Private Equity Direct - Summer 2011 - Business Development Companies
BACK TO THE FUTURE
If early indications are anything to go by, the next 12 months could see a resurgence in the market for Business Development Companies. The little-known investment vehicles specialize in providing capital to small private companies and, with credit still tight in some sectors — despite historically low interest rates — there is a growing appetite for alternative funding among both investors and target companies.
Unlike their private equity cousins, Business Development Companies face no restrictions on the type of investor they may attract. "It is essentially a vehicle through which the investment manager can make Private Equity investments and get access to the public markets to find investors and capital," explains Matt Maulbeck, a director in EisnerAmper's financial services group. Traditional Private Equity funds are often restricted to receiving investment capital from high net worth individuals or institutional investors but anyone can invest in a Business Development Company. In fact, a Business Development Company is actually restricted the other way, explains Maulbeck. "They are required to invest at least 70% of the portfolio in small, privately traded companies, which generally leads to greater investment diversity. Some financial advisors are starting to suggest Business Development Companies as a potential vehicle for investors looking to build a high-yield portfolio."
One primary factor driving renewed interest in Business Development Companies is the tax advantages. The reversal late last year of controversial 'carried interest' tax changes came as a welcome relief to the Private Equity and Business Development Company industry. Under the American Jobs and Closing Tax Loopholes Act of 2010 Business Development Companies, hedge funds and Private Equity funds would have seen 50% of carried partnership interest taxed at ordinary rates with the remaining 50% being charged at capital gains tax rates. This ratio was to increase to 75:25 after 2012. The announcement that Senator Baucus (D-MT) dropped the provision from the final Bill brought a collective cheer from industry insiders.
Furthermore, business development companies are treated as regulated investment companies (RICs) under tax laws and as such boast certain tax advantages. RIC rules allow for pass-through tax treatment on income and capital gains. This effectively means that there is no income tax, although investors would likely have to personally pay tax on distributions they receive. In order to maintain RIC status, a Business Development Company must distribute a minimum of 90% of taxable earnings annually to maintain their one-level tax paying status. In reality, many firms actually pay out virtually all taxable income and short- and long-term capital gains. This leads to a more stable and predictable dividend stream.
From the perspective of the investment manager, Business Development Companies have other advantages besides being flow-through tax entities. As Maulbeck explains, "One important thing about Business Development Companies is there are no issues with investor redemption. The money raised is permanent capital." Because stock is publicly issued and traded on exchanges, there are few restrictions on who can purchase the equities. Business Development Companies provide access to public capital markets, thus giving greater liquidity vs. regular Private Equity funds. Investors in Business Development Companies often consider them to be lower-risk investments than related products like high-yield ETFs or equity in single private companies.
Even though Business Development Companies are prone to volatility just like other common stocks, there is a belief that they are less susceptible to dramatic swings or complete collapse. This is in part because of strict leverage rules which require total debt to be no more than half of total assets, effectively setting a 2:1 asset coverage ratio. Over leveraging was identified as one of the problems that contributed to the global financial crisis.
Of course having access to public markets means that Business Development Companies are subject to many of the reporting requirements of public companies, Maulbeck explains. They have to comply with Sarbanes-Oxley and issue regulatory filings such as 10-K, 10-Q, and proxy statements. This requirement can be burdensome and may be a disincentive to setting up a Business Development Company.
Despite the clear tax advantages and potentially increased liquidity, Business Development Companies have never been all that popular. There are currently fewer than 30 being publicly traded and although there are signs of increased activity only time will tell if they become a more viable investment option.
Private Equity Direct - Summer 2011 Issue