Application of acquired fund fees and expenses (AFFE) rule to business development companies (BDCs)
SBIA Comment Letter to:
Chairman Jay Clayton
U.S. Securities and Exchange Commission
November 14, 2019
Re: Application of acquired fund fees and expenses (AFFE) rule to business development companies (BDCs)
Dear Chairman Clayton:
The Small Business Investor Alliance (SBIA), representing hundreds of funds, is a national association that develops, supports, and advocates for policies that benefit investment funds that finance small and mid-size domestic businesses in the middle market and lower middle market, as well as the investors that provide capital to these funds. SBIA is also the largest representative of the business development company (“BDC”) industry, as our membership includes 28 firms that run approximately 50 BDC funds, and account for nearly 80% of all BDC assets under management. 1
BDCs are a critical source of financing for small and mid-size businesses in the United States. BDCs are mandated by law to invest at least 70% of their assets in “qualifying assets” which consist of U.S. operating companies that are privately owned or have a market capitalization below $250 million. Many BDCs make 100% of their investments in qualifying assets. BDCs are also highly regulated and transparent investment vehicles that provide retail investors with a reliable source of income on their investment portfolios.
The SBIA appreciates the recent work of the Securities and Exchange Commission (“SEC” or
“Commission”) to prioritize the needs of Main Street investors, and to modernize regulations in order to help emerging businesses raise capital. The SEC’ s ongoing agenda reflects the reality that regulations must be continuously reassessed in order to keep up with our evolving capital markets.
Fund of Funds Proposal / Acquired Fund Fees and Expenses Rule
The SBIA commends the SEC for issuing its 2018 proposal to update the regulatory framework that applies to “fund of funds”2 arrangements (“Proposal”). The Proposal rightfully prioritizes the need to mitigate confusion surrounding current fund of funds regulation, and to ensure that investors are provided with accurate information necessary to make informed investment decisions.
The Proposal also presents an opportunity for the Commission to address some of the negative consequences resulting from BDCs being included in the definition of an “acquired fund” under the acquired fund fees and expenses (“AFFE”) rule. The AFFE rule was adopted in 2006 and requires a BDC ( or registered fund) to disclose as an additional line item in its prospectus fee table its pro rata share of the operating expenses paid by underlying funds in which an acquiring fund invests. When the AFFE rule was adopted, the Commission stated that the intent of the disclosure was to provide investors with “a better understanding of the actual costs of investing in a fund that invests in other funds” and “the means to compare directly the costs of investing in alternative fund of funds, or the costs of investing in a fund of funds to a more traditional fund.”3
As the SBIA noted in its comment letter on the Proposal 4, inclusion of BDCs in the definition of an “acquired” fund under the AFFE rule actually undermines the stated purpose of the disclosure and presents investors with a misleading picture of the true costs of investing in BDCs. The AFFE requirement suggests that a BDC’s expenses are operating expenses of the acquiring fund, and therefore constitute additional expenses borne by investors. However, a BDC’s trading price already reflects its operating expense structure, which in turn reduces the total return of the acquiring fund’s investment in the BDC. Reflecting these expenses again pursuant to the AFFE rule results in double-counting the BDC’s expenses, and therefore the AFFE rule results in significantly overstating acquiring fund’s expense ratio.
Regrettably, the AFFE requirement has inhibited the flow of capital into BDCs and therefore their ability to provide financing to Main Street businesses. Because of the perceived high cost of investing in BDCs, most mutual funds and exchange-traded funds (ETFs) have stopped investing in BDCs since the AFFE rule was adopted. In 2014, major index providers – including S&P and Russell – dropped BDCs from their indices, citing the impact of perceived fees caused by the AFFE rule. The exclusion of BDCs from these indices has, by one measure, decreased institutional ownership in BDCs by 25%. 5 The reduction of institutional ownership in BDCs and the corresponding curtailment of institutional owners’ participation in BDC governance has significantly negatively impacted retail shareholders.
Over the past year, several members of members of Congress have voiced concern regarding the impact that the AFFE rule has had on BDCs and investors. During a February 2019 hearing of the Senate Banking Committee, Sen. Pat Toomey observed that “BDCs have become a really important source of capital for small and growing companies” and that the “application of the SEC’s [AFFE requirements] has a particularly adverse impact on BDCs …. ” He also called the AFFE requirements “inappropriate,” noting that a BDC’s market price already reflects its fees.6 Additionally, Reps. Brad Sherman and Andy Barr expressed support for exempting BDCs from the AFFE requirement during a recent SEC oversight hearing of the House Financial Services Committee.7 These comments follow the inclusion oflanguage in the past three Financial Services and General Government Appropriations Bills calling on the SEC to take action to mitigate the “unnecessary,” “unintended,” and “harmful” consequences imposed on BDCs by the AFFE disclosure requirements. 8
The SEC also recently received an application from the Coalition for Business Development
(“Coalition”) to exempt certain BDCs from the definition of the term “acquired fund” for purposes of Form N-lA, Form N-2, Form N-3, Form N-4 and Form N-6 under the Investment Company Act of 1940 (” 1940 Act”). 9 If granted, this exemptive relief would narrowly apply only to exchange-traded BDCs and better inform investors as to the true costs of investing in BDCs.
Exemption from AFFE Rule for Similar Investment Vehicles
The SEC has already taken action to exempt certain types of investment vehicles – including those with structures very similar to BDCs – from the AFFE rule. For example, real estate investment trusts (REITs) are exempt from the AFFE rule because they are not an “investment company” under the 1940 Act. Like BDCs, REITs take an active role in the management of their portfolio companies, have similar expense structures as BDCs, and are pass-through entities to the extent that they distribute their income to their investors. We do not believe there is a compelling investor protection argument for treating BDCs and REITs differently under the AFFE rule – we believe both vehicles should be exempt.
The SBIA believes that exempting exchange-traded BDCs from the AFFE rule – whether through the fund of funds Proposal or the Coalition’s application – will facilitate capital formation for BDC portfolio companies and protect investors by providing them with more accurate information. We respectfully urge the Commission to prioritize this important issue, which will result in BDCs having a greater ability to provide critical financing for Main Street businesses throughout the country. The SBIA and our members stand ready to assist the SEC in any way on this important issue.
About the Small Business Investor Alliance (SBIA)
The Small Business Investor Alliance (SBIA) is the premier organization of lower middle market private equity funds and investors. SBIA works on behalf of its members as a tireless advocate for policies that promote competitive markets and robust domestic investment for growing small businesses. SBIA has been playing a pivotal role in promoting the growth and vitality of the private equity industry for over 50 years. For more information, visit www.SBIA.org or call (202) 628-5055.
1 A list of SBIA BDC membership is attached to this letter.
2 SEC, Fund of Funds Arrangements, Rel. 33-10590 (Dec. 19, 2018)
3 SEC, Funds of Funds Investments, Rel. 33-8713 (Jun. 20, 2006) at 41.
4 SBIA comment letter on December 2018 fund of funds proposal (April 30, 2019) Available at
https://www.sec.gov/comments/s7-27-l 8/s727 l 8-543 l 570-l 84653.pdf
5 Wells Fargo Securities Equity Research, The 2Ql8 BDC Scorecard (Jan. 18, 2017). See also Raymond James,
BDC Ownership Percentage by Investor Type (April 2019). The market cap weighted average ofBDC ownership
by institutional investors plunged by approximately one-quarter year-over-year between the end ofQ4 2013 (42.2%)
and Q4 2014 (31.7%).
6 Legislative Proposals on Capital Fonnation and Corporate Governance, Open Hearing before the S. Comm. on
Banking, Housing, and Urban Affairs, l 16th Cong., 1st Sess. (2019)
7 Oversight of the Securities and Exchange Commission: Wall Street’s Cop on the Beat, Hearing before the H.
Comm. on Financial Services, I l 61h Cong., l 51 Sess. (2019)
8 See H.R. Rep. No. 115-792, 115th Cong., 2d Sess. (2018); H.R. Rep. No. 115-234, 115th Cong., I st Sess. (2017);
H.R. Rep. No. 114-624, 114th Cong., 2d Sess. (2016)
9 Application submitted by the Coalition for Business Development (September 3, 2019) as an amendment to a
September 2018 application submitted by Apollo Investment Corporation and Ares Investment Corporation. The
Coalition’s application is available at https://www.sec.gov/Archives/edgar/data/l 780226/000 l l 9312519236604/d79 l 43 l d40app.htm