Portfolio Construction Using Non-Traded Business ... · Portfolio Construction Using Non-Traded BDCs 8 ! Regulatory Examinations The SEC has the authority under Section 31(a) of the

Portfolio Construction Using Non-Traded Business Development Companies (BDCs)

Advocating Direct InvestmentsThrough Education

Portfolio Construction Using Non-Traded BDCs 2 www.ipa.com

Table of contents

Overview ........................................................................................................................................................................... 3

I Basics of BDCs ...................................................................................................................................................... 3

II Portfolio Construction ..................................................................................................................................... 10

III Assessing the Investing Environment ....................................................................................................... 14

IV Life Cycle of a Non-Traded BDC ................................................................................................................... 16

V Basic BDC Accounting ..................................................................................................................................... 23

VI Taxation of Non-Traded BDCs ...................................................................................................................... 30

VII Risks and Suitability of Non-Traded BDCs ............................................................................................... 34

VIII Comparing Non-Traded and Traded BDCs .............................................................................................. 38

Copyright© 2013 Investment Program Association


Overview

Business development companies (BDCs) are closed-end investment companies that pool the capital

they raise by selling shares to make debt or equity investments in privately held or thinly traded US

corporations that otherwise might have limited access to capital.

BDCs may be traded, which means their shares can be bought and sold on a national securities

exchange, or non-traded, which means their shares are not traded on a national securities exchange

and so have limited liquidity.

This paper will review the characteristics that traded and non-traded BDCs share and explore the

factors that broker-dealers and financial advisors should consider in analyzing non-traded BDCs as

investment opportunities for clients.

I. Basics of BDCs

Business development companies (BDCs) are a type of closed-end investment company regulated

under the Investment Company Act of 1940 (1940 Act) as modified by the Small Business Investment

Incentive Act of 1980. The dual goals in authorizing the creation of this type of closed-end

investment company are to:

• Encourage investment in thinly traded companies

• Attract public investors and money managers to BDCs

BDCs typically elect to be treated as regulated investment companies (RICs) for tax purposes. If they

distribute at least 90% of their investment company taxable income each year to their shareholders,

and meet other source-of-income and asset diversification tests, they are exempt from federal

corporate taxes. This annual distribution makes BDCs attractive to investors seeking regular income,

though, of course, the income is not guaranteed.

The offering price of a BDC must always be at least equal to its net asset value (NAV), after excluding

selling commissions and discounts. As a result, an increase in the NAV will increase the offering

price. The reverse is also true. If the NAV falls, the offering price is decreased. NAV is calculated by

dividing the combined value of the portfolio assets minus fees and expenses by the number of the

BDC’s outstanding shares.


Regulatory and Compliance Issues

The 1940 Act regulates various aspects of a BDC, including its business model, capital structure, and

operations. A BDC must elect to be regulated as a business development company exempting it from

certain provisions of the 1940 Act. A vote of shareholders is required to withdraw such election. The

following are the most significant regulatory requirements that pertain to BDCs.

Business Model Requirements

To maintain their BDC designation, the companies are required to invest at least 70% of their assets

in a portfolio of qualifying investments, specifically private US companies or thinly traded public US

companies with a public float of less than $250 million. BDC investment portfolios may be internally

or externally managed, provided that any external advisor is registered under the Investment

Advisers Act of 1940.

In addition, BDCs must offer to provide substantial managerial assistance to their portfolio

companies if the companies request it. Managerial assistance may take the form of significant

guidance and counseling concerning the management, operations or business objectives and policies

of the portfolio company. In fact, a BDC may exercise a controlling influence over the management

or policies of a portfolio company. For example, the BDC may arrange financing, recruit management

personnel, and evaluate proposed acquisitions and divestitures.

Capital Structure

BDCs may issue debt and equity securities as well as derivative securities, including options,

warrants, and rights that convert into voting securities. Any debt or senior security (as defined under

the 1940 Act) issued by a BDC must have asset coverage of at least 200% immediately after it is issued

or sold. That is, BDCs are generally subject to a cap on borrowing of 50% loan to value. A 50% LTV

corresponds to a 200% asset coverage ratio and will be used interchangeably. In addition, a BDC

cannot declare dividends on its common stock unless its debt and senior securities, if there are any,

have asset coverage of at least 200%.


A BDC’s board of directors must approve and its shareholders must authorize any issuance of

derivative securities. In some cases the BDC may need to obtain exemptive relief from the SEC as

well. Further, the number of voting securities that could result if all derivatives being issued were

exercised cannot exceed 25% of the outstanding voting securities at the time of the proposed

issuance.

Operational Requirements

The 1940 Act subjects BDCs to the following operational requirements:

Composition of Board of Directors

The majority of the directors of a BDC must be persons who are independent (i.e., not “interested

persons” as defined under the 1940 Act) of the BDC and its investment advisor. Additionally,

directors, rather than shareholders, can fill a vacancy on the board if, after the vacancy has been filled,

at least two-thirds (2/3) of the directors then holding office have been elected by shareholders.

Under the 1940 Act, the board of directors of a BDC is tasked with approving any investment advisory

agreement, underwriting agreement, valuation policies, and compliance policies.

Valuation

A BDC is required to value the BDC’s portfolio assets on a quarterly basis in connection with filing

certain required periodic reports. Those assets must be valued based on market value if a trading

market exists; and in the absence of a readily ascertainable market value for an asset, the board of

directors must determine the “fair value” of the asset in good faith. Fair value is generally determined

through the cooperation of the BDC’s management and board of directors and often involves the

participation of internal auditors and third party valuation firms or pricing services. Fair value is a

judgment made in light of the specific facts and circumstances surrounding each portfolio

investment through consistently applied valuation processes developed by the BDC. Each debt and

equity security is separately valued and disclosed on a “Schedule of Investments” contained in the

financial statements included in quarterly and annual reports filed with the SEC.


Compliance Procedures and Chief Compliance Officer

Additionally, under the 1940 Act, a BDC must adopt and implement policies and procedures

reasonably designed to prevent violations of the federal securities laws and must designate a chief

compliance officer (“CCO”) to oversee the administration of these policies and procedures. The BDC’s

compliance procedures must address, at a minimum, the following areas: (i) portfolio management

processes; (ii) trading practices; (iii) accuracy of disclosures; (iv) safeguards on client assets from

advisory personnel; (v) accurate creation of records; (vi) valuation of portfolio holdings; (vii)

identification of affiliated persons; (viii) protection of non-public information; and (ix) compliance

with the various governance requirements. The compliance procedures must be approved by the

BDC’s board of directors, including a majority of the independent directors. Annually, the board of

directors is required to review the compliance policies and procedures to ensure the ongoing

effectiveness of such policies and procedures and the CCO is required to provide a report of the BDC’s

compliance policies and procedures to the board of directors.

Code of Ethics

Officers and directors of a BDC are subject to general fiduciary duties with respect to their conduct as

they impact the BDC. In order to address such fiduciary duties, the 1940 Act requires that a BDC

adopt a code of ethics and institute procedures reasonably necessary to ensure that its employees and

certain affiliates adhere to such code. The code of ethics must require periodic reporting by “access

persons,” who generally include any director, officer, or employee of the BDC or its investment

advisor or of any company in a control relationship to the BDC or its investment advisor, and impose

recordkeeping requirements on the BDC and its investment advisor, as applicable.

Fidelity Bond

Further, a BDC must provide and maintain a bond issued by a reputable fidelity insurance company

to protect the company against larceny and embezzlement. The bond must cover each officer and

employee with access to securities and funds of the company and generally cannot include a

deductible amount. The amount of coverage is prescribed by the rules promulgated under the 1940

Act and is tied to the amount of the BDC’s assets.


Custody

Furthermore, all securities of the BDC must be held under a custody agreement by a custodian

meeting certain requirements under the 1940 Act, either through bank custody or a “safekeeping

arrangement.” There are certain annual requirements to ensure that appropriate custody is

maintained.

Indemnification

A BDC can enter into an indemnification arrangement with its officers and directors but is prohibited

from protecting any director or officer against any liability to the company, or its security holders,

arising from willful misfeasance, bad faith, gross negligence, or reckless disregard of the duties

involved in the conduct of such person’s office.

Reporting

A BDC is required to have a class of securities registered under the Securities Exchange Act of 1934

(the “Exchange Act”) and meet the reporting and disclosure requirements under the Exchange Act.

Under the Exchange Act, issuers must file with the SEC periodic (e.g., Forms 10-Q and 10-K) and other

(e.g., Form 8-K) reports in order to provide current information about the BDC and its securities to the

public. Management also must report their purchases and sales of the BDC’s equity securities and are

restricted from obtaining short swing profits from trading in such equity securities within any six-month

period pursuant to Section 16(b) of the Exchange Act. In addition, a BDC must maintain a system of

disclosure controls and procedures, disclose whether such controls and procedures are effective, and

must maintain adequate control over financial reporting.

Transactions with Affiliates

Generally, a BDC is prohibited from effecting or participating in certain transactions with “affiliates”

(as defined under the 1940 Act) unless certain procedures are satisfied, such as obtaining SEC

exemptive relief and/or receiving board approval for a transaction.


Regulatory Examinations

The SEC has the authority under Section 31(a) of the 1940 Act to inspect the books and records of a

BDC and, under Section 204 of the Advisers Act, to enter the offices of a BDC’s investment advisor to

inspect the books and records of the BDC. The 1940 Act requires that every BDC maintain and

preserve records, such as documents relating to its financial statements, the purchase or sale of

securities, financial ledgers, corporate charter, brokerage orders and a list of persons or groups

authorized to transact in securities, as prescribed under the rules adopted by the SEC.

Additionally, the Investment Advisers Act of 1940, under which investment advisors are regulated,

requires that the advisor of an externally managed BDC must register with the SEC and update its

registration annually. Further, any arrangement with an external advisor must be approved initially

by the board of directors and the BDC shareholders and reapproved annually by either the board or

the shareholders.

An investment advisor to a BDC must also maintain certain conflict of interest and allocation policies

in addition to a 1940 Act code of ethics. An investment advisor must maintain similar compliance

policies and procedures.

The Advisers Act also regulates the fee structure paid to an investment advisor of a non-traded BDC.

Advisors to externally managed BDCs can receive management fees and incentive fees, which are

typically structured as follows:

• Base management fee, which is typically equal to 1.5% to 2.0% of gross assets, depending on

the BDC’s investment objective

• Incentive fee on ordinary income, which is typically equal to 20% of pre-incentive fee net

investment income, often subject to a “hurdle”; and

• Incentive fee on net capital gains, which is typically equal to 20% of net realized capital gains.

The fee structure discussed above is specific to externally managed non-traded BDCs and is not

applicable to internally managed non-traded BDCs.

There are also certain other regulatory requirements involving investment advisory agreements,

including that any investment advisory agreement must be terminable, without the payment of a


penalty, on not more than 60 days’ written notice by the board of directors of a BDC or its

shareholders.

NASAA

Since offerings of non-traded BDCs are not “covered securities” as defined by Section 18 of the

Securities Act of 1933, the offerings must be registered in all states or other jurisdictions in which

sales of shares are made. In connection with the “Blue Sky” registration of non-traded BDC offerings,

states have the ability to issue comments on the registration statement and governing documents of

the BDC. NASAA has developed a number of statements of policy that pertain to various offering

types, including non-traded REITs, commodity pools, and oil and gas programs. NASAA has not yet

developed a statement of policy dedicated to BDCs. In the meantime, BDCs have been subject to the

NASAA Omnibus Guidelines, which was initially developed to govern offerings by limited

partnerships. Often, the comments from states center around provisions found in the NASAA

Omnibus Guidelines or, on occasion, the NASAA REIT Guidelines. NASAA has indicated that it is in

the process of developing a statement of policy dedicated to offerings conducted by non-traded BDCs.

Characteristics of Non-Traded BDCs

While non-traded BDCs share certain defining features with traded BDCs, they are different in

significant ways. Beyond the distinction that traded BDC shares are liquid while non-traded BDC

shares are essentially illiquid, the following features are also relevant:

• Non-traded BDC shares are available only to investors who meet suitability standards

established by the state where they live.

• A number of non-traded BDCs utilize a “sub-advisor,” which is typically an affiliate of an

established investment advisor to a BDC or other financial institution, to source or

originate investment opportunities. To compensate a sub-advisor for its services, a

portion of the management and incentive fees are generally paid by the investment

advisor to the sub-advisor.


• Non-traded BDC shares are sold in a continuous offering period through independent

broker-dealers and financial advisors rather than on an exchange, permitting the BDC to

continue to raise capital despite fluctuations in market environments.

• A non-traded BDC’s performance may be measured by total return which includes the sum

of cash distributions during the lifespan of the program plus any appreciation or

depreciation of its share price up through the liquidity event.

• The 1940 Act requires that all BDC shares must be sold at a price at least equal to its net

asset value (NAV), after excluding selling commissions and discounts. As a result, an

increase in a BDC’s NAV will require the BDC to increase its offering price and to disclose

the new offering price publicly. Most non-traded BDCs have also adopted a policy that if

the NAV declines by a certain percentage, the offering price will also be decreased. NAV is

calculated by dividing the net assets of the BDC by the number of the BDC’s outstanding

shares.

• A non-traded BDC is designed to have a limited offering and operational period, often up

to ten years although sometimes longer, before ending in a liquidity event, such as a

listing, a merger, or a sale of its assets.

• The return of a non-traded BDC may display limited correlation with the return of

exchange-listed investments.

• The up-front fees of a non-traded BDC may be up to 11.5% to 15%, which includes the

sales load paid in connection with the purchase of shares and organization and offering

expenses borne by the BDC.

II. Portfolio Construction

A BDC identifies the investment objective it will strive to achieve and the strategy it will adopt to

accomplish its investment objective. Among the choices it must make as it positions itself in the

universe of non-traded business development companies, are:

• Whether it will focus on debt or equity securities or both

• Which types of securities within an asset class it will emphasize

• Where it will position itself along the spectrum of risk


• Whether it will invest in companies within a particular industry or diversify more broadly

• How the BDC investment portfolio will be managed and by whom

Types of BDCs

Non-traded BDCs can generally be classified into two broad categories: debt and equity. Of the two,

debt BDCs are much more common than equity BDCs, which seek capital appreciation. Sometimes,

however, a BDC makes significant investments in both debt and equity securities rather than

focusing on one or the other.

Investors in a non-traded BDC often measure the success of the program by its total return. Total

return is the sum of the distributions they receive, any capital appreciation, and the profit or loss

from the liquidity event, measured by the extent to which the amount differs from the original

purchase price.

Debt BDCs

A debt BDC invests primarily in the debt securities of eligible portfolio companies, ranging from

senior secured debt at the top of a company’s capital structure to unsecured mezzanine debt and debt

that may incorporate derivatives such as warrants or rights that may be converted to equity at lower

levels of the capital structure. They may also purchase a company’s preferred stock, which is

sometimes described as a hybrid of debt and equity, or convertible bonds.

A debt BDC generally makes investments that it expects will provide regular interest and perhaps

dividend income, allowing it to make regular distributions to its shareholders. Investors in debt BDCs

may also receive cash distributions from the sale or disposition of securities in the BDC portfolio.

Return of principal from early repayments may be used to make new investments.

If a debt BDC concentrates its investments on senior secured debt at the top of a portfolio company’s

capital structure, its investment risk profile is lower but typically earns interest at a lower rate than it

would if it concentrated on subordinated debt with a risk profile that is greater but typically offers a

higher interest rate. However, additional income from higher-rate loans comes with greater risk that

the borrower will be unable to cover its interest payments.


What a BDC that concentrates on debt investments sacrifices is the potential to benefit from the

possible capital appreciation of a portfolio company, since growth in value does not increase the

interest the company owes or the amount of principal that must be returned.

Equity BDCs

An equity BDC invests principally in equity securities of eligible portfolio companies, including

venture capital-backed emerging and pre-IPO companies and publicly traded companies with market

capitalizations of less than $250 million.

Equity BDCs focus primarily on seeking capital appreciation and few, if any, of their portfolio

companies pay distributions. As a result, equity BDCs are less likely than debt BDCs to make income

distributions on a regular schedule, if at all. Rather, investors anticipate cash distributions of net

realized gains from the sale or other disposition of the underlying portfolio investments and eventual

capital gains from the liquidity event.

Equity BDCs may be considered riskier than debt BDCs because of the relative risk of the equity

investment. Because common stock occupies the lowest rung in the capital structure, stockholders

rarely recover the full value of their investment if the portfolio company declares bankruptcy.

Instead, the remaining assets are shared among lenders, with holders of senior secured debt having

priority. Further, since the qualifying companies in which a BDC must invest are, by definition, small

private or thinly traded public companies, they may have a greater risk of failure during economic

downturns.

Industry Focus

Whether a non-traded BDC invests primarily in debt or equity, it may focus its portfolio in a

particular industry, such as energy, technology, or healthcare, or on companies that meet certain

financial criteria, such as micro-cap companies. In contrast, some BDCs establish broader investment

criteria and diversify across industries in companies of all sizes within the qualifying range. While

industry focus is an important consideration in evaluating a non-traded BDC, it’s not necessarily a

predictor of performance success. A particular sub-type or sector can substantially outperform the

broad market. But the opposite could also be equally true.


The more critical assessment that a financial professional must make is of the skill with which a non-

traded BDC’s investment managers have analyzed the capital markets and the economy in setting its

unique strategy for meeting its investment objective.

Investment Managers

BDCs may be managed externally or internally. When a BDC is externally managed, it has an

investment advisory agreement with an outside investment advisor. All the investment personnel

are employed and compensated by the investment advisor rather than by the BDC. In contrast, when

a BDC is internally managed, all the investment personnel are employees of the BDC. To date, all non-

traded BDCs are externally managed, as are most traded BDCs.

Some of the external investment advisors engaged by non-traded BDCs have engaged investment sub-

advisors to source investment opportunities and present them to the investment advisor for

approval. When this is the case, the investment advisors generally pay a portion of the management

and incentive fees they receive from the BDCs to the sub-advisors. Other external investment

advisors have their own staffs of investment professionals to source transactions and do not use sub-

advisors.

Evaluating Portfolio Construction

When performing due diligence on a non-traded BDC, a retail broker-dealer or financial advisor will

want to be comfortable with the answers to these questions:

• Is the investment objective and strategy presented in the BDC’s prospectus logical and

backed up by research and market data?

• Do the BDC’s managers and investment advisors have the experience and necessary

expertise to execute its proposed strategy and meet its investment objective?

• Do the current status of and future expectations for the capital markets and overall

economy support the BDC’s investment objective and strategy?

• Is the investment objective and strategy of the BDC appropriate and suitable for the

specific investor?


III. Assessing the Investment Environment

Investment markets move through recurring cycles, from expansion through contraction to recession

and ultimately through recovery back to expansion. While the movement through these phases is

predictable, the duration and magnitude of the phases and the triggers that move the cycle from one

phase to the next are not. Because the managers of non-traded BDCs raise and invest capital over an

extended period, they must be prepared for the market to evolve and develop appropriate strategies

for different phases.

It’s relevant that debt and equity market cycles are often negatively correlated. In other words,

when debt markets are outperforming, equity markets may be underperforming, and vice versa.

Market Cycles

Although it is impossible to predict when a market contraction will begin, how long the recessionary

period that follows will last, and how severe the impact will be, there is ample historical evidence to

support the likelihood that such a downturn will occur within the projected lifespan of a non-traded BDC.

So it is appropriate for a financial advisor to consider the potential impact an economic downturn

could have as part of evaluating whether to recommend a specific BDC.

Since 1980, traded BDCs have performed in a number of different market conditions. Beginning in

the third quarter of 2007, global credit and other financial markets suffered substantial stress,

volatility, illiquidity, and disruption. These forces reached extraordinary levels in late 2008, resulting

in the bankruptcy of, the acquisition of, or government intervention in the affairs of several major

domestic and international financial institutions. In particular, the financial services sector was

negatively impacted by significant write-offs as the value of the assets held by financial firms

declined, impairing their capital positions and abilities to lend and invest. These declines in value

compelled leveraged holders of financial assets to sell to meet margin requirements and maintain

compliance with applicable capital standards. Such forced liquidations also impaired or eliminated

many investors and investment vehicles, leading to a decline in the supply of capital for investment

and depressed pricing levels for many assets. These events significantly diminished overall

confidence in the debt and equity markets, engendered unprecedented declines in the values of


certain assets, and caused extreme economic uncertainty. Since the recession officially ended,

economic growth remains subdued and unemployment rates have not declined significantly. Despite

this, many sectors of the capital markets have largely recovered from their depths during the credit

crisis.

The effect of the credit crisis on traded BDCs was that many traded at substantial discounts to their

published net asset values for prolonged periods of time, and the industry as a whole experienced

consolidation through a series of mergers. Many traded BDCs were also forced to reduce the amount

of distributions paid to shareholders as a result of generating less net investment income. As the

markets recovered, however, distribution rates paid by traded BDCs were largely restored.

Considering the depth of the credit crisis, the resurgence of traded BDCs illustrates the resiliency of

the BDC model. Because the first non-traded BDC launched in January 2009, non-traded BDCs have

not yet had to perform in a variety of different market conditions. However, non-traded BDCs

generally purchase the same types of debt securities and have exposure to small and middle market

private companies in the same manner as traded BDCs, so we would expect some correlation between

traded and non-traded BDCs in this regard.

Below is a general summary of how the traded and non-traded BDC structures are designed to operate

in rising and declining market environments. The summary assumes that the investments held by

the traded or non-traded BDC are performing as expected and are not in default. The ability of an

investment advisor or investment personnel of a BDC to make sound investment decisions plays

perhaps the largest role in the success or failure of a BDC, regardless of whether the BDC is traded or

non-traded and regardless of whether the markets are rising or declining. However, there are other

factors that may affect how traded and non-traded BDCs perform in rising and declining markets. For

example, market prices of traded BDCs may be influenced by price movements in the markets as well

as changes to the values of the investments they hold.


Rising Markets

In rising markets, the market price of a traded BDC is more likely to be at or above the net asset

value of the traded BDC which aids in the BDC being able to access the capital markets or obtain

leverage on favorable terms. Non-traded BDCs are structured to be able to raise capital in either

rising or declining markets at offering prices that are pegged to their net asset values. The portfolio

companies in which traded and non-traded BDCs may be more financially sound in a rising market,

but the ability to purchase debt securities at significant discounts may be limited.

Declining Markets

In declining markets, traded BDCs may have more difficulty raising capital because of the

prohibition under the 1940 Act of selling shares at a price, after selling commissions and discounts,

that is below net asset value, while non-traded BDCs are less likely to be affected since they have the

ability to peg their offering prices, less selling commissions and dealer manager fees, to a multiple of

net asset value. In declining markets, the values of many financial instruments, including senior

debt securities that trade on the over-the-counter market for institutional loans, may trade at

substantial discounts to par, but the loans may also carry greater risk. Investors who invested in

certain of the better-performing traded BDCs during the credit crisis and held their investment to

the present have seen appreciation in the value of their shares, enhanced by the fact that they were

able to purchase shares at prices well below the net asset value of such BDCs.

IV. Life Cycle of a Non-Traded BDC

The life cycle of a non-traded BDC has three phases — offering, operations, and liquidity event —

with the offering and operation phases typically overlapping. The full cycle may last up to ten

years, though it could be extended.

Phase 1. Offering

A non-traded BDC’s offering phase begins when the SEC issues a Notice of Effectiveness of the

BDC’s registration statement, the Financial Industry Regulatory Authority (FINRA) issues a no


objections letter, and the securities administrators of any states or other jurisdictions in which the

non-traded BDC intends to sell its shares provide clearance for the sale. The North American

Securities Administrators Association (NASAA) sets general suitability standards and has indicated

it intends to draft a set of guidelines that will apply specifically to BDCs.

A BDC may impose a minimum offering requirement, or escrow provision, that must be raised by

purchasers not affiliated with the BDC or its investment advisor before any shares can be sold. Once

the BDC has raised the minimum amount of capital, it will begin to sell shares in its extended

public offering, which generally involves a dealer manager or a retail broker-dealer network, or

both.

Sales of shares in the offering will be made at an offering price that approximately reflects the sum

of the net asset value per share plus any selling commissions and dealer manager fees payable by

the investor. During the offering and operational stage, the BDC must value its assets at least

quarterly, and, as a result of the 1940 Act prohibition against selling shares below net asset value,

the offering price for its shares may be adjusted upward or downward. As the retail broker-dealers or

financial advisors continue to sell the BDC’s shares, the funds received are used to purchase the

BDC’s investments in portfolio companies according to the BDC’s investment strategy. The initial

public offering of a non-traded BDC can last from one year to three years and is generally extendible

by the BDC’s board of directors and management. Once the initial public offering is sold out or

expires, a BDC may choose to conduct a follow-on offering, which would extend the amount of time

before a liquidity event will be explored or consummated.

Offering Phase Assessment

Retail broker-dealers and financial advisors should be attuned to several important factors as they

evaluate a non-traded BDC in its offering phase as a potential investment opportunity for their

clients. The logical starting point is the viability of the BDC’s investment objective and strategy,

along with the experience and expertise of its management team, investment advisor, and sub-

advisors if any.


In addition, because a non-traded BDC invests over an extended period, it may make investments in

different economic and capital market conditions. This means the quality and risk profile of its

investments may change over time, for better or worse. At the same time, a longer investment

period adds the potential benefits of greater diversification and dollar cost averaging.

They should also bear in mind that the exact composition of the BDC’s investment portfolio will be

at least partially unknown as the offering begins but also that potential rates of return are

determined by the composition of the overall portfolio.

With these points in mind, due diligence should include:

• A review of the investments made to date and what investments are planned

• An assessment of whether the investment strategy seems reasonable in the current

market environment and whether the BDC’s investment objective and strategy is flexible

enough to permit changes based on market conditions

• A comparison of the net investment income earned to the BDC’s current distribution

yield to ensure the coverage is adequate and sustainable

• A determination of whether the BDC intends to employ leverage, such as lines of credit,

to make investments and how that leverage will affect the program

Early Stage Risk Assessment

In addition to the general risks of investing in a non-traded BDC, there may be risks that are

especially relevant during the early stages of an offering:

• Since it may take time to raise sufficient capital, the BDC’s portfolio may be overly

concentrated initially in a specific industry, geographic region, or one or more individual

investments.

• Since the BDC is under pressure to produce net investment income that can be paid to

shareholders as cash distributions, it may invest in fairly liquid over-the-counter (OTC)

syndicated loans to reduce the lag time between share purchase and distribution subject

to the limitations of its investment objective and strategy.


• Once the BDC has an established portfolio — even a small one — the question becomes

whether the investments are consistent with the objective and strategy described in the

prospectus. The answer may provide (1) an indication of how successful the BDC has

been in executing its plan, and (2) a preview of its ability to continue to do so.

Phase 2. Operations

Once a non-traded BDC has raised significant capital, its investment team creates a mature portfolio

that may differ at least to some extent from its earlier portfolio. For example, some more mature

BDCs seek to originate loans directly to their portfolio companies, a different approach than

successfully investing in syndicated loans that trade in the OTC market or in securities quoted in

active markets.

At the same time the BDC’s managers expand their emphasis on operations, for example by taking

steps to control or reduce expenses wherever practical. An experienced team seeks efficiency in

managing the portfolio through the scale created by having additional assets under management.

As a BDC’s portfolio grows, it should be self-sufficient in covering capital expenditures and other

large costs, and ideally it should be producing cash flow to cover its distributions.

Operations Phase Assessment

As the offering stage comes to an end, and the BDC shifts its focus from managing its continuous

offering and its operations to effecting a liquidity event, retail broker-dealers and financial advisors

should make:

• An assessment of the BDC’s portfolio composition to determine the program’s financial

health, its ability to continue to make distributions, and the likelihood that it will

support a liquidity event that benefits shareholders

• A determination of whether net investment income, net realized gains, or both, are

sufficient to cover the cash distributions that are being paid


• An evaluation of whether the BDC maintains sufficient levels of cash to fund unexpected

expenses or defaults by its portfolio companies or to fund any share repurchases that it

might make

The key question is whether the BDC’s investment portfolio offers the potential for capital

appreciation through a future liquidity event. As part of determining their answer, the broker-

dealers and financial advisors should consider the value of the investments in the portfolio,

including whether any are at risk of default. Once the offering period ends — which will occur

before the operations phase ends — and any subsequent follow-on offering is completed, no new

capital will be available for investment unless the BDC uses additional sources of leverage, receives

principal from debt repayment, or sells existing investments.

Phase 3: Liquidity Event

Non-traded BDCs are generally designed to be finite life entities that are expected to execute an exit

strategy, generally described as a liquidity event, at a predetermined time — or within a

predetermined time frame — detailed in the prospectus. Potential liquidity events include:

1. Listing on a national securities exchange

2. The sale or merger of the entire portfolio

3. The orderly sale of the underlying investments one-by-one or in small blocks

Ultimately, the non-traded BDC’s board of directors is responsible for approving the liquidity event

or combination of strategies that best optimizes shareholder value while providing the required

liquidity. It is often a best practice for a non-traded BDC to have the flexibility to delay a pre-timed

liquidity event if market conditions are unstable or unfavorable.

A retail broker-dealer, financial advisor, or other investment professional should be able to explain

the various liquidity event options to potential investors as well as the expected timing of the event.

Each alternative may have unique tax and other implications for shareholders and affect whether or

not the BDC is a suitable investment. The possibility that a liquidity event may be delayed is

similarly germane.


1. Listing on a National Securities Exchange

In a listing, the non-traded BDC is issued a ticker symbol and listed as a traded BDC on a national

securities exchange, such as the New York Stock Exchange (NYSE) or the NASDAQ Stock Market

(NASDAQ). From that point, the BDC’s shares trade continuously, as the shares of other listed

companies do, at a price that is set by supply and demand, subject to external market forces, and

likely to be at a premium or a discount to book value, expressed as NAV, of the BDC.

A non-traded BDC’s board of directors may decide the listing option is advantageous in these

circumstances:

• If shares of traded BDCs are selling at premiums to NAV, which means that investors are

paying more for BDC assets than the fair value of the assets as determined by the BDC’s

board of directors

• If continuing to operate the BDC has value for investors and ceasing operations would be

value destroying

• If the BDC’s investment portfolio is well understood by traded BDC analysts and other

market participants

• If potential private buyers for either the entire portfolio or its individual assets are

limited

Sell or Hold?

After the listing occurs, shareholders of the non-traded BDC have the option to (1) sell all or some of

their shares and receive cash to reinvest or spend, or (2) continue to hold the shares and receive any

cash distributions the newly traded BDC pays. Holding for the present provides the flexibility to sell

at some point in the future.

Retail broker-dealers or financial advisors should be prepared to assist their clients in evaluating the

choice between selling and holding, based in large part on projections of future performance keyed

to the financial information in the periodic reports the non-traded BDC has filed with the SEC and

assessment of the investment climate. However, tax planning and portfolio rebalancing will be

major factors in each investor’s decision, so different clients may make different choices.


2. Sale or Merger of Entire Portfolio

In choosing to sell or merge, a non-traded BDC’s board attempts to complete a transfer of assets in a

single transaction. If the assets are sold, shareholders receive a lump sum of cash at a predetermined

closing date. If the non-traded BDC is merged with another fund, such as a publicly traded BDC, the

shares of the non-traded entity may be converted into a combination of shares of the acquiring BDC

and cash on the closing date.

The board of directors may choose the sale or merger option if:

• A suitable acquirer or merger partner can be identified and the terms of the deal are

advantageous to the non-traded BDC’s shareholders

• Shares of traded BDCs are generally selling at a discount to NAV, which means investors

are paying less than the fair value of BDC assets as determined by the BDC boards of

directors

• A single transaction involves the lowest cost and the least amount of uncertainty

If the payout is entirely in cash, the retail broker-dealer or financial advisor should review each

investor’s portfolio to provide guidance on reallocating assets and managing any tax payments that

may be due. If the payout includes securities in a publicly traded BDC, the broker-dealer or advisor

should additionally analyze the future performance potential of that BDC based on SEC filings and

other information to help investors determine whether to sell the new shares immediately or hold

them at least for the present.

3. Orderly Sale of Investments

In an orderly sale, a non-traded BDC board liquidates its portfolio of investments either individually

or in blocks. These transactions typically occur over several months and may take years to

complete, depending on demand for the investments the BDC holds and the number of potential

buyers.

While the liquidation continues, the non-traded BDC’s shareholders receive distributions that

include net investment income from securities in the portfolio as well as any net realized gains


from the sales of investments as they occur, or at least on an annual basis. Of course, there is no

guarantee that the sales will produce capital gains, and there could be capital losses.

Once all investments are liquidated, the BDC issues a final liquidating distribution that returns any

remaining capital to shareholders and ceases operations.

The board of directors may choose the incremental sale option if:

• The individual investments are too heterogeneous to be sold to a single purchaser in a

single transaction.

• The investments are difficult for publicly traded BDC analysts to understand and value

appropriately.

• Shares of traded BDCs are selling at discounts to NAV, which means investors are paying

less for BDC assets than the assets are intrinsically worth.

• Certain investments have either a high or low value and should be sold separately before

other disposition decisions are made.

• It is easier, and so preferable, to dispose of smaller investments, especially syndicated

loans that trade on the OTC secondary market, on an individual rather than a portfolio

basis.

For the retail broker-dealer or financial advisor, the considerations are similar to the considerations

involved in the sale or merger of an entire portfolio. However, in an incremental sale, capital may be

returned to shareholders in multiple payments of varying amounts rather than in a single lump

sum.

V. Basic BDC Accounting

A significant part of conducting due diligence on a non-traded BDC investment involves analyzing

its financial health and performance. Since the BDC’s shares do not trade on public markets, a retail

broker-dealer or financial advisor and an investor must rely on examining its financial statements

to determine whether it is an appropriate investment.


Non-traded BDC financial statements are prepared in accordance with GAAP and SEC accounting

regulations applied to investment companies and are significantly different from the financial

statements of operating companies. This section highlights certain line items and concepts that are

included in BDC financial statements, including the balance sheet and income statement, that may

not be found in the financial statement of an operating company or even a specialty finance

company.

When looking at balance sheet or income statement entries, it is important to compare data on a

year-over-year or quarter-over-quarter basis to assess whether a non-traded BDC’s financial

condition is improving or worsening. The increased use of leverage by a BDC, when combined with

falling asset values, may signal a deteriorating financial condition.

Similarly, increases in investment income represent growth in the BDC’s operations. However,

since a non-traded BDC raises capital over an extended period, it may not be enough to look for

growth merely in total investment income. It is also necessary to take expense line items into

account.

Balance Sheet

Among the key items to review on a non-traded BDC balance sheet are the aggregate fair value of its

investments, its total liabilities, and its net asset value.

Investments, At Fair Value

The first line of a BDC balance sheet shows the aggregate fair value of the assets, or investments, in

its portfolio at the end of the reporting period. Fair value is defined by the Financial Accounting

Standards Board (FASB) as the amount that would be received to sell an asset in an orderly

transaction between market participants at the measurement date. To arrive at the aggregate value,

each asset in the portfolio must be valued separately before being included in the total.

A BDC’s board of directors is required to determine the fair value of each investment at least

quarterly. Since most non-traded BDCs invest in illiquid debt securities, a significant number of


their investments are held at fair value. The fair value of an investment differs from its cost, which

refers to the nominal or original cost of the investment.

To the extent aggregate fair value exceeds aggregate cost, the difference is unrealized appreciation

(gain) in the value of a BDC’s investments. Similarly, to the extent that the fair value is less than the

cost, the difference is unrealized depreciation (loss).

Tracking the differences between aggregate fair value and aggregate cost over a number of reporting

periods can provide useful information about potential trends in unrealized appreciation (gain) or

depreciation (loss) of the portfolio.

The first line of the balance sheet will also contain a breakdown of the portfolio into investment

categories defined by the 1940 Act:

• Control investments, or portfolio companies in which the BDC owns more than 25% of

the voting securities or fills more than 50% of the seats on the board

• Affiliate investments, or portfolio companies in which the BDC owns between 5% and

25% of the voting securities

• Investments that are neither control investments or affiliate investments

Total Liabilities

Total liabilities are often defined as the sum of short-term liabilities, long-term debt, and certain

other liabilities of the BDC. The fair value of a liability is the amount it would cost to transfer the

liability to a new obligor, not the amount that would be paid to settle the liability with the creditor.

The amount of leverage a BDC can employ is limited under the 1940 Act. Specifically, a BDC may

not issue a senior security unless its asset coverage is at least equal to 200% immediately following

the issuance. For the purposes of the Act, a senior security includes any bond, debenture, note, or

similar obligation or instrument that evidences indebtedness. This includes a class of preferred

stock, for example, that has preference over the outstanding common stock.

It is important for investors to know whether a BDC has incurred leverage and whether the BDC

needs the leverage to maintain its current distribution rate. Disclosure of the sources of


distribution, including whether a portion of prior distributions came from leverage, is generally

found in the BDC’s prospectus or periodic reports, or both.

Net Asset Value

BDCs are required to publish their net asset value (NAV) per share in their periodic reports filed

with the SEC. NAV per share is calculated by dividing the net assets as of the end of the period by

the number of shares of common stock outstanding as of the end of the period. Net assets equals

total assets minus total liabilities.

It is useful for investors to be aware of the NAV of a non-traded BDC and compare it against prior

periods as well as against the current public offering price. As explained earlier, a BDC is prohibited

from selling its shares at a price, after excluding selling commissions and discounts, that is below

NAV, so the correlation between NAV and public offering price is critical information.

NAV shows what is commonly referred to as book value in the case of operating companies. Unlike

an operating company, a BDC’s NAV is a significant number to watch because of its correlation to

fair value.

Income Statement

Some key items to review in a non-traded BDC income statement are total investment income, net

investment income, realized gains/losses, and unrealized appreciation/depreciation.

Total Investment Income

A BDC’s total investment income derives from three sources: interest (including payment-in-kind),

dividends, and fees.

The BDC’s portfolio companies pay interest and dividends on the debt securities, including

preferred stock, the BDC holds. Depending on the terms of a particular investment, all or a portion

of these payments may be payment-in-kind (PIK) income. That is, the interest payments are made in

something other than cash, including additional securities in the portfolio company. While

investing in securities with a PIK feature is fairly common, holding a large number of these


securities may limit the amount of cash distributions that the BDC is able to make or reduce the

portion of the distributions that are fully covered by the BDC’s cash net investment income.

Fee income includes monthly servicing charges on the debt investments the BDC holds, and any

structuring fees or prepayment fees that the BDC receives.

Net Investment Income

Net investment income is total investment income minus total expenses during a particular period.

Net investment income generally represents the amount of cash available for distribution to

shareholders, although BDCs may distribute more or less.

If the BDC distributes more than the net investment income, a portion may come from net realized

gains on securities it has sold. Any amounts in excess of net investment income and net realized

gains are considered return of capital.

If the BDC distributes less than its total net income, but greater than 90%, RIC distribution

requirements may mean it will have to pay a 4% excise tax on amounts that were not distributed.

Realized and Unrealized Gains or Losses

Realized gains or losses occur when a BDC sells or otherwise disposes of an investment it holds.

Distribution of long-term net realized gains to the BDC’s shareholders is not required by RIC rules,

unlike short-term gains recognized as ordinary income, which must be distributed. However, a BDC

is taxed at normal corporate rates on any net realized gains that are not distributed.

Unlike realized gains or losses, unrealized appreciation or depreciation refers to the difference

between the fair value of an investment and its amortized cost. The change is recorded on the

income statement. The amount of unrealized depreciation may reflect amounts that the BDC may

not be able to recover, while the amount of unrealized appreciation may reflect future realized

gains. It is important to note, however, that realized and unrealized appreciation or depreciation is

difficult to predict and appears below the income line item in the income statement.

A BDC that is externally managed will generally pay incentive fees to its investment advisor based

on a percentage of net realized gains determined at the end of the calendar year. While BDCs are


required to accrue the amount of incentive fees that would be payable as of the end of any period as

if an investment had been sold by that date, they are required to pay incentive fees on realized gains

only, not on any unrealized appreciation prior to the sale or other disposition of the investment.

Unique BDC Financial Information

Two requirements of BDC accounting — providing a schedule of investments and valuing each

asset for each report — differ from the accounting requirements of other corporations or trusts.

Schedule of Investments

A BDC is required to include a schedule of investments as part of its financial statements with each

quarterly or annual report filed with the SEC, providing a unique level of portfolio transparency.

This information can be particularly valuable as retail broker-dealers, financial advisors, and their

clients perform due diligence on a potential BDC investment.

The schedule of investments lists each investment the BDC holds at the end of the period and also

reports information such as:

• Identity and industry of the portfolio company

• Fair value as determined by the BDC’s board of directors

• Amortized cost and specific information about each security (i.e., senior debt, mezzanine

debt, equity)

• Payment terms (including PIK)

• Maturity dates, if applicable

In addition, the schedule of investments includes information about whether an investment is an

eligible portfolio company as defined by the 1940 Act, whether it is a control or affiliate investment,

and whether or not it is income producing.

In sum, the schedule of investments provides more detail about the individual investments in a

BDC portfolio than is generally found in a prospectus or periodic report.


Valuation

A BDC is required to report the fair value of its assets and liabilities at least quarterly, including

those that are not publicly traded or for which current market values are not readily available.

Those valuations are determined on an individual basis.

The 1940 Act requires that the BDC’s board of directors be solely responsible for fair value

determinations. Often the board’s audit committee will recommend fair values to the full board for

its consideration and approval, after consultation with the BDC’s management and its investment

advisor. A BDC may also engage one or more third party valuation providers or independent pricing

services to assist with the valuation of some or all of the investments it holds.

Fair value, which is defined in Topic 820, “Fair Value Measurements and Disclosures” of FASB

Accounting Standards Codification (ASC) is determined by observable market prices if they are

available and reliable. If that is not the case, valuation techniques, which require some level of

management estimation and judgment, are used. That level varies based on the price transparency

for the investment or the market and the investment’s complexity.

Assets recorded at fair value in a BDC’s financial statements are categorized based on the level of

judgment associated with the inputs used to measure that fair value. Risks inherent in the valuation

technique and in the inputs to the model are also considered. These hierarchical levels, defined by

ASC 820 and directly linked to the degree of subjectivity that has been used, are:

• Level 1: Observable inputs such as quoted prices in active markets for identical assets or

liabilities at the measurement date

• Level 2: Observable inputs, other than Level 1 prices, such as quoted prices for similar

assets or liabilities in active markets, quoted prices in inactive markets, or other inputs

that are observable or can be corroborated by observable market data at the

measurement date for substantially the full term of the asset or liability

• Level 3: Unobservable inputs for which little or no market data exists that reflect

management’s best estimate of what market participants would use in pricing the asset

or liability


Fair value that is reflected in a BDC’s financial statements reflects overall market value of its

investments as well as the health of the portfolio companies. Many BDCs also have a grading

system to provide additional transparency to the portfolio. The grading system generally indicates

the portion of the investments that are performing better than expected, as expected, worse than

expected, or not performing. While this grading system is not required by GAAP or the SEC, it has

become an industry standard and can be found in the management discussion and analysis (MD&A)

section of the prospectus or periodic reports and often within the notes to the financial statements.

VI. Taxation of Non-Traded BDCs

Typically, a BDC elects to be treated as a regulated investment company (RIC) under Subchapter M

of the Internal Revenue Code (IRC) beginning with its first taxable year. As a RIC, a non-traded BDC

does not have to pay corporate-level US federal income taxes on any income or capital gains that it

distributes to its shareholders from its taxable earnings and profits.

One benefit to this treatment is that distributions of profits are not subject to double taxation, at the

corporate and then at the individual taxpayer level, as is the case with dividends paid by many

traditional corporations.

Corporate Level Taxation

To qualify as a RIC, a non-traded BDC must, among other things, maintain its status as a BDC

throughout the taxable year and:

• Meet certain source-of-income requirements

• Meet asset diversification requirements

• Distribute to its shareholders at least 90% of its investment company taxable income,

including short-term capital gains, for each taxable year

Source-of-Income Test

To meet the source-of-income test, a non-traded BDC must derive at least 90% of its gross income

for each taxable year from dividends, interest, payments with respect to certain securities, gains


from the sale of stock or other securities, net income from certain qualified publicly traded

partnerships, or other income from its business of investing in such stock or securities.

Asset Diversification Test

To satisfy asset diversification requirements, a non-traded BDC portfolio must:

• Meet the 50% of value test by holding at least 50% of the value of its total assets in cash,

cash equivalents, securities of other regulated companies, US government securities, and

other securities provided that the securities of any one issuer do not represent more than

5% of the value of the BDC’s assets or no more than 10% of the outstanding voting

securities of the issuer

• Meet the diversification test by having no more than 25% of its assets invested in the

securities of (1) one issuer, other than the US government or other RICs, (2) two or more

issuers that are controlled by the BDC and engaged in the same, similar, or related trades

or businesses, or (3) certain qualified publicly traded partnerships

If the BDC has satisfied both these tests as of the end of any quarter of its taxable year, it will not lose

its status as a RIC because of a discrepancy during a subsequent quarter between the value of its

various investments and the requirements unless the discrepancy exists immediately after the

acquisition of any security or other property and is wholly or partly the result of that acquisition.

In addition, if an investment does not satisfy both of the tests at the end of any quarter, it will be

considered to have met the requirement if it satisfies the tests within 30 days after the close of the

quarter.

It is relevant to note that the limitation on holdings required by the second test adds built-in

diversification to the non-traded BDC and provides a layer of investor protection.

Distribution Requirement

To fulfill the distribution requirement that qualifies it as a RIC, a non-traded BDC must distribute at

least 90% of its investment company taxable income to its shareholders for each taxable year.


Investment company taxable income is generally the BDC’s net ordinary income plus the excess, if

any, of realized short-term capital gains over realized long-term capital losses.

However, non-traded BDCs that elect to be treated as RICs generally distribute substantially all of

their investment company taxable income as well as their net realized capital gains to shareholders

to avoid corporate-level taxation. Net realized capital gains are the excess of realized capital gains

over realized capital losses.

BDCs make this choice because, while Subchapter M does not require that long-term realized gains

be distributed to maintain RIC qualification, a RIC is subject to US federal income taxes at normal

corporate rates on any net realized gains. Further, even if the non-traded BDC satisfies the 90%

distribution rule, any remaining income or gains that are not distributed are similarly taxable.

In addition, RICs are subject to a 4% nondeductible US federal excise tax on certain undistributed

income unless the RIC distributes in a timely manner an amount at least equal to (1) 98% of its

ordinary income for each calendar year, (2) 98.2% of its capital gains net income for the one-year

period ending October 31 in that calendar year, and (3) any income recognized, but not distributed,

in preceding years and on which no US federal income tax was paid.

A BDC may retain some or all realized net long-term capital gains in excess of realized short-term

capital losses, designating the amount a deemed distribution. In that case, it must pay tax on the

retained amount and provide written notice to shareholders of the deemed distribution within 60

days after the close of the taxable year.

Investor Level Taxation

Although non-traded BDCs that qualify as RICs are not taxed at the federal corporate level on

income they distribute to their shareholders, the shareholders may be liable for US federal income

tax and potentially state income tax on the income they receive. From a tax standpoint, BDC

distributions can be classified into three categories: dividends, capital gains, and return of capital.

The BDC makes the appropriate designations and reports that information to shareholders annually

on IRS Form 1099-DIV.


Dividends

Because BDCs do not pay federal corporate income tax, dividends that non-traded BDCs pay to

shareholders are non-qualified. This means the BDC shareholders pay US federal income tax on

those distributions at their marginal personal income tax rate rather than at the lower tax rate that

applies to qualified dividends and long-term capital gains. State income taxes may also apply.

Capital Gains

When a BDC distributes capital gains realized by selling portfolio investments at a profit, these

gains are classified as either short-term or long-term gains. Shareholders pay US federal income tax

on short-term gains at their marginal personal income tax rates. On long-term gains, they pay tax at

a rate determined by their adjusted gross income (AGI) and potentially a surcharge also determined

by AGI. The rate on long-term gains is always lower than their marginal personal rate. State income

and capital gains taxes may also apply.

If the BDC has made a deemed distribution, each US shareholder must report his or her share of the

distribution as if it had actually been paid but is entitled to claim a tax credit equal to his or her

allocable share of the tax paid by the BDC.

Return of Capital

Distributions that are classified as return of capital are technically nontaxable at the time of payout.

However, they reduce the shareholder’s cost basis and are eventually taxed at the long-term capital

gains rate when the investor sells his or her shares or the BDC liquidates.

Section 19(a) of the 1940 Act prohibits a BDC from making any distribution from a source other

than net investment income or capital gains without providing a written disclosure of the source of

the payment. These notices, generally known as 19a Notices, may be issued quarterly, when a

portion of the BDC’s distribution constitutes a return of capital, or at the end of the taxable year. At

year-end, a BDC can determine the exact amount of the prior year’s distributions that were return of

capital.


Given the unique tax structure of BDCs and RICs, an investor should discuss BDC investments with

a qualified tax professional to determine his or her optimal tax strategy.

VII. Risks and Suitability of Non-Traded BDCs

A non-traded BDC is a unique investment that offers individual investors potential benefits that

may be appropriate for their goals and objectives, including current yields, total returns, and access

to experienced investment professionals. A non-traded BDC may also have a low correlation to

other asset classes, which can help to enhance an investor’s overall portfolio return while reducing

risk by providing added diversification.

At the same time, a non-traded BDC has features that may make it unsuitable for some individual

investors. Illiquidity is a significant risk, as it is with all direct participation investments. So is the

timing and implementation of a liquidity event, which non-traded BDCs typically seek to effect in

order to return investment capital to shareholders.

Additionally, non-traded BDCs share with traded BDCs a number of risks, including, though not

limited to, regulatory, market cycle, interest rate, and leverage risks as well as risks directly related

to the skills of their investment advisors.

Suitability Guidelines

Before potential investors purchase shares of a non-traded BDC, they must meet suitability

standards imposed by NASAA or by certain individual states. Retail broker-dealers who sell shares

of a non-traded BDC and financial advisors who recommend their purchase must be aware of these

requirements, which are included in the BDC’s prospectus, and must ensure that potential investors

meet the specific standards imposed by the state where they reside.

The following general guidelines provide an overview of the circumstances in which a non-traded

BDC may be a suitable investment. Additionally, before recommending a specific non-traded BDC

to a specific investor, a broker-dealer or financial advisor should review the specific suitability

standards included in its prospectus and take into account the financial effect of making the

investment.


A potential investor in a non-traded BDC should:

• Have sufficient liquid net worth and annual income to cover foreseeable and some

unforeseeable liquidity needs for the period prior to the non-traded BDC’s planned

liquidity event

• Have a total portfolio well diversified across asset types and sectors to decrease overall

liquidity risk if part of the portfolio needs to be liquidated to fulfill a large, extraordinary

cash need

• Have sufficient cash reserves so that he or she can cover a loss of employment income or

other unexpected liquidity need without having to sell shares in the non-traded BDC

Further, a debt BDC may be suitable for a client looking for an investment that seeks to distribute

regular income. If the potential investor does not anticipate spending the income immediately, he

or she should have a reinvestment plan, including the potential to reinvest directly in the non-

traded BDC through a published dividend reinvestment plan.

In contrast, an equity BDC may be suitable for a client looking for an investment that offers the

potential for capital gains resulting from the sale of securities of the BDC’s portfolio companies but

does not seek to provide regular income.

Illiquidity Risks

Illiquidity created by the lack of a secondary market for non-traded BDC shares is the single greatest

risk and the primary reason a non-traded BDC investment may be unsuitable for some investors. In

essence, an investor should expect his or her initial investment to be unavailable for a period of up

to ten years depending on the intended timing of a liquidity event by the specific BDC — or more if

a liquidity event cannot be completed within the anticipated time frame.

Many non-traded BDCs offer investors limited liquidity through a periodic share repurchase

program. When this occurs, a BDC offers to repurchase a certain number of stockholder shares at a

price that has some relationship to the current offering price. This price may be more or less than

the price investors paid when they purchased the shares depending on the performance of the non-

traded BDC and resultant changes in the public offering price. In addition, non-traded BDCs


generally limit the number of shares they will repurchase, and they are able to suspend or terminate

their share-repurchase programs if market conditions deteriorate.

In other words, the potential for liquidity in a share-repurchase program is not an adequate

substitute for an organized secondary market, such as a national securities exchange.

Market Cycle Risk

Because capital markets and the economy as a whole go through cycles that can affect a BDC’s total

return, retail broker-dealers and financial advisors should seek non-traded BDCs with expert

management and an investment advisor with experience in (1) understanding macro- and micro-

level market risk and (2) executing tactical strategies in all markets.

Risks of Using Leverage

Because many non-traded BDCs invest a significant portion of their assets in debt investments,

especially senior debt, returns can be relatively predictable in certain market environments. As a

result, many non-traded BDCs consider debt financing an attractive tool to enhance total returns.

Using leverage allows each dollar of equity to make more investments and to potentially produce a

higher total return if the investments appreciate. Further, if the debt securities the BDC holds yield

higher rates of return than the borrowing costs, yield may also be magnified.

On the other hand, if the investments the BDC has made depreciate in value, or the portfolio

company’s cash flow declines, and it cannot meet its interest obligations, or both situations occur,

the return may be lower than if the BDC had a zero debt load. Worse, leverage can create default

situations in which investors can lose their entire investment if a BDC cannot meet its obligations

in a difficult market environment.

Mitigating Use of Leverage Risks

Broker-dealers and financial advisors should examine a BDC’s debt level closely to ensure the BDC is

not taking imprudent risks and that it maintains sufficient liquidity to cover unexpected


circumstances. Further, as part of due diligence, they should review the BDC’s target or maximum

debt levels to confirm that its leverage ratio satisfies the 50% LTV coverage requirement.

Leverage risk can also be managed by diversifying an investor’s portfolio by recommending shares

of a non-traded BDC that utilizes low levels of leverage, or no leverage at all, as well as a BDC that

takes more risk for the potential of providing higher returns.

Investment Advisor Skill

Since the investment professionals employed by the investment advisor or sub-advisor to a non-

traded BDC will make all investment and disposition decisions and oversee management of the

investment portfolio, their skill and expertise can either aid in enhancing investor returns or serve

to diminish them over time.

It is essential for a broker-dealer or financial advisor to ensure that a BDC’s investment advisor has

adequate experience and the relevant expertise to execute the specific investment strategy detailed

in its prospectus. Risks that result from individual investment advisors can be mitigated somewhat

by diversifying an investor’s allocation to include more than one BDC, each managed by a different

sponsor.

Liquidity Event Implementation and Timing Risk

To achieve the goal of returning investment principal and any accrued capital to its shareholders,

the management, investment professionals, and board of directors of a non-traded BDC must

determine the form and timing of the liquidity event. However, executing a liquidity event involves

a unique degree of risk that could negatively impact shareholders if the effort is not successful.

Shareholder value could potentially be reduced if:

• Capital markets are unstable at the time that listing on a public exchange is planned.

• Market prices of traded BDCs are less than their NAVs.

• Transaction costs of a planned sale or merger are high.


• Investments held by the BDC are out of favor with other investors, making the sale of the

BDC’s portfolio difficult or forcing liquidation at prices that may be less than the value of

the investments.

• The economy is contracting or in recession, which may reduce the value of the BDC’s

investments.

• The board of directors chooses to delay a liquidity event as the result of market or other

factors, which could result in a lower total return as the result of time value of money

discounting and would require shareholders to hold their shares longer than anticipated.

Mitigating Liquidity Event Risk

The risks associated with a potential liquidity event are hard to predict or measure during the

offering and operational phases, as the non-traded BDC’s end point is still many years away. In order

to mitigate some of the risks that may occur, a broker-dealer or financial advisor may consider:

• Diversification techniques, such as recommending investment in more than one non-

traded BDC or other direct investment, especially those with different investment

objectives or strategies

• A thorough assessment of the experience and backgrounds of the independent directors

of a non-traded BDC, since the board of directors, which will make liquidity event

decisions, must include a majority who are independent of the BDC and its investment

advisor

VIII. Comparing Non-Traded and Traded BDCs

Non-traded and traded BDCs share many key characteristics but also have significant differences. If

an investor’s objective includes adding a non-traditional, income-producing alternative to his or her

portfolio, a retail broker-dealer or financial advisor might suggest a BDC. But whether a non-traded

or traded BDC is the more suitable choice will vary for a number of reasons, including the investor’s

profile.


Overview of Key Similarities

The key similarities of the two types of BDCs are that both:

• Are subject to certain provisions of the 1940 Act and the Advisers Act

• Must register with and file periodic reports (i.e. 10-Qs, 10-Ks and 8-Ks) with the SEC

• Can elect to be treated as RICs, which means they do not pay US federal corporate

income tax on any income or capital gains which they distribute to their shareholders so

long as they distribute at least 90% of their investment company taxable income each

year and meet source-of-income and asset diversification requirements

• Must provide fair market values for portfolio investments with no readily ascertainable

market price on at least a quarterly basis

Overview of Key Differences

Traded BDCs generally sell their shares in an underwritten initial public offering (IPO) and follow-

on underwritten offerings, after which the shares are traded on a national securities exchange

among investors at prices determined by supply and demand. The public price on a national

securities exchange may be greater than or less than the BDC’s NAV. In contrast, non-traded BDCs

raise capital over an extended offering period at an offering price that is adjusted to ensure that the

net offering price is never less than the current NAV. The shares are available only to those

investors who meet the suitability standards imposed by the state where they live.

Because they’re listed, traded BDCs are considered covered securities and so do not have to register

in each state or jurisdiction where their shares are sold. Non-traded BDCs, in addition to registering

its securities with the SEC, are also required to register its securities in each state where offers and

sales are made and comply with NASAA requirements.

In addition, a traded BDC can be described as a perpetual life entity that could, at least in concept,

operate indefinitely with a shareholder creating his or her own exit strategy by selling shares or

participating in a share repurchase program if one is offered. A non-traded BDC, on the other hand,


is designed to have a finite life, which is expected to end with a liquidity event designed to return

capital to the shareholders.

From an investment portfolio perspective, non-traded and traded BDCs are also quite different and

are subject to separate risks that investors and their financial advisors should understand.

Investor Liquidity Concerns

Traded BDCs are listed on a national securities exchange and offer liquidity to their shareholders,

while non-traded BDCs are not listed and generally offer extremely limited liquidity. Illiquidity

makes non-traded BDCs unsuitable for some individual investors, especially those with small

portfolios or those who may need access to their funds before the BDC completes its liquidity event.

For these investors, a traded BDC may be preferable as a way to invest in private companies. Retail

broker-dealers and financial advisors who may be concerned about whether a client meets NASAA

and state-imposed suitability standards for investing in a non-traded BDC may consider

recommending a traded BDC instead.

Distribution Yields

The distribution yields paid by a traded BDC vary not only with the performance of its investment

portfolio and the amount of net investment income generated from its portfolio, but also with

fluctuations in its stock price. For example, if the market price of a traded BDC increases, its yield

decreases. The opposite is also true: If the price drops, the yield increases.

Interestingly, however, there does not seem to be a meaningful difference between the average

yields of traded BDCs and the average yields of non-traded BDCs. One reason may be that most non-

traded BDCs currently offering shares focus their investments heavily in syndicated loans traded in

the OTC market. These investments are generally senior secured loans at the top of a portfolio

company’s capital structure. So they carry the least risk of default but yield a lower interest rate.

In contrast many — though not all — traded BDCs originate loans to their portfolio companies or

hold a combination of directly originated and syndicated loans. As a result, they may own senior


secured debt but also mezzanine debt. Mezzanine loans have an increased likelihood of default

since the loans are unsecured, but they also tend to yield a higher interest rate.

This dynamic could change, of course, if some non-traded BDCs alter their focus, including adding

more exposure to mezzanine debt and other products lower in a portfolio company’s capital

structure.

It is relevant, however, that while there does not appear to be any evidence that non-traded BDCs

provide a higher distribution yield than traded BDCs, distribution yields of non-traded BDCs could

be more predictable than those of their traded counterparts, which could be attractive to certain

investors. In addition, non-traded BDCs measure their performance by total return, which is the

sum of cash distributions, any capital appreciation in the value of the shares during the life of the

program, and any premium received in connection with the liquidity event. Since the offering price

must increase when NAV increases, a strong investment portfolio can provide a total return that

exceeds the distribution yield.

Share Price Volatility

Shares that trade on a national securities exchange, including shares of traded BDCs, have

historically reflected the volatility inherent in the broader capital markets. For example, a traded

BDC’s share price may have a high correlation with the broad stock market indexes, although the

price may not be consistent with the performance of the companies in its investment portfolio.

Healthy capital markets may contribute to the share price of a traded BDC being above its NAV —

or trading at a premium — while a downturn in the markets may contribute to a traded BDC

trading at a discount to NAV. There’s ample evidence of this pattern in both full market cycles over

the past decade.

The share price of a non-traded BDC, on the other hand, is generally correlated to the BDC’s NAV.

Because BDCs are prohibited from selling shares at a price below NAV, after subtracting

underwriting commissions and dealer manager fees, a non-traded BDC is required to raise its

offering price when its NAV increases and generally decreases the offering price when the NAV


decreases. Since the offering period typically lasts a number of years, shareholders may buy at

different prices.

Share Price in Relation to NAV

The practical effect of this is that a BDC must make a determination within 48 hours prior to the

sale of shares that it is not issuing shares at a price that is below NAV, after deducting selling

commissions or other discounts. For a non-traded BDC, this means raising its offering price if the

NAV increases during its offering period and generally reducing the offering price if there is a

material decline in NAV. These changes make it possible for the BDC to raise capital whether its

NAV increases or decreases.

In contrast, if the market price of a traded BDC were trading at a discount to NAV, the BDC would be

unable to access the capital markets with a follow-on offering unless it first obtains shareholder

approval to issue shares at a price below NAV. Even traded BDCs that receive shareholder approval

generally are limited in the amount of dilution to existing shareholders as a result of the offering.

So if the market price were significantly below NAV, the BDC might still not be able to raise capital

by selling new shares.

Comparison of Fees and Costs

The up-front costs of purchasing shares of traded and non-traded BDCs also differ significantly.

Traded BDCs typically raise capital through underwritten offerings including an IPO and, in some

cases, follow-on offerings. Underwriting commissions and discounts in IPOs and follow on-

offerings generally total up to 7% of the gross proceeds, although these costs may not be

transparent to individual investors.

Selling commissions on non-traded BDCs have historically been 7% of gross proceeds, all of which

is generally paid to the retail broker-dealer, plus a dealer manager fee of 3%, some of which may

also be re-allowed to the broker-dealer. In addition, the sponsor of the non-traded BDC is generally


reimbursed for offering and organizational expenses from the proceeds of the offering, putting the

total up-front fees in the range of 11.5% to 15%.

Comparing Non-Traded and Traded BDCs Non-Traded BDCs Traded BDCs

Distribution Method

Continuous public offering through retail broker-‐dealer network

Underwritten public offering

Upfront Investor Fees and Expenses

Selling commissions, dealer manager fees, and offering and organizational reimbursements approximately 11.5% to 15% of purchase price

Underwriting commissions and discounts approximately 6% to 7% of the purchase price

Liquidity Limited liquidity through share repurchase program; investors should be prepared to hold through liquidity event

Liquidity provided by shares trading on a national securities exchange

Volatility

Offering price set to correlate to net asset value (NAV)

Daily volatility based on how market affects share price, which may limit correlation between price and NAV

Valuation

Must fair value investments with no readily ascertainable market price on at least a quarterly basis

Must fair value investments with no readily ascertainable market price on at least a quarterly basis

Investors Can be purchased only by investors who meet suitability standards imposed by the state or jurisdiction in which they reside

Can be bought and sold by any person or entity with access to a national securities exchange


About the Authors

Cynthia M. Krus, Partner and Vice Chair of the Corporate and Financial Services practices at

Sutherland Asbill & Brennan LLP, counsels companies and alternative investment funds in their

quest to grow their businesses, especially in the crucial area of raising capital. Cynthia works with

management teams and boards of directors to develop strategic plans and timing for critical

decisions in all aspects of their businesses, including mergers and acquisitions; proxy contests;

going-private transactions; reorganizations; debt equity and rights offerings; and other securities

and capital markets transactions. She is recognized as a leading adviser to traded and non-traded

business development companies (BDCs) as well as small business investment companies (SBICs).

With more than 20 years working in this specialized area, Cynthia brings deep hand-on experience

to the complex issues – both legal and strategic – faced by companies. She counsels public

companies in a broad range of corporate and securities matters such as corporate governance, crisis

management, whistleblower response, disclosure, executive compensation and shareholder

matters. Cynthia is the author of the Corporate Secretary’s Answer Book, which is updated

annually, and frequently speaks at industry conferences on regulatory, corporate governance, and

capital raising issues. Cynthia serves as vice chair of Sutherland’s corporate and financial services

practices.

Owen J . Pinkerton, Counsel at Sutherland Asbill & Brennan LLP, advises a variety of public and

private issuers and underwriters on a range of regulatory and transactional matters, such as public

and private offerings and ongoing regulatory compliance with the federal securities laws. In

particular, he frequently advises traded and non-traded business development companies (BDCs),

with a focus on publicly registered, non-traded BDCs, as well as publicly registered commodity

pools. Owen’s practice also involves ongoing regulatory advice to his clients regarding general

corporate governance matters, including preparing and reviewing periodic reports under the

Securities Exchange Act of 1934 and dealing with disclosure issues under the federal securities laws.


He also advises clients on issues arising under state "Blue Sky" laws and processes and FINRA

regulation of public offerings.

Before joining Sutherland, Owen was employed by the U.S. Securities and Exchange Commission

(SEC) as an attorney-adviser and senior counsel. Within the SEC’s Division of Corporation Finance,

Owen served as a reviewer of 1933 Act and 1934 Act registration statements filed by real estate

investment trusts (REITs), business services companies and commodity pools. He also served as

principal screener of proxy statements filed by a variety of issuers. Prior to this, Owen worked at the

U.S. Commodity Futures Trading Commission in the Division of Trading and Markets, and for the

U.S. House of Representatives. Owen is a participating author of the Corporate Secretary’s Answer

Book, which is updated annually.

Documents

Portfolio Construction Using Non-Traded Business ... · Portfolio Construction Using Non-Traded BDCs 8 ! Regulatory Examinations The SEC has the authority under Section 31(a) of the