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BDC Basics – What Every New BDC Must Know Before Launching Capital Roundtable BDC Conference February 25, 2015 1

BDC Basics – What Every New BDC Must Know Before Launching · BDC Basics – What Every New BDC Must Know Before Launching Capital Roundtable BDC Conference February 25, 2015

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Page 1: BDC Basics – What Every New BDC Must Know Before Launching · BDC Basics – What Every New BDC Must Know Before Launching Capital Roundtable BDC Conference February 25, 2015

BDC Basics – What Every New BDC Must Know Before Launching

Capital Roundtable BDC Conference February 25, 2015

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Page 2: BDC Basics – What Every New BDC Must Know Before Launching · BDC Basics – What Every New BDC Must Know Before Launching Capital Roundtable BDC Conference February 25, 2015

©2015 Sutherland Asbill & Brennan LLP

BDC Basics

• Part I: History and Overview of the BDC Model

• Part II: BDC Structures

• Part III: Regulatory and Reporting Requirements

• Part IV: Management and Operational Considerations

• Part V: Convergence of BDCs and SBICs

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©2015 Sutherland Asbill & Brennan LLP

Part I: History and Overview

of the BDC Model

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©2015 Sutherland Asbill & Brennan LLP

Overview

• Created by the Small Business Investment Incentive Act of 1980 (the “1980 Amendments”) as a result of a perceived crisis in the capital markets in the 1970s.

• Private equity and venture capital firms believed the “small private investment company” exemption (Section 3(c)(1) of the 1940 Act) limited their capacity to provide financing to small, growing businesses.

• Provided Regulated Investment Company (RIC) tax status in 1990.

• Special type of closed-end fund that:

Provides small, growing companies access to capital Enables private equity funds to access the public capital markets. Enables retail investors to participate in the upside of pre-IPO investing

with complete liquidity • Hybrid between an operating company and an investment company

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©2015 Sutherland Asbill & Brennan LLP

Benefits of the BDC Model

• Access to public capital markets

• Shares are traded on national exchanges

• Flow-through tax treatment as a RIC

• Reduced burden under 1940 Act, as compared to closed-end funds

Restrictions on leverage Restrictions on affiliated transactions

• External model permits management fee and “carried interest” incentive fee structure

• Publicly available financial information through quarterly reporting

• Portfolio is typically diversified

Reduces risk typically associated with private equity investments

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©2015 Sutherland Asbill & Brennan LLP

BDCs vs. Private Equity

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©2015 Sutherland Asbill & Brennan LLP

How the BDC Market Developed

• Prior to 2003, the largest BDCs were primarily internally managed.

Choice reflected the success of the internally managed, income producing BDC model

• In 2004, Apollo Investment Corporation raised $930 million in less than three months which ignited the growth in the BDC industry.

• There has been a steady stream of BDC IPOs since that period.

• At the end of 2014, traded BDCs collectively had approximately $59 billion in total assets

• During 2014, BDCs raised approximately $6.2 billion in capital, including IPOs, follow-on equity, and debt offerings

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©2015 Sutherland Asbill & Brennan LLP

The BDC Industry – at Dec 2014

• 66 Total Operating BDCs 51 traded BDCs with aggregate market cap

of $32.9 billion and $61 billion in assets

13 non-traded BDCs with aggregate capital of $11.8 billion raised

2 private BDCs with aggregate capital of $825.8 million raised

• 6 IPOs Completed in 2014 Alcentra Capital Corp American Capital Senior Floating Ltd. CM Finance Inc. Newtek Business Services, Inc. TPG Specialty Lending Inc. TriplePoint Venture Growth BDC Corp.

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10 internally managed

56 externally managed

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©2015 Sutherland Asbill & Brennan LLP

BDC Equity Capital Raised

$466.9 $1,059.5

$141.2 $0.0 $533.9 $707.8 $497.8 $311.0

$680.3

$2,097.7

$4,076.7

$1,291.0

$823.4

$1,570.2 $908.3

$3,550.9

$3,229.5 $2,360.5

$0.0

$1,000.0

$2,000.0

$3,000.0

$4,000.0

$5,000.0

2006 2007 2008 2009 2010 2011 2012 2013 2014

IPOs Follow-on Equity Offerings

($ in millions)

* Includes traded BDCs, as of December 31, 2014 9

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©2015 Sutherland Asbill & Brennan LLP

BDC Debt Capital Raised

$650.0 $780.0

$193.0

$650.0

$265.0

$1,222.0 $1,505.8

$2,391.4

$150.0

$1,477.5

$1,077.5 $415.0

$738.0

$0.0

$500.0

$1,000.0

$1,500.0

$2,000.0

$2,500.0

$3,000.0

$3,500.0

2006 2007 2008 2009 2010 2011 2012 2013 2014

Debt Convertible Debt

($ in millions)

* Includes traded BDCs, as of December 31, 2014 10

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©2015 Sutherland Asbill & Brennan LLP

BDC Price / Book (NAV)

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1.48

1.40

1.22

1.14 1.09

1.06 1.04 1.01 1.00

0.97 0.97 0.96 0.96 0.96 0.95 0.93 0.91 0.90 0.89 0.89 0.88 0.88 0.86 0.86 0.85 0.84 0.84 0.83 0.83 0.83 0.82 0.82 0.82 0.81 0.81 0.80 0.79 0.79 0.79 0.74

0.71 0.69 0.63

0.56

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

Median Price/Book = 0.87x

As of 12/31/14 - traded BDCs only

Internally managed Externally managed

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©2015 Sutherland Asbill & Brennan LLP

BDC Yields

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0.17

0.16

0.15 0.15

0.14 0.14

0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.11 0.11 0.11 0.11 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.09 0.09 0.09 0.09 0.09 0.09 0.09

0.08 0.08 0.08

0.07 0.07

0.06 0.05

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

Average Yield = 10.0%

As of 12/31/14; Excludes BDCs that are not paying dividends

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©2015 Sutherland Asbill & Brennan LLP

Part II: BDC Structures

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©2015 Sutherland Asbill & Brennan LLP

• Traded BDCs Listed on NASDAQ or NYSE Formed either as a blind-pool vehicle, or through the acquisition of an existing

portfolio IPO through traditional firm commitment underwritten offering

• Non-Traded BDCs Shares are not listed on an exchange Shares sold through continuous offerings up to preset maximum amount Liquidity offering through periodic repurchase offers Typically have fixed 5-7 year period before exchange listing or traditional IPO

• Private BDCs Shares are not listed on an exchange Shares are sold through private placement offering and funding effected through

a capital call model Intention to conduct IPO in near term Generally no liquidity prior to a qualifying IPO

Types of BDC Structures

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©2015 Sutherland Asbill & Brennan LLP

Traded BDCs

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©2015 Sutherland Asbill & Brennan LLP

• Typically requires 6 – 8 months to complete IPO

• Fees and expenses range from $800k - $1mm

• Consider formation / structuring issues Portfolio acquisition / manage any built-in gain Form of consideration SEC staff expressing more flexibility in acquisition of affiliate assets

• Consider any necessary exemptive relief Co-investment with sister funds

• Prepare registration of investment adviser (if externally-managed)

• Develop compliance / corporate governance programs

• Select service providers Public accountants, valuation assistance, custodian, etc.

IPO Process Overview

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©2015 Sutherland Asbill & Brennan LLP

• Organize the entity - typically as a Delaware or a Maryland corporation

• File an IPO registration statement on Form N-2 under the Securities Act The JOBS Act allows “emerging growth companies” to confidentially file an

initial registration statement, minimizing market and reputational risk

• Register a class of securities under the Exchange Act

• Apply to list securities on the NASDAQ/NYSE

• File Form N-54A to make an election to be regulated as a BDC

• Have N-2 registration statement declared effective by the SEC

• Comply with regulatory requirements of the 1940 Act

• Comply with reporting requirements including the Exchange Act, Sarbanes-Oxley Act, etc.

IPO Process Overview (cont.)

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©2015 Sutherland Asbill & Brennan LLP

• May start with or without an initial portfolio Market has generally favored vehicles with existing portfolios

• Initial portfolio may be acquired from an affiliated fund on a pre-IPO basis Recent staff guidance has provided more flexibility for these transactions

• Considerations in connection with the acquisition of an initial portfolio: Required approvals at the private fund level Funding / timing issues on a pre-BDC basis

Use of a bridge facility or notes Equity may be issued in certain cases

Tax implications Timing and recognition of accrued but unrealized appreciation/depreciation

in initial portfolio

• Disclosure requirements for initial portfolio Typically an audited schedule of investments is required More fulsome financial statements may also be acquired in certain cases

Initial Portfolio Acquisitions

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©2015 Sutherland Asbill & Brennan LLP

Non-Traded BDCs

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©2015 Sutherland Asbill & Brennan LLP

• REITs have successfully used the non-traded model for years.

• In January 2009, FS Investment Corporation launched the first non-traded BDC Affiliated with GSO / Blackstone Raised $2.67 billion through a continuous offering Listed its shares during 2014 to provide shareholder liquidity

• 15 non-traded BDCs have successfully had registration statements go effective with the SEC

• 13 non-traded BDCs are currently selling shares in continuous offerings and have collectively raised $11.9 billion

• Traditional closed-end funds are now launching non-traded funds Priority Senior Secured Income Fund (joint venture between Behringer

Harvard Holdings and Prospect Capital Management)

FS Global Opportunities Fund (advisory/sub-advisory relationship between Franklin Square and GSO/Blackstone)

Development of Non-Traded BDCs

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©2015 Sutherland Asbill & Brennan LLP

• A Non-Traded BDC enables retail investors that meet certain suitability standards to participate in the upside of pre-IPO investing. Shares not listed on any exchange but issued on a continuous basis

Price volatility of shares reduced through the adjustment of the public offering price so that shares are not sold below NAV

Non-traded issuers typically offer to repurchase a portion of outstanding shares on quarterly basis. Periodic tender offers by closed-end funds, including BDCs, excepted from Regulation M under the Securities Exchange Act of 1934 if made at net asset value or if they comply with Rule 23c-3 of the Investment Company Act of 1940. Certain BDCs have received No Action relief under Regulation M for repurchase programs that peg the repurchase price to something other than NAV.

Offering must be registered in each state where offers and sales are made

• All the non-traded BDCs that are currently offering and in registration are externally managed

Non-Traded BDC Structures/Features

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©2015 Sutherland Asbill & Brennan LLP

• Non-traded BDCs are generally structured as a combination of an investment adviser or sub-adviser and a distributor. For example,

GSO/Blackstone serves as the sub-adviser for Franklin Square’s funds, while FS2 Capital Partners is the dealer manager.

KKR Asset Management is the investment sub-adviser for Corporate Capital Trust, while CNL Fund Advisors serves as the dealer manager.

Apollo Global Management serves as investment sub-adviser for CION Invetsment Corp., while ICON Securities serves as the dealer manager

SIC Advisors (investment personnel of Medley) is the investment adviser to Sierra Income Corporation, while SC Distributors is the dealer manager.

Business Development Corporation of America is the only non-traded BDC that does not utilize a third-party investment adviser or sub-adviser.

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Non-Traded BDC Structures/Features

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©2015 Sutherland Asbill & Brennan LLP

These non-traded BDCs are making continuous offerings and have raised in excess of $11.9 billion to date (as of the most recent financials): • Business Development Corporation of America - $1.6 billion • Business Development Corporation of America II - $200 million - Affiliated with AR Capital, LLC • CION Investment Corporation - $476 million - Affiliated with ICON Capital Corp. and Apollo Global Management, LLC • Corporate Capital Trust, Inc. - $2.1 billion - Affiliated with CNL Fund Advisors Company and KKR Asset Management • FS Energy and Power Fund - $2.9 billion • FS Energy and Power Fund II – escrow not yet broken • FS Investment Corporation II - $3.2 billion • FS Investment Corporation III - $649 million - Affiliated with GSO / Blackstone • HMS Income Fund, Inc. - $236 million - Affiliated with Hines Securities, Inc. and Main Street Capital Corporation • MacKenzie Realty Capital, Inc. - $14.7 million - Affiliated with MacKenzie Capital Management, LP • NexPoint Capital, Inc. – $10 million - Affiliated with NexPoint Advisors LP and Highland Capital Funds Distributor • Sierra Income Corporation - $555 million - Affiliated with Medley Capital, LLC and SC Distributors, LLC • VII Peaks Co-Optivist Income BDC II, Inc. - $50 million - Affiliated with VII Peaks Capital, LLC

Non-Traded BDCs

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©2015 Sutherland Asbill & Brennan LLP

• Suitability requirements May only be sold to investors who meet certain suitability standards, typically through

the independent broker-dealer or RIA channels

• FINRA review – more time-consuming and thorough review than traded BDCs

• State blue sky review Must be approved to sell securities in each state where solicitations will occur,

requiring compliance with the “Omnibus Guidelines” published by the National Association of State Securities Administrators (“NASAA”)

Completing blue sky process can take several months

• Continuous offering over a period of time Prospectus supplements filed periodically to report material events and provide

updates on fundraising efforts and portfolio composition

• Liquidity Event Typically complete liquidity event within five to seven years following completion of

offering Liquidity event could include: (1) sale of all or substantially all of company’s assets

either on a complete portfolio basis or individually followed by a liquidation, (2) listing of company’s shares on a national securities exchange, or (3) merger or another transaction in which shareholders receive cash or shares of a publicly traded company

Additional Requirements for Non-Traded BDCs

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©2015 Sutherland Asbill & Brennan LLP

• Sponsor Requirements Sponsor must have adequate experience and net worth Limited indemnification of Sponsor, which may affect charter of the

issuer

• Suitability of Investors Default minimum suitability standards of either $70,000 gross

income and $70,000 net worth or $250,000 net worth Suitability standards may vary across states States may impose concentration restrictions (i.e., 10% of net

worth in the issuer or all non-traded BDCs) Minimum investment amounts Suitability typically determined through subscription agreement

NASAA Omnibus Guidelines: Compliance with “Blue Sky Laws”

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©2015 Sutherland Asbill & Brennan LLP

• Fees, Compensation and Expenses Sponsor’s compensation must be “reasonable”

For BDCs, compensation presumptively reasonable if limited to “participation in net gains” of the issuer

For Sponsor providing services to the issuer, fees must be competitive as compared to independent third-parties

Offering document must estimate and itemize fees and expenses

• Conflicts of Interest Issuer may only invest in joint ventures or general partnerships with non-

affiliates so long has “controlling interest” Issuer may only invest in joint ventures or general partnerships with affiliated

entities provided there are no duplication of fees and each investor has right of first refusal to buy the affiliates’ interests in the venture

Limited ability to invest in joint ventures or general partnerships with non publicly registered affiliates

Multi-tiered arrangements permissible so long as not designed to circumvent the Guidelines, there are no duplication of fees, no decrease in the voting rights of stockholders and the fiduciary obligations of the various parties are adjusted

NASAA Omnibus Guidelines: Compliance with “Blue Sky Laws” (cont.)

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©2015 Sutherland Asbill & Brennan LLP

• Rights and Obligations of Participants (i.e. Stockholders)

10% holders have right to call stockholders meetings Majority approval of stockholders required to amend entity charter,

dissolve the company, remove the Sponsor, elect a new Sponsor or approve the sale of substantially all of the assets of the company

Stockholder right to inspect and copy the company’s records, including stockholder list

Distribution Reinvestment Plans (“DRPs”) may not charge sales commissions for shares issued under the DRP Stockholders must be able to elect or revoke participation in

the DRP

NASAA Omnibus Guidelines: Compliance with “Blue Sky Laws” (cont.)

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©2015 Sutherland Asbill & Brennan LLP

Private BDCs

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©2015 Sutherland Asbill & Brennan LLP

• Typically sponsored by large private equity firms with an existing investor base

• Operates similar to a non-traded BDC, but draws down capital via a capital call model, similar to a private fund structure

• Shares are offered through a private placement offering to the sponsor’s existing investor base, rather than via a continuous public offering

• BDC/RIC structure helps mitigate need for offshore feeder fund structure for foreign/tax exempt investors

• Generally target an initial public offering and exchange listing, similar to the non-traded BDC structure

• Private placement structure eliminates need for “blue sky” registration process faced by traditional non-traded BDCs

What is a Private BDC?

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©2015 Sutherland Asbill & Brennan LLP

• Organize the entity - typically as a Delaware or a Maryland corporation

• File a registration statement on Form 10 to register a class of securities under the Exchange Act

No registration statement on Form N-2 needs to be filed under the Securities Act

• Prepare a private placement memorandum and subscription agreement for the private offering

• Make an election to be regulated as a BDC by filing a Form N-54A

• Comply with regulatory requirements of the 1940 Act, and the reporting requirements including the Exchange Act, Sarbanes-Oxley Act, etc.

Private BDC Process

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©2015 Sutherland Asbill & Brennan LLP

• Three private BDCs have been organized to date TPG Specialty Lending, Inc. (completed qualifying IPO in 2014) Carlyle GMS Finance, Inc. TCW Direct Lending LLC

• In September 2013, the SEC adopted amendments Rule 506 under Reg D and Rule 144A under the Securities Act to implement elements of the JOBS Act

• Made the process of forming a private BDC potentially more attractive

Eliminated the prohibition on using general solicitation under Rule 506 where all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that the purchasers are accredited investors.

The SEC adopted Rule 506(c), pursuant to which issuers can offer securities through means of general solicitation, provided that: all purchasers in the offering are accredited investors, the issuer takes reasonable steps to verify their accredited investor status, and certain other conditions in Regulation D are satisfied.

Private BDCs Operating

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Part III: Regulatory and

Reporting Requirements

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• Organize the BDC as a Delaware or a Maryland corporation

• Register a class of securities under the 1934 Act

• Make an election to be a BDC - file a Form N-54A (Notification of election to be subject to sections 55 through 65 of the 1940 Act)

• Register a class of securities on Form N-2

• List securities on the New York Stock Exchange (NYSE) or the Nasdaq Stock Market, Inc. (Nasdaq), or the BDC can be a non-traded BDC

• Comply with the Sarbanes-Oxley Act of 2002 and Dodd-Frank Act

• Comply with regulatory requirements of the 1940 Act

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How Does a Company Become a BDC?

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©2015 Sutherland Asbill & Brennan LLP

• Form 10-K (Annual Report)

• Form 10-Q (Quarterly Report)

• Form 8-K (Current Report)

• Proxy Statements

• Sections 13 and 16 Filings

Forms 3, 4 or 5 for reporting beneficial ownership by insiders Schedules 13D and 13G for reporting beneficial ownership by others

• Regulation G and Regulation FD

• Comply with the Sarbanes-Oxley Act of 2002

• Disclosure Controls and Procedures

• Internal Control over Financial Reporting/Attestation

JOBS Act provides that “emerging growth companies” may take advantage of reduced reporting obligations on internal controls during the first five years

SEC Reporting Requirements for BDCs

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• Valuation policy

• Control investments, investments in affiliates vs. investment in non-affiliates

• Schedule of investments

Disclose non-income producing investments Disclose assets held in securitized vehicles

• Concentration – Geography and industry sectors

• Fair value and Level 3 reconciliation tables

Financial Statement Disclosures

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• BDCs that have their securities listed or traded on NASDAQ/NYSE must comply with the corporate governance listing standards, including: A listed BDC must have an audit committee composed solely of

“independent directors” (as defined by the applicable exchange or association).

Director nominees of a listed BDC must be selected or recommended for the Board’s selection by a nominating committee or the vote of a majority of the BDC’s independent directors (depending on the exchange).

The non-management, or “independent directors”, of the BDC must hold regularly scheduled executive sessions.

The BDC must adopt a code of business conduct and ethics, various committee charters and, in the case of NYSE-listed BDCs, corporate governance guidelines. All such documents must be posted on the company’s website.

NASDAQ/NYSE Listing Standards

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• BDC must have a majority of independent directors - persons who are not “interested persons” as defined in Section 2(a)(19) of the 1940 Act.

• Custodian Agreement A BDC generally must place and maintain its securities and similar

investments in the custody of a bank qualified under Section 26(a)(1) of the 1940 Act or a broker dealer, or be subject to additional audit and operational procedures related to securities held in safekeeping.

• Fidelity Bond A BDC must maintain a bond issued by a reputable fidelity insurance company, in an

amount prescribed by the 1940 Act, to protect the BDC against larceny and embezzlement. The bond must cover each officer and employee with access to securities and funds of the BDC.

• Requirement to maintain and enforce a Code of Ethics for officers of the BDC Includes reporting of all securities holdings and transactions.

1940 Act Requirements

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• Restrictions on investing in other investment companies. A BDC may not invest: In more than 3% of the outstanding voting stock of an investment company More than 5% of the value of its total assets in an investment company More than an aggregate of 10% of its total assets in investment companies

• Restrictions on investment funds investing in a BDC Neither a public (i.e. registered) or private investment fund may own more than

3% of the outstanding voting stock of a BDC

• Limitations on indemnification A BDC is prohibited from protecting any director or officer against any liability to

the company, or its security holders, arising from willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of such person’s office.

• Bookkeeping and records requirements A BDC must maintain and make available for inspection prescribed books and

records.

• BDCs must make available significant managerial assistance to their portfolio companies

1940 Act Requirements (cont.)

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• Must appoint a Chief Compliance Officer

• Must maintain a compliance program compliant with Rule 38a-1 of the 1940 Act, which requires: Adoption and implementation of policies and procedures designed to

prevent violation of the federal securities laws. Review of these policies and procedures annually for their adequacy and

the effectiveness of their implementation.

• Compliance polices and procedures for the registered investment adviser under Rule 206(4)-7 of the Investment Advisers Act of 1940 Requires an investment adviser of a BDC to adopt and implement

policies and procedures. Requires maintenance and enforcement of a code of ethics for advisor’s

employees.

• Subject to regular examinations by the SEC

1940 Act Requirements (cont.)

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• BDCs are not permitted to sell shares below net asset value without shareholder approval Approval must be obtained annually Markets have imposed limitations on how much an BDC can sell below

NAV

• BDCs may seek to receive an SEC order granting exemptive relief permitting, among other things: Co-investment among affiliates Ownership of a registered investment adviser Exclusion of leverage from the asset coverage calculation for debt held by

an SBIC subsidiary Issuance of restricted stock to officers / employees Issuance of stock options to independent directors

• Exemptive relief process may take from 6 – 18 months depending on complexity Typically based on precedents

Other Important Limitations

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• A BDC must invest 70% of its assets in “good” BDC assets.

• 70% basket includes securities issued by an “eligible portfolio company,” as defined in Section 2(a)(46), which includes: U.S. issuers that are neither an investment company as defined in section 3

(other than a wholly-owned SBIC) nor a company which would be an investment company except for the exclusion from the definition of investment company in section 3(c) and (i) do not have any class of securities listed on a national securities

exchange; or (ii) have a class of securities listed on a national securities exchange, but

have an aggregate market value of outstanding voting and non-voting common equity of less than $250 million.

• A BDC can generally invest with flexibility in “bad” assets that do not fall within the “70% basket”. The SEC Staff has never been called upon to consider whether utilizing a

specific strategy for the entire “30% basket,” e.g., investing solely in foreign companies, might run afoul of the intent of Section 55(a)

“Good” vs. “Bad” BDC Assets

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• BDCs must have 200% asset coverage (Total Assets/Total Debt). For example, a BDC with $50 in equity can borrow up to $50 A BDC would be able to invest $100 in growing businesses

• Other investment companies are restricted to a 300% asset coverage requirement with respect to issuing debt.

• BDCs may exclude leverage at the SBIC level if the SEC grants

exemptive relief, which many have received.

$50 Equity

$50 Debt $50

Equity

$50 Equity

$25 Debt $50

Equity

Limitations on Borrowings

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BDC Use of Leverage

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0.91 0.87

0.85

0.80 0.80 0.78

0.76 0.75 0.74 0.73 0.70

0.68 0.67 0.65 0.64 0.63 0.63 0.62

0.60 0.59

0.52 0.52 0.52 0.50

0.48 0.48 0.46 0.46 0.45 0.44 0.44

0.40 0.38

0.29 0.25 0.24

0.16

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

Average Debt/ Equity = 0.53x

As of 12/31/14; Excludes SBA debt; includes preferred securities as debt

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• Section 57 addresses the ability of BDCs to engage in certain types of transactions with affiliates:

Section 57 is less onerous than its counterpart for registered investment companies (Section 17).

• Depending on the nature of the affiliation with the BDC, transactions involving a BDC and one or more of its affiliates require either:

Authorization by the required majority of the board of directors, which consists of a majority of the board, including a majority of disinterested board members; or

An order of the Commission. • Co-investment between a BDC and an affiliated fund generally

requires SEC exemptive relief

Mass Mutual exception (i.e., no terms negotiated other than price) Recent staff guidance has provided additional flexibility without

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Limitations on Transactions with Affiliates

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Part IV: Management and

Operational Considerations

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• BDC is managed internally by executive officers (i.e., no external adviser)

• Must comply with SEC executive compensation disclosure requirements

• Certain performance-based compensation is permitted, including: Issuance of at-the-market options, warrant, or rights pursuant to an

executive compensation plan; or Maintenance of a profit sharing plan

• Otherwise, the BDC must use cash assets as compensation

• Exemptive orders permitting the issuance of restricted stock have been issued in a number of circumstances including: Hercules Growth Technology, Inc. MCG Capital Corporation Main Street Capital Corporation

Internally-Managed Structure

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• Portfolio managed by external investment adviser

• Investment adviser must be registered under the Advisers Act

• May utilize an external administrator for expense reimbursement purposes

• Adviser is permitted to take a base management fee, as well as an incentive fee on both:

Investment income Realized capital gains

• Contrasts with most registered closed-end funds, which are typically prohibited from taking an incentive fee on capital gains

• Incentive fees are often subject to hurdle/catch-up features

Externally-Managed Structure

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• SEC Staff has taken no formal position on the calculation of the fee but requires BDCs to contain extensive disclosure in registration statements regarding the manner in which the fee will be calculated in varying scenarios.

• Section 205(b)(3) of the Advisers Act permits external investment advisers to BDCs to receive incentive fees, provided that the BDCs do not have outstanding any equity-based compensation arrangement or profit-sharing plan. Section 205(b)(3) provides an exception from the general prohibition on an investment

adviser charging an incentive fee based on a share of capital gains. May assess an incentive performance fee of up to 20% on a BDC’s realized capital

gains net of all realized capital losses and unrealized capital depreciation over a specified period.

• Section 205(b)(3) of the Advisers Act makes no reference to whether the unrealized capital depreciation by which the fee must be reduced includes: Only depreciation below the original cost of the security in question, or Whether it includes a decrease in value in a security above the original cost but below

the point of a previous unrealized capital appreciation.

Calculation of Adviser’s Incentive Fee

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• Investments are reported at fair value, as determined in good faith by the board of directors.

• ASC 820 – Fair Value Measurements and Disclosures (formerly FAS 157).

• “Fair value” – Price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at measurement date.

• Key Controls in the Valuation Process: Documented approval of trades Controls over inputs in valuation write-ups Segregation between preparation and review of valuations Use of independent third-party valuation consultants to assist Identified and monitored problem loans High level analytical reviews Completeness of disclosures All controls evidence Sarbanes-Oxley 404 readiness

Portfolio Valuation Process

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• Investments classified into three levels: Level 1: Inputs are unadjusted, quoted prices in active markets for identical financial

instruments at the measurement date.

Level 2: Inputs include quoted prices for similar financial instruments in active markets and inputs that are observable for the financial instruments, either directly or indirectly, for substantially the full term of the financial instrument.

Level 3: Inputs include significant unobservable inputs for the financial instruments and include situations where there is little, if any, market activity for the investment. The inputs into the determination of fair value are based upon the best information available and may require significant management judgment or estimation.

• Majority of BDCs classify debt and equity investments as Level 3 instruments.

• Debt investments with broker quotes may be considered a Level 2 instrument (broadly syndicated loans).

General Principles of Valuation

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• General Economic Factors Changes in interest rates and credit spreads and return on equity Changes in aggregate demand level Changes in economic outlook

• Industry Factors Change in supply or demand for product Change in competition Barriers to entry

• Company Specific Factors Current and expected life cycle of company – Achievement of milestones, company

performance relative to projections Experience and competence of the top management team and board of directors Existence of intellectual capital and intangible assets

Proprietary technology, products, or services Quality of work force Strategic relationships with major suppliers or customers

Cost structure and financial condition

Factors That Impact Valuation

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• A BDC may elect to be taxed as a “regulated investment company,” or RIC, under the Internal Revenue Code

• Taxation as a RIC:

Allows “pass through” tax treatment for income and capital gains that are distributed to shareholders.

A BDC must distribute at least 90% of its investment income to shareholders annually.

The BDC may retain, distribute or “deem distribute” capital gains. BDC must meet minimum source of income requirements annually

and meet requirements on a quarterly basis with respect to the portfolio diversification.

• Conversion to RIC status

Formation considerations – Built-in gains

Taxation as a RIC

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BDC Proposed Legislative Changes

• Industry continues to seek to modernize the BDC model

• Various bills have been introduced over the years, including during 113th Congress: H.R, 31 - Next Steps for Credit Availability Act, co-sponsored by Nydia

Velazquez (D-NY) and Gregory Meeks (D-NY)

H.R. 1973 - Small Business Credit Availability Act, sponsored by Mick Mulvaney (R-SC)

H.R. 1800 - Small Business Credit Availability Act, co-sponsored by Michael Grimm (R-NY) and Tom Graves (R-GA)

• None were ultimately passed

• Industry continues to pursue similar legislative changes through 114th Congress, which convened in January 2015 Efforts led by Small Business Investor Alliance and several BDC

management teams

Focused on same issues

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Proposed Legislative Changes Section, Rule or Form to be Amended

Explanation Impact on BDCs

Ownership of Registered Investment Advisers

1940 Act – Section 60 Allows BDCs to own registered investment advisers

Eliminate need for BDCs to seek SEC exemptive relief, leveling the playing field between BDCs that have been granted exemptive relief and those that have not.

Asset Coverage Limit Reductions

1940 Act – Sections 18 and 61(a) Lowers the asset coverage requirement for BDCs from 200% to 150%, subject to shareholder approval and disclosure of the increased indebtedness, and allows BDCs to issue multiple classes of preferred stock

Would allow BDCs to incur more leverage, enabling them to raise additional assets to invest in small to mid-size U.S. companies.

Registration and Reporting Parity

Forward incorporation (Form N-2) Allows BDCs to incorporate already-filed information by reference.

Would allow BDCs to raise capital more efficiently and respond to market conditions more quickly. Investors also able to readily access most important information about an issuer.

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Proposed Legislative Changes Section, Rule or Form to be Amended

Explanation Impact on BDCs

Flexible Communications Free writing prospectuses are useful to convey recent developments or other updated disclosure, as a way of avoiding recirculation of an updated preliminary prospectus.

Would allow BDCs to communicate to potential investors without violating gun-jumping provisions. Permits BDCs to release factual and forward-looking business information, keeping BDCs in step with market.

Prospectus Safe Harbors (Rules 134, 163 and 163A)

Allows BDCs to communicate with investors more freely during the preparation and filing periods for a registration statement.

Would permit BDCs to release factual business information with more certainty; more flexibility in communicating to investors.

Research (Rules 138 and 139)

Provides safe harbors for brokers and dealers providing market analysis to investors. Publications, distributions or reports within either rule will not constitute offers to/for sale under 1933 Act.

Allows broker-dealers and other providers of market research more flexibility to disseminate research on BDCs and allows more communication of information to the market about BDCs.

WKSI Status (Rules 405 and 433) Allows BDCs to: (1)Qualify as WKSIs; (2)File automatic shelf registrations; and (3)Use free-writing prospectuses.

Less stringent disclosure and communication requirements. Would allow BDCs to file automatic shelf registrations to take advantage of frequently changing market windows.

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Proposed Legislative Changes Section, Rule or Form to be Amended

Explanation Impact on BDCs

Shelf Registration (Rule 415)

Rule 415 specifies which offerings qualify for shelf registration and imposes certain obligations to remain qualified under the rule.

Allows for SEC review of BDC N-2 shelf-registration statement in advance of accessing public markets. Offers more certainties with respect to timing.

Final Prospectus (Rule 497) Rule 497 governs when investment companies must file prospectuses during the registration process.

Allows a BDC to file final prospectus with SEC, and not deliver prospectus to individual investors. Would synchronize BDC prospectus filing requirements with those of other registrants and save considerable time and money.

Written Confirmation (Rules 172 and 173)

Relieves BDCs of requirement to provide written confirmations of sales, notifications of allocation, and deliveries of securities.

Would permit BDCs greater flexibility in the sales process in parity with other issuers covered by the rule.

Free-Writing Prospectus Safe Harbor (Rule 164)

Provides safe harbor to BDCs for post-filing free-writing prospectuses.

BDCs would be able to more freely communicate to potential investors.

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Impact of the Volcker Rule

• Final Dodd-Frank Volcker Rule issued December 10, 2013 Generally prohibits banking entities from:

Engaging in short-term proprietary trading, or Investing in, or having certain relationships with, hedge funds and private

equity funds, referred to as “covered funds” under the Volcker Rule. BDCs are excluded from the definition of “covered fund” under the Volcker

Rule As a result, a banking entity generally may invest in a BDC, including one

that potentially engages in activities subject to restriction under the Volcker Rule so long as that banking entity does not hold the power to vote 25% of such BDC’s voting shares, provided that it is otherwise permitted to do so under applicable banking law.

Likewise, a banking entity may manage such a BDC, so long as it does so in compliance with applicable securities and banking law.

As written, the Volcker Rule potentially creates incentives for banks to invest in BDCs.

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Impact of the JOBS Act on BDCs

• Designed to encourage capital formation for small U.S. businesses

• Permits “emerging growth companies” (EGCs) to confidentially file an initial registration statement EGC is defined as having less than $1 billion total annual gross revenues in its most

recent fiscal year.

• EGCs are exempt from certain requirements of the Sarbanes-Oxley Act EGCs planning an IPO have more time to ramp up their SOX programs, allowing the

companies to focus on expanding their business

For the five years following an IPO, companies with revenues of less than $1 billion a year are not required to comply with Section 404(b) of SOX, which requires external auditors to attest to the EGC’s internal controls over financial reporting unless: The company’s revenue grows to more than $1 billion, The company issues more than $1 billion in nonconvertible debt over a three-year period, or The company’s worldwide public float exceeds $700 million.

• EGCs must continue to comply with the other provisions of SOX, including management certification that internal controls are operating effectively.

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Part V: Convergence of BDCs and SBICs

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BDC - SBIC Trends

• SBIC Subsidiaries

19 BDCs have one or more SBIC subsidiaries. Provides access to low-cost debt (a fully funded SBIC with $75

million in regulatory capital can access up to $150 million in leverage from the SBA with an option for a second license for an additional $75 million).

SBICs under common control can access up to $225 million in leverage, which Congress may increase to $350 million.

• Fund Platforms

BDCs are building platforms of funds that complement the BDC’s business

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• Four (4) SBICs elected to become BDCs and conducted successful IPOs Main Street Capital Corporation / $64,500,000 Triangle Capital Corporation / $71,550,000 Fidus Investment Corporation / $70,050,000 Capitala Finance Corp / $80,000,000

• One (1) BDC began IPO process with one or more SBIC subsidiaries Golub Capital BDC, Inc.

• Fourteen (14) BDCs have received an SBIC license for a wholly-owned subsidiary or acquired an SBIC subsidiary: Fifth Street Finance Corp. Garrison Capital, Inc. Hercules Technology Growth Capital MCG Capital Corporation Medallion Financial Corp Medley Capital Corp. Monroe Capital Corp.

• Additional BDCs are in the process of obtaining an SBIC license

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BDCs With SBIC Subsidiaries

New Mountain Finance Corp. OFS Capital Corporation PennantPark Investment Corp. Rand Capital Corporation Saratoga Investment Corporation Stellus Capital Investment Corp TCP Capital Corp

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• Conversion Transaction Approval of LPs in advance of valuation and merger Merger of SBIC into subsidiary of BDC Amend limited partnership agreement SBA approval

• SEC Review Affiliate transaction issues Compensation issues Disclosure issues

How Does an SBIC Convert to a BDC?

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BDC/SBIC Structure

• Exemptive Relief

• Relief to get SBIC leverage treatment at BDC level

• Section 18(a):

Question of whether BDC with an SBIC subsidiary must comply with the asset coverage requirements of Section 18(a) (as modified by Section 61(a) for BDCs) on a consolidated basis.

The senior securities issued by the SBIC Subsidiary would be excluded from the SBIC Subsidiary’s individual asset coverage ratio by Section 18(k) if the SBIC Subsidiary were a BDC.

Exemption requested- senior securities representing indebtedness issued by the SBIC Subsidiary may be excluded from the BDC’s consolidated asset coverage ratio.

The SEC regularly provides this exemptive relief, which generally does not take as long as other forms of relief.

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What are the Incentives for an SBIC to Convert to a BDC?

• Why Are BDCs Attractive to SBICs? Ability to access public market Flexibility in funding portfolio investments Permanent capital base Additional compensation incentives

• Why Are SBICs Attractive to the BDC Market?

Existing portfolio – not blind pool Existing management team with track record Market niche – lower middle market Additional leverage capacity

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Contact Information

For more information, please visit our practice site at www.publiclytradedprivateequity.com and our corporate site at

www.sutherland.com.

Harry S. Pangas Partner 202.383.0805 [email protected]

Lisa Morgan Partner 202.383.0523 [email protected]

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Disclaimer

All Rights Reserved. This communication is for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making any decisions or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Sutherland and the recipient.

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