Legal Reform and Business Development Companies

The House had under consideration legislation that would reform the regulatory regime for business development companies.  These are closed end companies that invest 70% of their assets in private and distressed operating companies.  The legislation creating these companies was put in place in 1980 to improve funding sources for these middle market companies.

The House subcommittee on Capital Markets and Government Sponsored Enterprises held a hearing this week on the proposed reforms.  The list of witnesses (I was one of them) is here.  There are a number of interesting developments in the area.  

First, the legislative proposal would permit BDCs to invest a higher percentage of their assets in financial rather than operating companies (the percentage would increase from 30% to 50% under the current draft).  The concern is that BDCs, as leveraged entities, will be investing a greater portion of their assets in other leveraged entities, increasing the risk.  In addition, the concern is that this will result in less lending to operating companies, an important segment of the economy.  The latter issue is discussed in my testimony.

Second, commercial banks appear to be entering the area. Goldman has formed a BDC.  The registration statement is here.  Concerns have arisen as to whether this constitutes a circumvention of the Volcker Rule by allowing what would otherwise be prohibited proprietary trading.  As discussed in my testimony, the Volcker Rule specifically allows for ownership of BDCs by commercial banks (although they are limited to 25% if they want to avoid making them an affiliate).  Thus, the practice is expressly authorized under the Volcker Rule.

Nonetheless, bank entry into the area does raise concerns.  Large commercial banks have inherent advantages.  See The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.  Discussion has occurred over whether the market perceives banks as providing "implicit guarantees" of subsidiaries or entities that they create.  To the extent that the market believes there are implicit guarantees, the borrowing costs of banks sponsored BDCs may be less.  This may provide a competitive advantage that allows for increased market share.  

Bank sponsored BDCs can make loans like any other BDC.  The issue is whether banks sponsored BDCs will have different lending criteria.  To the extent that commercial banks, for example, have a more conservative approach to lending (in fact or in practice), the result could be a decline in funding to some operating companies.