BDCs notched up another victory in a quest to boost leverage and reduce paperwork requirements.
In a 53-to-4 vote last month, the House Financial Services Committee passed HR 3868, the Small Business Credit Availability Act.
What’s notable in the committee vote is the strong showing of bipartisan support. A previous version of the bill was passed by the House Financial Services Committee 31-26, along a straight party line vote.
“The industry has come together to make their case. Even though they’ll compete passionately against each other in the market, they have to work collaboratively to create a regulatory environment in which they can compete and thrive,” said Brett Palmer, President of the Small Business Investor Alliance (SBIA), in an interview with LCD.
“The mark of a mature industry is recognizing a common interest.”
The next step for the current bill, HR 3868, is the passage by the full House of Representatives, which may come in the next few months. The strong support for the bill by the committee could reflect the bill’s chances of succeeding.
A short legislative calendar next year, in part due to the presidential election, could diminish the bill’s chances of full passage by January 2017. The previous bill expired with the expiration of that Congress. An even earlier version of the bill suffered from an introduction near the end of a congressional cycle, and also eventually expired.
However, working in the bill’s favor this time is the fact that it was marked up in the first session of this Congress, giving the bill all next year to work through full House and Senate votes.
“This may be slow, but it is a very good trend,” said Palmer. “The clock matters.”
Leverage increase: image problem?
The bill was the result of compromise to bring former opponents to the bill from the committee on board. But even with changes, it was not without critics, including from the SEC and state regulators. Proponents of the bill say they have met criticism with increased investor protection.
“Every time the SEC came back to us with changes, we made them,” said Rep. Mick Mulvaney (R-SC), the sponsor of the legislation, in the Nov. 4 markup.
Possibly the most important potential change in the works for BDCs is the asset-coverage requirement. The bill would effectively raise the leverage limit to a 2:1 debt-to-equity ratio, from the current 1:1 limit.
Moreover, existing rules dictate that BDCs invest at least 70% of total assets into “eligible portfolio companies,” leaving out many financial companies. The new bill aims to allow investments in 20% of certain finance companies. The bill would also allow a BDC to issue multiple classes of preferred stock, and streamline their registration process.
“It includes provisions I would have preferred were never offered. For example, I see no reason to allow BDCs to invest more assets in finance companies. However, by agreeing to cap the additional assets by 20% I think we will still preserve the character of BDCs as a useful mechanism for delivering funding to small businesses,” Maxine Waters, (D.-Calif.), Ranking Member of the House Financial Services Committee, said in the markup last month.
“I have bent over backwards for this bill, because I do want our small businesses have access to capital,” Waters said.
Jim Himes (D-Conn.), who voted against the bill, raised his reservations during the Nov. 4 markup. He said he had concerns with the bill mainly due to consumer protection issues.
“The underlying idea of expanding credit availability to small businesses through the BDCs is a good idea,” Himes said in an address to the committee at the markup. “They are fairly complicated instruments, but at the end of the day they end up in the hands of retail investors.”
The increase in leverage to 2-to-1 from 1-to-1 is actually a much larger increase in leverage than it appears, particularly in the 30% basket which could include leveraged businesses that are part of CLOs, Himes said.
“Of course it is banks that are lending to these BDCs, and they do their work. They’re not going to lend, hopefully, to BDCs that are behaving irresponsibly. But remember, that BDCs will chase yield… which means they have an incentive to lever up through that 30% bucket.”
Himes also expressed concern about the expansion of investment to financial services companies.
“This bill, which again, I think I can find my way to supporting, will simply make these instruments slightly more risky.
“More of these instruments will fail, and the retail investors will pay the cost for those additional failures. That may be ok so long as we’re comfortable with the idea that credit should be more available to the business. That’s the trade off,” Himes said.
Bill has bi-partisan support
Rep. Mick Mulvaney (R-SC), the sponsor of the bill, cites a 2013 tour of Ajax Rolled Ring and Machine as the moment he learned what a BDC was. At the time of Mulvaney’s tour, Ajax was controlled by Prospect Capital. Propsect’s investment in Ajax from April 2008 included a $22 million loan and $11.5 million of subordinated term debt.
The SBIA has long argued that BDCs are an important lender to small and mid-sized companies, a segment underserved since increased regulation on banks in the wake of the credit crisis. The middle market, which the SBIA defines as companies that generate $10 million to $1 billion of revenue, is growing faster than other parts of the economy.
Mulvaney stands by BDCs as an important source of credit for companies that are too big for their local bank but too small for a regional bank, capital markets, or national financial institutions. He believes modernization of BDC regulation is overdue.
“This is in a world now where other financial institutions that are competing for similar types of businesses are leveraged as much as eight or nine to one. It would seem fit today to expand that leverage slightly, slightly, to 2 to one, not eight to one or nine to one,” said Mulvaney at the markup.
“Another limitation we put on these entities when we created them for some reason was not to allow them to invest in financial institutions small and medium sized financial institutions, investment advisor firms… These are segments of our economy that badly need access to capital. The BDCs stand willing and able in a very sound way to provide those businesses with capital.
“This is a tool that we are not using adequately. This is a tool that we should be using,” Mulvaney said. — Abby Latour
Follow Abby on Twitter @abbynyhk for middle-market deals, leveraged M&A, BDCs, distressed debt, private equity, and more.
See also “BDCs head to Washington to make case to modernize rules,” LCD News, June 20, 2015.