In 2013, Rep. Mick Mulvaney (R-SC) toured the factory of Ajax Rolled Ring and Machine which manufactures steel rings used in construction equipment and power turbines.
The factory, which is located in York, S.C., now employs about 100 people. It has since been acquired by FOMAS Group.
But at the time of Mulvaney’s tour, Ajax was controlled by Prospect Capital, a business development company, or a BDC. Propsect Capital’s investment from April 2008 included a $22 million loan and $11.5 million of subordinated term debt.
Mulvaney said he had never heard of a BDC before that day at Ajax, nor realized how important BDCs were as an investment source in his district.
That has changed. Bringing laws for BDCs up-to-date has since become a key issue for Mulvaney, who is on the House Committee on Financial Services. He has proposed a draft bill to modernize the laws governing BDCs.
As a former small business owner himself, Mulvaney believes allowing BDCs to grow more easily, a key component of his proposed legislation, will provide much-needed financing to the mid-sized companies to which banks have cut lending since the credit crisis.
“BDCs fill a niche for companies too big to access their local banks, but too small to access public debt and equity markets. I am acutely aware of the importance of having capital for growth when you are running a company,” Mulvaney said.
Last week, the modernization of the laws governing BDCs was the subject of a hearing by the House Subcommittee on Capital Markets and Government Sponsored Enterprises. The hearing brought together titans of the BDC industry.
“The BDC industry is maturing, and growing in a meaningful way. They are beginning to realize they need to come together as a regulated industry and speak with a common voice,” said Brett Palmer, President of the Small Business Investor Alliance (SBIA).
“They are incredibly competitive, which is one of the challenges of getting them all in the same regulatory boat, rowing in the same direction.”
The timing of Prospect Capital’s purchase of Ajax Rolled Ring in April 2008 was not fortuitous. The company was heavily reliant on Caterpillar, which accounted for roughly 50% of revenue, and the global financial crisis took a heavy toll on Ajax in 2009 and 2010.
Still, Prospect Capital increased its investment in Ajax during those tough years. That investment allowed Ajax to build a machine shop, and thus deliver a more finished product to its customers. Last year, when Italy-based FOMAS unveiled an offer for Ajax in a bid to expand in the U.S. market, Ajax was a much stronger business with revenue diversified away from Caterpillar, according to Prospect Capital.
Rep. Mulvaney is hoping a bill could be ready at the end of July, and that it could be on the floor for debate by fall. The new draft of the bill addresses concerns raised over a prior proposal to reform BDC rules.
One size does not fit all
The SBIA estimated the number of active BDCs exceeds 80, and the size of the rapidly growing industry has surpassed $70 billion. “What’s a priority for one BDC is not necessarily a priority for another,” SBIA’s Palmer said.
Even with differences across the industry, possibly the most important potential change for BDCs is the asset coverage requirement. The change would effectively raise the leverage limit to a 2:1 debt-to-equity ratio, from the current 1:1 limit.
BDC managers argue that even with the change, leverage of BDCs would be conservative compared to other lenders, which can reach a level of 15:1, for banks, and even higher, to the low-20x, for hedge funds.
“It should allow BDCs to invest in lower-yielding, lower-risk assets that don’t currently fit their economic model,” Ares Capital Board Co-Chairman Michael Arougheti told the hearing. “In fact, the current asset coverage test actually forces BDCs to invest in riskier, higher-yielding securities in order to meet the dividend requirements of their shareholders.”
BDC managers say that BDCs are far more transparent than banks traditionally have been. After all, BDCs regularly publish their loans, as well as the loans’ interest rates and fair values, in quarterly disclosures with the Securities and Exchange Commission.
“We believe it would be good public policy to increase the lending capacity of BDCs, and promote the more heavily regulated, and more transparent, BDC model,” said Mike Gerber, an executive vice president at Franklin Square Capital Partners.
To garner support for the leverage change, the bill may require BDCs to give as much as a year’s notice for any increase, allowing shareholders to sell holdings before any change comes into effect, if they don’t approve.
However, the idea of “increasing leverage” has suffered a tarnished image with the public since the credit bubble and resulting global financial crisis. BDCs are popular with retail investors because of their high dividends.
Testimony of Professor J. Robert Brown, who was a Democratic witness at the June 16 hearing on BDC laws, could help repair this image problem, supporters of the change say. Brown said reducing the asset coverage for senior securities was an “appropriate” move toward giving BDCs more fundraising capacity.
“Such a change will potentially increase the risks associated with a BDC. Nonetheless, this is one area where adequate disclosure to investors appears to be a reasonable method of addressing the concern,” Brown’s published testimony said.
“In addition, the draft legislative proposal provides investors with an opportunity to exit the company before the new limits become applicable.”
Another change under discussion is the definition of “eligible portfolio company,” which dictates what type of companies BDCs can invest in.
BDCs were designed to furnish small developing and financially troubled businesses with capital. Existing rules dictate that BDCs invest at least 70% of total assets into “eligible portfolio companies,” leaving out many financial companies.
Some argue that the economy has changed since this BDC rule was put in place, moving away from traditional manufacturing companies.
“Changing the definition of eligible portfolio company to permit increased investment in financial firms may result in a reduction in the funds available to operating companies. It may also result in an increase in the cost of funds to operating companies,” Brown said in his published testimony.
Less controversial in a potential BDC modernization bill appears to be the desire to ease regulatory burdens for BDCs.
Main Street Capital CEO Vincent Foster drew attention to the SEC filing requirements born by even the smallest BDCs. He called for reform to the offering and registration rules, such as allowing BDCs to use “incorporation by reference” that would allow them to cite previous filings instead of repeating information in a new SEC filing. He said the change would not diminish investor protections.
By way of example, Foster held up a stack of papers at the hearing on the BDC bill, about four inches thick, that was needed by Main Street to issue $1.5 billion in stock. He then held up a stack of papers, less than one inch thick, needed by CIT, not a BDC, to allow for a $50 billion equity issuance.
“Do four more inches of paper protect better than a half an inch? Hundreds of pages represent wasted money and manpower,” Foster said.
“This discussion draft would fix this absurdity and make a host of clearly-needed reforms.” – Abby Latour
Follow Abby on Twitter @abbynyhk for middle-market deals, leveraged M&A, BDCs, distressed debt, private equity, and more.