Bipartisan bill would ensure accurate disclosure to small business investors
WASHINGTON, D.C. (June 25, 2020) – The Small Business Investor Alliance (SBIA), the premiere association representing Business Development Companies (“BDCs”) and lower middle market private equity and its investors, today announced that bipartisan legislation has been introduced by Rep. Brad Sherman (D-CA) and Rep. Steve Stivers (R-OH) that will exempt exchange-traded BDCs – as a vehicle that invests in small- and medium-sized American businesses – from the SEC’s 2006 acquired fund fees and expenses (“AFFE”) rule.
Currently, funds that acquire BDCs are required to provide information to the SEC that forces them to report fees inaccurately. This disclosure form essentially results in double counting the actual cost to shareholders of investing in BDCs. Because of this, the indices decided to remove BDCs which has severely impacted institutional investment and harmed retail investors.
“This legislation will improve our nation’s securities laws and ensure that the U.S. capital markets remain the most competitive, transparent, and liquid in the world – at a time when we need it most,” said SBIA President Brett Palmer.
Background on AFFE
- Given the capital and personnel-intensive nature of actively sourcing and managing a portfolio of smaller private investments, BDC operating expenses are naturally higher than, for example, passive index funds. However, these expenses are already reflected in a BDC’s quarterly reported net asset value (“NAV”) and, thus, ultimately reflected in its trading price.
- Requiring funds to report BDC expenses again under the AFFE rule results in a double counting of BDC expenses that artificially inflates acquiring fund expense ratios.
- The AFFE rule’s application to BDCs has reduced institutional investment in the industry, as the artificially inflated expense ratios make it difficult for funds to justify BDC holdings.
- Between 2006 and 2014, the BDC industry experienced dramatic growth, magnifying the impact of the AFFE rule. As a result, the MSCI, Russell and S&P indices removed BDCs from their indices in 2014, which precipitated a 25 percent decrease in institutional investment (primarily by index funds) in BDCs. Between 2014 and 2018 there was another 13 percent drop in institutional investors in the BDC space.
- Several unintended consequences of the AFFE Rule’s application to BDCs have proven harmful to retail investors: fewer analysts cover BDCs, reducing publicly available information for retail investors; reduced institutional ownership of BDCs denies retail investors the benefit of corporate governance oversight provided by sophisticated institutional investors; and, finally, reduced trading volume and liquidity of BDC shares makes the BDC market less efficient and increases the cost of capital.
- In 1980, when the U.S. was dealing with high unemployment and an energy crisis, Congress wanted to boost economic growth by increasing access to capital for American businesses. This was a bi-partisan effort.
- The BDC structure is one of the most transparent, heavily regulated forms of middle market lending in the capital markets.
- BDCs provide funding to middle market companies that are not yet large enough to access broad capital markets, but require more capital for growth than banks can provide.
- The BDC structure also offers retail or Main Street investors the opportunity to invest in smaller U.S. companies that otherwise only high net worth investors can access. This helps to close both the investment opportunity gap and the capital gap.
- BDCs have provided good returns to investors compared to traditional fixed income investments.
- SEC Chairman Jay Clayton told The Wall Street Journal that individual investors need more access to the private markets. In his speech in Nashville, he also said that companies located in the center of the U.S. need more access to capital.
- By law, BDCs must invest at least 70% of their assets in private and small-cap U.S. businesses, creating jobs and helping fill a void in the capital markets. In actuality, 95.2% of BDC investments are made in U.S. entities.
- BDCs are currently held by the following types of investors:
- 50% Individuals
- 30% IRAs
- 20% Institutions
About the Small Business Investor Alliance (SBIA)
The Small Business Investor Alliance (SBIA) is the premier organization of lower middle market private equity funds and investors. SBIA works on behalf of its members as a tireless advocate for policies that promote competitive markets and robust domestic investment for growing small businesses. SBIA has been playing a pivotal role in promoting the growth and vitality of the private equity industry for over 60 years. For more information, visit www.SBIA.org or call (202) 628-5055.