A hearing by the Senate banking committee showed bi-partisan agreement for BDCs as a driver of growth for smaller U.S. companies, but exposed some rifts over whether financial companies should benefit from easier regulation.
BDCs are seeking to reform laws, including allowing more leverage of a 2:1 debt-to-equity ratio, up from the current 1:1 limit. They say the increase would be modest compared to existing levels for other lenders, which can reach 15:1 for banks, and the low-20x ratio for hedge funds.
A handful of BDCs are seeking to raise investment limits in financial companies. They argue that the current regulatory framework, dating from the 1980s when Congress created BDCs, fails to reflect the transformation of the U.S. economy, away from manufacturing.
BDCs stress that they are not seeking any government or taxpayer support.
They are also seeking to ease SEC filing requirements, a change that would streamline offering and registration rules, but not diminish investor protections.
Ares Management President Michael Arougheti told the committee members in a hearing on May 19 that although BDCs vary by scope, they largely agree that regulation is outdated and holding back the industry from more lending from a sector of the U.S. economy responsible for much job creation.
“While the BDC industry has been thriving, we are not capitalized well enough to meet the needs of middle market borrowers that we serve. We could grow more to meet these needs,” Arougheti said.
In response to criticism about expansion of investment to financial services companies, the issue of the 30% limit requires further discussion, Arougheti said.
The legislation under discussion is the result of lengthy bi-partisan collaboration and reflects concern about increased financial services investments, resulting in a prohibition on certain investments, including private equity funds, hedge funds and CLOs, Arougheti added.
“There are many financial services companies that have mandates that are consistent with the policy mandates of a BDC,” Arougheti added.
Senator Elizabeth Warren (D-MA) raised the issue of high management fees of BDCs even in the face of poor shareholder returns. Several BDCs have indeed moved to cut fees in order to better align interests of shareholders and BDC management companies.
She said that Ares’ management and incentive fees have soared, at over 35% annually over the past decade, outpacing shareholder returns of 5%, driving institutional investors away from the sector, and leaving behind vulnerable mom-and-pop retail investors. Arougheti countered by saying reinvestment of dividends needed to be taken into account when calculating returns, and said institutional investors account for 50–60% of shareholders.
Warren said raising the limit of financial services investment to 50%, from 30%, diverts money away from small businesses that need it, while BDCs still reap the tax break used to incentivize small business investment.
“A lot of BDCs focus on small business investments and fill a hole in the market. A lot of companies in Massachusetts and across the country get investment money from BDCs,” said Warren.
“If you really want to have more money to invest, why don’t you lower your high fees and offer better returns to your investors? Then you get more money, and you can go invest it in small businesses,” Warren said.
Brett Palmer, President of the Small Business Investor Alliance (SBIA), said the May 19 hearing, the first major legislative action on BDCs in the Senate, was a step toward a bill that could lead to a new law.
“There is broad agreement that BDCs are filling a critical gap in helping middle market and lower middle market companies grow. There is a road map for getting a BDC bill across the finish line, if not this year, then next,” Palmer said, stressing the goal was this year.
Technically, the hearing record is still open. The Senate banking subcommittee for securities and investment could return with further questions to any of the witnesses. Then, senators can decide what the next stop will be, ranging from no action to introduction of a bill.
Pat Toomey (R-PA) brought up the example of Pittsburgh Glass Works, a company that has benefited from a BDC against a backdrop that has seen banks pulling back from lending to smaller companies following the financial crisis, resulting in a declining number of small businesses from 2009 to 2014.
The windshield manufacturer, a portfolio company of Kohlberg & Co., received $410 million in financing, of which $181 million came from Franklin Square BDCs.
“Business development companies have stepped in to fill that void,” Toomey told the committee hearing. “For Pittsburgh Glass, it was the best financing option available to them.”
FS Investment Corp.’s investment portfolio showed a $68 million L+912 (1% floor) first-lien loan due 2021 as of March 31, an SEC filing showed.
Arougheti cited the example of OTG Management, a borrower of Ares Capital. OTG Management won a contract to build out and operate food and beverage concessions at JetBlue’s terminal at New York airport JFK, but was unable to borrow from traditional senior debt lenders or private equity firms due to its limited operating history.
Ares Capital’s investment in OTG Management included a $24.7 million L+725 first-lien loan due 2017 as of March 31, an SEC filing showed. — Abby Latour
Follow Abby on Twitter @abbynyhk for middle-market deals, leveraged M&A, BDCs, distressed debt, private equity, and more.