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BDC Fees and Structures Evolving

Multiple drivers spurring change


Aproliferation of different fee levels and structures is evident throughout the alternative investment industry, and Business Development Companies (BDCs) are no exception. For instance, management and incentive fees within the BDC space vary widely between issuers, with management fees ranging from as low as 1% to as high as 2% of gross assets. Throughout the industry, common drivers for revisiting existing fee structures include changing market norms and pressure from investors. BDCs can face additional demands to alter fees and terms in view of their public nature. Being publicly listed opens the door to pressure from both analysts and activist investors, and BDC regulation, namely section 15 under the Investment Company Act of 1940, or the “1940 Act”, requires boards of directors of BDCs to review and reapprove fee agreements annually.

Netting between sources of incentive fees

BDC fee structures have, historically, been based on the same principles as for other funds - and were superficially similar. Headline fees were, traditionally, 2% management fees and 20% incentive fees, applying to both net investment income and realised capital gains, calculated net of realised losses and unrealised depreciation. Even today, for each of these return streams, the incentive fee has special criteria, intended to ensure that incentive fees applied only to net and new profits. “For the net investment income incentive fee, there is typically a hurdle and a catch-up feature, to mirror private fund waterfalls. Typically, a 6-8% hurdle applies, after which the catch-up provision lets managers receive 100% of net investment income above the hurdle until they got caught up to 20% of total net investment income,” explains Schulte Roth & Zabel investment management partner John J. Mahon, who is based in the firm’s Washington D.C. office and regularly assists clients in connection with the establishment and operation of BDCs and both open-ended and closed-ended registered funds. “For the realised capital gains incentive fee, regulatory provisions applicable to BDCs govern the calculation. As a result, the capital gains incentive fee requires BDCs to take into account both capital losses and unrealized depreciation, but excludes unrealized appreciation in a BDC’s portfolio,” he goes on. But BDC fees have shown somewhat unique quirks, partly as a consequence of regulatory complexity. Viewed independently, each of the two sets of incentive fee calculations seem similar enough to those applying on many other funds. “But the nuance is that the incentive fee structure for a BDC is bifurcated, with net investment income calculated separately from realised capital gains,” explains Mahon. This absence of netting created the potential for BDCs to continue receiving incentive fees from net investment income, even if it was outweighed by realised capital losses and/or unrealised depreciation (and even after some BDCs cut their dividends). The spike in corporate defaults, seen in the wake of the global financial crisis, shone the spotlight on this anomaly, as some BDCs did, indeed, suffer substantial write-downs. Conversely, the issue has always remained largely theoretical for the best performing BDCs.

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Informing the Hedge Fund Community. With access to some of the industry’s biggest names and an astute and talented group of writers and contributors, The Hedge Fund Journal has established itself as a trusted source of information on the hedge fund industry.