(Refile for wider audience)
By David Brooke
NEW YORK, July 23 (LPC) - Participants in the business development company (BDC) sector are pondering whether the Securities and Exchange Commission (SEC) will push through with exempting the market from the Acquired Funds Fees Expenses (AFFE), an arcane rule that many see as the key to restricting liquidity.
AFFE calls for investment companies like mutual funds to provide an additional line on their expenses outlining the fees and operating costs charged by the BDC they are investing in, which results in inflating the overall expense ratio of the fund.
The SEC adopted the AFFE requirement in 2006 for BDCs as part of its push for greater transparency on fee structures in the market. Multiple fund indices, like the Russell and the S&P, had since then delisted BDCs, resulting in the negative impact on BDC share prices the requirement has generated.
Market participants have argued that the requirement is old fashioned and has had the adverse effect of making BDCs appear prohibitively expensive to a number of investors, therefore shrinking the overall investor base and reducing the amount of capital in the market.
“The AFFE has been a long-standing complaint. BDCs are not like a fund of funds, but are more like an operating company. In theory it makes the BDC look more expensive, but you’re not really comparing apples to apples,” said George Zornada, partner at law firm K&L Gates.
In December, the SEC provided hope to the market that it was open to exempting BDCs from the AFFE guideline as it added a request for views from the market alongside its broader fund of funds reforms proposal.
But some have said that hope has dissipated since the launch of the consultation, although there is widespread agreement on the benefits of removing the AFFE.
“When the SEC put out the question in December some were excited it could happen this year, but I think now there is more sobriety across the market. I’d quite frankly be shocked if it happened. It wouldn’t necessarily be a black swan, but instead more of a grey swan moment,” one analyst said, suggesting an AFFE exemption is possible, although seemingly unlikely at this moment.
Overtime, the AFFE rule has resulted in a retail-heavy shareholder base. And while retail investors like mutual funds are important, it has prevented more sophisticated investors like pension funds and insurance companies from buying BDC shares.
“A cohort of investors appreciates the BDC investment opportunity and they stomach the pains of the AFFE, but that small group would buy more and others would join them,” the analyst added.
Still, others remain optimistic and point to the exemption for Real Estate Investment Trusts and collateralized debt obligations from the AFFE as a precedent for the potential change.
“We’re certainly hopeful,” said Michael Gerber, senior managing director of corporate affairs at FS Investments. “We see no sound policy reasons for BDCs to be treated less fairly than these other types of investments when it comes to AFFE.”
Joe Glatt, chairman of the Coalition for Business Development, a group representing BDCs that lobbied against the rule, said he is “pleased with the SEC’s staff engagement on our exemptive request.”
“We remain cautiously optimistic,” he said.
The BDC market has become an important source of funding for middle market companies since the inception of the rule 13 years ago. Further prompting optimism is the echoes of sympathy for the market in Washington.
BDC total assets were US$106bn in the first quarter of 2019, according to data from Wells Fargo and BDC Collateral. This was an increase from US$94.5bn and US$84.7bn recorded in the first quarters of 2018 and 2017.
Last year’s passage of the Small Business Credit Availability Act that increased the amount of debt that BDCs can incur was a big win for the market, enabling BDCs to increase their leverage facilities, which many have since taken advantage of.
Before the mid-terms, Republican congressman Tom Graves addressed BDCs’ complaint about the AFFE requirement in an appropriations bill, urging the SEC to address the “adverse impacts” on the market. This has fueled hope that lawmakers are on their side.
“There seems to be a strong bipartisan understanding of the harmful consequences the AFFE disclosure requirements are having on BDC investors and the industry as a whole,” Gerber said. (Reporting by David Brooke Editing by Michelle Sierra and Jon Methven)