good For All
The above notwithstanding, though, changing the AFFE rules is one of those issues which should benefit both the BDC managers and their shareholders.
Just as importantly for those who believe in the value of long term investing in the BDC sector – as we do – the proposed change would open up investing to a whole class of individual and institutional investors that have been effectively barred from having a diversified exposure to non-investment grade credit by the AFFE regulations.
From our perspective, the AFFE rules – whatever their original intention to protect investors by providing better information about costs – have artificially barred mutual fund investors from what has become in recent years for many institutions an important asset class.
Investment funds, sovereign wealth groups, family offices etc. have “discovered” private credit and have invested capital through different mechanisms, of which public BDCs are only one avenue.
A far greater amount of AUM than the $78bn in public BDCs is invested in private credit funds of different stripes; non-listed BDCs; direct investment etc.
It seems a shame that mutual fund investors – many of them individuals seeking portfolio diversification – might be indirectly deprived of access by the AFFE rules .
Hopefully, the SEC will shortly find a way to right this well intentioned wrong for the benefit of both investors and their asset managers.
We’ll report back once in a while when we get wind of material new developments, but we warn in advance that we might only hear of a change in the rules at the very last minute.
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