The BDCs have several advantages when compared to other types of investment funds:
- Unlike private venture capital funds, BDCs offer liquidity to the investors because their shares trade in the public markets
- Unlike private venture capital funds, BDC investors need not be limited to to “qualified purchasers” and the investors don’t have to meet the net worth and income requirements applicable to private funds.
- BDCs give their fund managers accessibility to “permanent capital” which is not subject to shareholder redemption as is common in private fund structures.
- Unlike the other types of registered investment companies, BDC managers can charge performance fees, similar to managers of private venture capital funds.
BDCs have some limitations and restrictions, including of the following:
- BDCs are forced to maintain low leverage and the total amount of debt is not permitted to exceed their total equity. This restriction does not apply to private Venture capital funds.
- BDCs are restricted in their ability to enter into transactions with affiliates
- BDCs are required to implement procedures and policies that will prevent any violations of the Federal securities laws. This involves the appointing of a chief compliance officer that will administer these procedures and policies
- A single BDC investment may not account for over 25% of the total holdings of the BDC. In addition, 70% of all the assets have to be invested in a limited amount of categories, as discussed below.
- BDCs are required to distribute a minimum of 90% of the taxable earnings every quarter
Section 55 of the Company Act requires every BDC to invest a minimum of 70% of its total assets into the following:
- Privately issued securities that are purchased from the issuers which are “eligible portfolio companies”;
- The securities of the “eligible portfolio companies” controlled by the BDC, whereby an affiliated individual of the BDC must be the director;
- The privately issued-securities of the companies that are subjected to reorganization, bankruptcy proceedings, insolvency or any other similar proceeding as well as those that are not able to meet the required obligations without any material assistance;
- Government securities, cash items, cash or the high-quality debt-securities that are about to mature in 1 year or less; and
- Office equipment and furniture, interests in either real-estate or other non-investment assets that are similar that are incidental to the operations of the BDC.
An “eligible portfolio company” is defined as any issuer that (a) is organized and has its principal place of business in the United States, (b) is not an investment company other than a small business investment company wholly owned by the BDC, and (c) does not have any class of publicly-traded securities with respect to which a broker may extend credit.
In most instances, BDCs are organized as a regulated investment companies (RICs) under Subchapter M of the Internal Revenue Code so that they are able to avoid taxation at the company level on that portion of income and capital gains distributed to shareholders. Distributions to shareholders will be taxable either as capital gains or ordinary income in a similar manner as are distributions from the mutual funds. To qualify for RIC treatment, in general at least 90% of the BDC’s income must consist of interest, dividends, gains from sales of securities and similar types of income and gains and the BDC must distribute to its stockholders for each taxable year at least 90% of its investment company taxable income (consisting generally of net investment income from interest and dividends and net short-term capital gains). A BDC must also satisfy certain requirements with respect to its portfolio diversification.
How to Form a BDC
In order to become a BDC, the company is required to file a Form N-6 with the SEC. This is followed by the requirement of filing the notice on the Form N-54A which indicates that it has chosen to be an entity that will be regulated in the form of a BDC.
The process of electing to become regulated as a BDC, the company is required to register its equity securities under Section 12 of the Securities Exchange Act of 1934. These registrations necessitate that the BDC must periodically file Forms 10-K, 10-Q and 8-K along with proxy statements like any other public company. The BDC is also required to register the offer and sale of its shares under the Securities Act of 1933, as well as filing a Form N-2 registration statement that includes a detailed prospectus and other information, including audited financial statements.