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Investing in Non-Traded BDCs May Get Even Riskier

On November 15, 2017, H.R. Bill 4267 (the “Bill”), entitled the Small Business Credit Availability Act (the “Act”), passed the House Financial Services Committee by an overwhelming 58-2 vote.  This Bill seeks to amend the Investment Company Act of 1940 (’40 Act), specifically the regulations currently governing business development companies (“BDCs”).  In recent years, financial advisors have increasingly recommended BDCs, allowing for Mom and Pop retail investors to participate in private-equity-type investing.  Many income-oriented investors are attracted to BDCs because of their characteristic enhanced dividend yield.

As an investment vehicle, BDCs were first made available pursuant to the Small Business Investment Incentive Act of 1980, as a result of a perceived crisis in the capital markets.  At that time, small businesses were encountering severe difficulties in accessing credit through traditional means.  BDCs are a special type of closed-end fund designed to provide small, growing companies with access to capital.

BDCs are structured as hybrid between an operating company and an investment company under the ’40 Act.  Regulated as an investment company, BDCs are required to file periodic reports under the Securities Exchange Act, and further, are subject to a number of regulatory requirements.  Three of the most notable regulations currently governing BDCs are as follows:

  • Character of Investments – a BDC must generally invest at least 70% of its assets in “qualifying assets” pursuant to Section 55(a) of the ’40 Act;
    • The qualifying assets requirement means that BDCs must typically invest in “eligible portfolio companies,” which are private U.S. companies with a market cap of no greater than $250 million;
  • Adviser Compensation – Investment Advisers to BDCs are able to receive capital gains incentive fees in an amount not to exceed 20% of realized capital gains;
    • Investment advisers to other investment companies are generally prohibited from receiving capital gains incentive fees;
  • Leverage – a BDC must maintain at least a 200% asset coverage ratio. This means that for every dollar invested in the BDC, only one dollar can be borrowed for additional investment purposes (1:1 ratio).

If the proposed Bill passes the House and Senate, then the current 1:1 leverage requirement imposed on BDCs will no longer apply.  If enacted, the Bill will allow BDCs to leverage 2:1 against their investment dollars.  Proponents of the bill argued that asset coverage rules for BDCs are far more restrictive than for other lending vehicles, including traditional banks, as well as Collateralized Loan Obligation (“CLO”) funds.  Further, proponents of the Bill have reasoned that with increased leverage, BDCs will be better positioned to focus on investing in senior debt that is less inherently risky than junior, or even junk, debt.

If the Bill passes, investors in BDCs — particularly non-traded BDCs — should be aware of the significant risk associated with allowing their investment vehicle, and its manager(s), to further leverage their investment dollars.  As our office has discussed in previous blog posts, non-traded BDCs should rightly be regarded as risky, complex and illiquid investment products.  As their name implies, non-traded BDCs do not trade on a national securities exchange, and are therefore difficult to exit.  Typically, investors can only sell their shares through redemption with the issuer, or through a fragmented and inefficient secondary market.

In addition, non-traded BDCs have high up-front fees (typically as high as 10%), which are paid to the financial advisor selling the product, his or her broker-dealer, and the wholesale broker or manager.  These high fees may create an incentive for some financial advisors to recommend a non-traded BDC, without first conducting the necessary due diligence on the investment, or performing a meaningful suitability analysis to determine if the investment meets the customer’s stated objectives and risk profile.

If the Bill passes, investors in non-traded BDCs will not only face the risks associated with illiquidity and high fees, but they will also be encountering the risk associated with additional leverage, particularly on an investment vehicle that also permits its managers to earn considerable performance fees of up to 20% of capital gains.  Thus, the risk becomes whether some BDC managers will consciously (or subconsciously) make riskier investments (with leveraged capital) on the hopes of netting outsized returns and performance fees.  Under the ’40 Act, other traditional lending vehicles do not permit such outsized performance fees.

If you have invested in any of the following non-traded BDCs, and you have suffered losses in connection with your investment (or are currently unable to exit your illiquid investment position without incurring losses), you may have legal claims to be pursued through FINRA arbitration:

  • FS Investment Corporation II (FSIC II);
  • FS Investment Corporation III (FSIC III);
  • FS Investment Corporation IV (FSIC IV);
  • FS Energy and Power Fund (FSEP);
  • FS Global Credit Opportunities;
  • CNL Corporate Capital Trust II;
  • CION Investment Corporation (offered by ICON Investments);
  • Business Development Corporation of America (BDCA);
  • Business Development Corporation of America II (BDCA II).

To find out more about your rights and options, contact a securities arbitration lawyer at Law Office of Christopher J. Gray, P.C. at (866) 966-9598 or via email at for a no-cost, confidential consultation.

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