SEC Proposes Changes to Regulatory Framework of Fund of Funds Arrangements

Many BDC industry participants have recommended that the SEC’s Division of Investment Management remove or alter the line item titled “Acquired Fund Fees and Expenses” (“AFFE”) that is currently required to be included in a BDC’s prospectus fee table. AFFE disclosure requires acquiring funds to aggregate and disclose in their prospectuses the amount of total annual acquired fund operating expenses and express the total amount as a percentage of an acquiring fund’s net assets. The calculation of AFFE typically results in an overstated expense ratio because an acquiring fund’s indirect expenses are often significantly greater than the expense ratio of the BDC. As a consequence, some index providers removed BDCs from their indices, causing a significant reduction in institutional ownership of BDCs. On September 4, 2018, The Coalition for Business Development, Apollo Investment Management, L.P., and Ares Capital Management LLC submitted an application requesting that the SEC issue an exemptive order exempting BDCs from the AFFE disclosure. On December 19, 2018, as part of the release for Rule 12d1-4 described below, the SEC formally requested industry suggestions to improve AFFE disclosure. The BDC market would likely be receptive if the SEC takes action with respect to AFFE disclosure in 2019.

The Securities and Exchange Commission voted on December 19, 2018, to propose Rule 12d1-4 (proposed rule) and related amendments to the regulatory framework governing funds that invest in other funds (“fund of funds” arrangements). The proposed rule would allow a registered investment company or a business development company (acquiring fund) to acquire shares of any other registered investment company or business development company (acquired fund) in excess of the limitations currently imposed by the Investment Company Act of 1940 without obtaining individual exemptive relief from the SEC.

The SEC is also proposing to rescind Rule 12d1-2 under the 1940 Act as well as most exemptive orders granting relief from sections 12(d)(1)(A), (B), (C) and (G) of the 1940 Act. Further, the SEC is proposing to make related amendments to Rule 12d1-1 and Form N-CEN.

Although the proposed rule would allow fund groups to establish fund of funds arrangements without undergoing the costly and time-consuming process of obtaining individual exemptive relief from the SEC, the proposed rule and related amendments would, if adopted as proposed, limit a number of the fund of funds arrangements currently in place (namely, certain three-tiered fund of funds arrangements). However, the proposed rule would also permit new types of fund of funds arrangements, including fund of funds arrangements involving listed and unlisted business development companies (BDCs) and closed-end funds.

Further, in potential foreshadowing of the adoption of changes to the “Acquired Fund Fees and Expenses” (AFFE) disclosure requirements for which the BDC industry has been advocating since 2014, the Proposing Release solicits comments on potential revisions to these requirements, including whether the SEC should “exempt certain types of acquired funds from the definition of acquired funds for the purposes of AFFE disclosure” and “[i]f so, which types of acquired funds should be exempted and why[.]”

The comment period for the proposed rule is 90 days following its publication in the Federal Register. As of the date of this OnPoint, the proposed rule has not yet been published in the Federal Register.

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