The COVID-19 pandemic continues to affect nearly everyone worldwide, causing widespread economic disruption. While certain provisions and leniency have been granted in regards to financial reporting, some markets have experienced unanticipated effects – including the capital market, and more specifically, closed-end investment companies that have elected to be regulated as business development companies (BDCs).
Investment companies regulated as BDCs have the ability to issue and sell senior securities and participate in joint enterprises or arrangements that would otherwise be prohibited by provisions of the Investment Company Act of 1940. BDCs can provide capital to smaller companies that do not have readily available access to capital markets.
These smaller domestic operating companies – a BDC’s portfolio companies – may be affected by the COVID-19 pandemic, but under the current provisions, a BDC may face challenges with raising additional equity capital to assist those companies. As described by Prospect Capital Corporation [Nasdaq: PSEC] – a closed-end management investment company regulated as a BDC – the COVID-19 pandemic has disrupted capital markets, adversely affecting the value of financial assets, which subsequently impacts other functions of their operations as a BDC.
Due to the impacts from the coronavirus, Prospect Capital disclosed that it may not have access to sufficient equity capital required to maintain compliance with current requirements, which could prevent the Company from paying cash dividends or taking advantage of investment opportunities that may arise. If a BDC were to fail to make required distributions, it would no longer qualify as a regulated investment company and would then become subject to corporate-level U.S. federal income taxes.
When market conditions are not favorable to raising additional equity capital – particularly as a result of market volatility and disruption, such as a financial crisis or global pandemic – and a BDC is unable to access additional capital for the purposes of an attractive investment opportunity, a BDC’s ability to grow over time and continue to pay distributions to stockholders could be adversely affected.
In order to address some of these challenges facing BDCs, on April 8, 2020 the SEC provided the option of a temporary exemption period that can assist BDCs with continuing to provide credit support to their portfolio companies. The provisions last through December 31, 2020, or on the date that the BDC ceases to rely on the exemptions. According to the SEC’s Release No. 33837, the exemptions are meant to address the following challenges:
Prospect Capital disclosed in an April 13 filing that it would rely on the election allowed by the SEC in order to issue and sell the Company’s senior securities.
Specifically, Prospect Capital is taking advantage of the order to provide greater flexibility in calculating its asset coverage ratio requirement, as defined by the Investment Company Act. Under the current requirements, a BDC such as Prospect Capital is generally required to have an asset ratio coverage of at least 200% (a 1:1 debt to equity ratio) immediately after issuance of new debt securities or preferred stock, or after it draws down its revolving credit facility; under certain conditions the ratio may be reduced to 150% (a 2:1 debt to equity ratio).
The SEC order does not eliminate the asset coverage ratio, but under the order, BDCs are allowed to use a modified formula to calculate its ratios to meet the requirement. The standard calculation for the ratio subtracts liabilities (lest senior securities) from total assets (as determined by current fair value) and divides by pro forma senior securities.
However, the modified ratio can be calculated using the fair value of its assets as of December 31, 2019. As discussed by Prospect Capital, this flexibility can assist BDCs with meeting the asset coverage ratio requirement:
The overall effect of the Election is to make it easier for the Company to meet its applicable asset coverage ratios for purposes of the Asset Coverage Requirements, as well as for purposes of covenants referencing the Asset Coverage Requirements, which could result in the Company incurring additional leverage and being subject to the risks associated with additional leverage, but while also providing the Company with additional flexibility to manage its portfolio and support its portfolio companies during the economic disruption caused by the novel coronavirus (COVID-19) pandemic.
As of December 31, 2019, Prospect Capital’s asset coverage ratio was 246%. Using the SEC order to reduce the ratio to 150% would allow the Company to borrow nearly $3,180 million in additional capital. This would provide necessary capital to pursue investment opportunities, particularly where there may be opportunities with favorable risk/return profiles in providing capital to support Main Street businesses impacted by the coronavirus crisis. Prospect Capital notes that the Company does not intend to use the flexibility to increase its leverage for the “purpose of chasing unduly speculative opportunities or to imprudently increase the Company’s overall risk profile.”
Though the flexibility is intended to facilitate the ability of BDCs to borrow under existing credit agreements and issue new stock, the order does not provide relief in connection with the declaration or payment of a dividend or other distribution, and there are certain conditions that must be met – including disclosing that a BDC has opted to take advantage of the order in a Form 8-K filed with the SEC.
In the 90 days following the election of the order, BDCs are not able to invest in a portfolio company in which it was not already invested in as of April 8, 2020 – unless the BDC can meet its asset coverage requirement, absent the provisions of the order. Additionally, prior to the election to utilize the SEC relief, the BDC’s board must consider if the additional leverage is in the best interests of the company and its shareholders.
For Prospect Capital, capital raised through additional debt financing may help generate additional investment and acquisition opportunities, which the Company’s board anticipates is in the best interest of Prospect Capital and its stockholders.
As of April 14, 2020, Prospect Capital is the only BDC that has elected to take advantage of the SEC Release No. 33837. However, the ongoing uncertainty and disruption caused by the coronavirus may contribute to additional BDCs taking advantage of the SEC’s provisions.
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