Venture Capital Investment Companies

As stated in FASB ASC 946-20-45-7, although all venture capital investment companies should prepare their financial statements in conformity with U.S. generally accepted accounting principles (GAAP), the statement presentation of some venture capital investment companies may need to be tailored to present the information in a manner most meaningful to their particular group of investors. For example, if debt is a significant item, a conventional balance sheet might be more appropriate than a statement of net assets.

Small Business Investment Companies

Leverage opportunities available to the owners of SBICs are not available to other investment companies. SBICs, by statute, may borrow from the Small Business Administration (SBA), often at advantageous rates, up to two or three times their paid-in capital.

Also, different regulatory requirements may apply to these entities. Publicly owned SBICs are subject to the provisions of Article 5 of Regulation S-X.

As noted by FASB ASC 946-20-45-6, the unique features (primarily the existence of significant debt) of SBICs often make it desirable that their financial statements be presented in a conventional balance sheet format.

SBICs are regulated by the SBA and, accordingly, are required to comply with Part 107 of the SBA rules and regulations. Part 107 deals with specific aspects of SBA regulation, such as the relevant audit procedures and reporting requirements (for example, on Form 468) of the SBA for SBICs; the system of account classification; and guidance on proper techniques and standards to be followed in valuing portfolios. SBA guidelines on valuing portfolio investments may not be in accordance with FASB ASC 820, Fair Value Measurement.

The auditor of an SBIC should be familiar with the relevant publications and aware of changes in SBA regulations.¹

The format for reporting the results of SBIC operations varies from that presented in this guide for other types of investment companies because the financial statements for SBICs are presented based on regulations promulgated by the SBA, which is a comprehensive basis of accounting other than GAAP. SBICs may consider maintaining separate accounting records for GAAP and SBA reporting purposes.

Business Development Companies

BDCs were established from the enactment of the Small Business Investment Incentive Act of 1980, and were designed by Congress to facilitate capital formation for small, middle-market, and financially troubled companies that do not have ready access to the public capital markets or other forms of conventional financing.

Under Section 2(a)(48) of the Investment Company Act of 1940, as amended (the 1940 Act), a BDC is defined as a U.S. closed-end company that (1) operates for the purpose of making investments in certain securities specified in Section 55(a) of the 1940 Act and, with limited exceptions, makes available significant managerial assistance with respect to the issuers of such securities, and (2) has elected business development company status and be subject to Sections 55–65 of the 1940 Act.

Sections 55–65 of the 1940 Act allow BDCs greater flexibility and exemption from many 1940 Act provisions applicable to registered investment companies (for example, greater flexibility in managing portfolio company investments, issuing securities, and compensating their managers).

Following are some of the special regulatory considerations of BDCs:

•     Pursuant to Section 55(a) of the 1940 Act, a BDC must have at least 70 percent of its total assets invested in securities of specified types of companies (the 70 percent basket). Among other things, the 70 percent basket includes securities of eligible portfolio companies purchased in transactions not involving any public offering; securities of eligible portfolio companies already controlled by the BDC without regard to the nature of the offering; securities of certain financially distressed companies that do not meet the definition of eligible portfolio company and that are purchased in transactions not involving any public offering; cash; cash items; government securities; or high quality debt securities maturing in one year or less from the time of investment in such high quality debt securities.

—     An eligible portfolio company² means a U.S. issuer that is neither an investment company as defined in Section 3 (other than a wholly-owned SBIC) nor a company which would be an investment company except for the exclusion from the definition of investment company in Section 3(c) of the 1940 Act and

•     does not have any class of securities listed on a national securities exchange; or

•     has a class of securities listed on a national securities exchange, but has aggregate market value of outstanding voting and nonvoting common equity of less than $250 million.

•     Unlike typical registered investment companies, BDCs are not passive investors. Rather, a BDC is required to “make available significant managerial assistance”³ to the companies that it treats as satisfying the 70 percent basket. This includes any arrangement whereby a BDC, through its directors, officers, employees, or general partners, offers to provide, and if accepted, provides significant guidance and counsel concerning the management, operations, or business objectives and policies of the portfolio company. It may also mean exercising a controlling influence over the management or policies of the portfolio company.

•     Any debt or senior security issued by a BDC must have an asset coverage ratio of 200 percent,⁴ which is less restrictive than the 300 percent asset coverage requirement imposed on traditional closed-end funds and mutual funds.

A BDC may invest in a wholly-owned subsidiary which is licensed by SBA to operate SBICs (an SBIC Subsidiary). The SBIC Subsidiary typically issues SBA-guaranteed debentures, subject to the SBA’s separate regulation of permissible leverage in the SBIC Subsidiary’s capital structure. The SEC has, from time to time, issued exemptive orders to BDCs granting limited relief from the asset coverage requirements of sections 18(a) and 61(a) of the 1940 Act. Subject to representations and a condition described in the exemptive applications, the SEC has provided relief and permitted BDCs to treat certain indebtedness issued by their wholly owned SBIC Subsidiary as indebtedness not represented by senior securities for purposes of determining the BDCs’ consolidated asset coverage.⁵ In June 2014, the SEC issued Investment Management Guidance Update 2014-09, Business Development Companies with Wholly-Owned SBIC Subsidiaries—Asset Coverage Requirements,⁶ which the SEC Staff requests that all new exemptive applications include a modified condition. Specifically, the condition should provide that any senior securities representing indebtedness of an SBIC Subsidiary will not be considered senior securities and, for purposes of the definition of asset coverage in Section 18(h) of the 1940 Act, will be treated as indebtedness not represented by senior securities, but only if that SBIC Subsidiary has issued indebtedness that is held or guaranteed by the SBA.^7,8

•     BDCs either (i) register their securities under the Securities Exchange Act of 1934 for public offering and listing on a national securities exchange, for example, NASDAQ (these are listed BDCs); or (ii) do not register their securities for offering and listing on an exchange (these are non-listed BDCs).

Operationally, a BDC may be either internally managed or externally managed.

•     For an internally managed BDC, its daily operations are either managed by the officers and the directors of the BDC or by a separate wholly-owned subsidiary of the BDC. The officers, directors, or wholly owned subsidiary of an internally managed BDC are not registered with the SEC as investment advisers. Internally managed BDCs have compensation costs associated with investment management professionals and other professionals as opposed to an investment advisory fee, which also includes a performance based fee.

•     An externally managed BDC must contract with a third party to provide investment advisory services. The investment advisory agreement memorializing the third party contract is subject to the requirements of the 1940 Act, which include, among other things, approval by the board of directors and shareholders of the BDC. Certain inherent conflicts of interest may exist regarding the adviser’s allocation of investment opportunities between the BDC and the adviser’s other clients. Investment advisers to externally managed BDCs also must be registered with the SEC. Typically, the investment adviser to a BDC is compensated in two forms of fees:

—     An asset-based management fee, which is equal to an annual rate that may range from 1.5 percent to 2.5 percent of the BDC’s gross assets (that is, total assets); and

—     A performance-based (incentive) fee, which is typically equal to:

•     20 percent of the BDC’s net investment income (before the incentive fee), subject to the achievement of a performance hurdle rate, for example, an annual rate of 7 percent; and

•     20 percent of the BDC’s realized gains, net of realized losses and unrealized losses.

BDCs typically have been organized as corporations and obtained pass-through tax treatment by qualifying as regulated investment companies (RICs) under Subchapter M of the Internal Revenue Code of 1986, as amended. See chapter 6, “Taxes,” of this guide for discussion of RIC taxation and Excise Tax on undistributed income.

BDCs are issuers as defined in the Sarbanes-Oxley Act of 2002 (SOX), and therefore, as required by SOX, an independent registered public accounting firm must audit a BDC’s financial statements and comply with the auditing standards of the PCAOB in connection with the issuance of any audit report on the financial statements of the BDC.

Verification of Securities Owned and the Auditor’s Opinion on the Financial Statements

Although Section 59 of the Investment Company Act of 1940 does not make Section 30(g) applicable to a BDC, a BDC’s auditor plays an important role under the 1940 Act in preventing a BDC's assets from being lost, misused, or misappropriated. Therefore, the SEC Staff believes that it is a best practice for a BDC to have its auditor verify all of the securities owned by the BDC, either by actual examination or by receipt of a certificate from the custodian, and affirmatively state in the audit opinion whether the auditor has confirmed the existence of all such securities.¹⁰

BDCs do not fall within the scope exception contained in Section 405 of SOX, and are subject to the management assessment of internal controls under Section 404 of SOX. As implemented by Regulation S-K 308(a), management of a BDC must provide its report on the BDC’s internal control over financial reporting (ICFR). Further, if the BDC is a not an emerging growth company (EGC) and is either an accelerated filer or large accelerated filer, the BDC’s registered public accounting firm must attest, and report on, management’s assessment of the BDC’s ICFR (Regulation S-K 308(b)). AS 2201, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements, provides guidance that applies when an auditor is engaged to perform an audit of management's assessment of the effectiveness of ICFR that is integrated with an audit of the financial statements.

Non-accelerated filers and EGCs are not required to include an auditor attestation report under Regulation S-K 308(b). Further, see paragraphs 1.57–.59 of this guide for discussion of the Jumpstart Our Business Startups Act of 2012, which explains that certain BDCs may be exempt from certain financial reporting disclosures and regulatory requirements.

Listed and non-listed BDCs are required to file periodic reports under the 1934 Exchange Act, including 10-K and 10-Q. Therefore, unlike other registered open-end and closed-end investment companies, BDCs are subject to the periods of financial statements required by Forms 10-K and 10-Q.

The financial statements of BDCs must comply with Articles 6 and 12 of Regulation S-X, that is, the same requirements that apply to open-end and closed-end registered investment companies,¹¹ as well the senior securities table requirement under Item 4.3 of Form N-2.

Although most BDCs present financial highlights, Instruction 1 to Item 4.1 of Form N-2 notes that BDCs may omit from providing financial highlights but does explain that they are required to furnish the financial information required by Item 301 (Selected Financial Data), Item 302 (Supplementary Financial Information), and Item 303 (Management's discussion and analysis of financial condition and results of operations) of Regulation S-K.

As noted in paragraphs 7.204–.205 of this guide, BDCs are subject to Rules 3-09 and 4-08(g) of Regulation S-X. Rule 3-09 identifies circumstances where separate financial statements of an unconsolidated majority-owned subsidiary are required. Rule 4-08(g) identifies circumstances where summarized financial information should be presented in the notes to the financial statements for subsidiaries not consolidated (whether an investment company or similar company subsidiary, or portfolio company subsidiary).¹² The determination of both (i) whether the financial statements of an unconsolidated majority-owned subsidiary should be attached under Rule 3-09 or (ii) whether summarized financial information should be disclosed in the notes to the financial statements of the BDC under Rule 4-08(g), based on the three tests used to determine a significant subsidiary specified in Rule 1-02(w) of Regulation S-X. The thresholds for the level of significance are specified in Rules 3-09 and 4-08(g) of Regulation S-X. In addition, if a BDC is required to present summarized financial information pursuant to Rule 4-08(g), the SEC’s Division of Investment Management generally would not object if the BDC presents summarized financial information in the notes to the financial statements individually for each unconsolidated subsidiary which individually meets the definition of a significant subsidiary in Rule 1-02(w) of Regulation S-X but does not present summarized financial information in the notes to the financial statements for all unconsolidated subsidiaries.

For purposes of Rules 3-09 and 4-08(g) of Regulation S-X, the definition of a controlled subsidiary is based on the 1940 Act definition, which includes the presumption that a BDC that owns more than 25 percent of the voting securities of the investee company has control. The SEC staff cautioned that structuring transactions to avoid presenting summarized financial information for a BDC’s subsidiaries might raise issues under Section 48(a) of the 1940 Act.