June 2004

A Business Development Company (BDC) is, in short, a publicly registered, closed-end investment company created by the Small Business Incentive Act of 1980 to provide capital and assistance to small, developing, or troubled businesses. Since Apollo Advisors LP filed a registration statement in February 2004 for its newly formed BDC, thirteen other BDCs have entered the IPO pipeline. KKR, Blackstone, Thomas H. Lee, Kelso/Blackrock, Evercore, and Ares are among the established private equity stalwarts to follow Apollo’s lead. Of the new BDC class, only Apollo’s vehicle has actually made it to the public markets thus far. The others wait breathlessly (OK, maybe that’s a bit dramatic), hoping the BDC window will remain open long enough for them to climb through.

While there have been a plethora of articles detailing the advantages and disadvantages of BDCs to both sponsors and investors, we focus here on the issues associated with obtaining Directors’ and Officers’ Liability (D&O) insurance for a BDC. Many insurers have voiced significant skepticism about the viability of these BDCs, and expressed concern over the exposures arising from retail investors investing in private equity vehicles. Forming a regulated entity next to an unregulated one makes insurers uncomfortable. In fact, several carriers have either (i) completely refused to offer D&O insurance and related coverages to the BDCs (just as Goldman Sachs and Morgan Stanley have refused to participate in the underwriting of BDC securities offerings); (ii) provided quotes at such a high rate that no reasonable party would buy coverage from them; or (iii) agreed to participate on a program, but only at very high layers, far removed from the primary risk.

WThere are certain carriers willing to provide executive liability coverages to BDCs. However, understanding the primary concerns of these carriers and putting together a high quality submission is critical. The following are five suggestions for BDCs and their equity sponsors when obtaining the necessary insurance:

1. Demonstrate your preparedness for the increased disclosure requirements.
   This includes qualitative descriptions of your existing fund’s activities and portfolio holdings, valuation methodologies utilized for illiquid investments, investment hurdle rates, and calculation of management fees. If you haven’t been particularly forthcoming or transparent in past limited partner communication, create a pro forma sample of a "public filing" using your private fund investments for illustrative purposes.
2. Select your directors before seeking insurance.
   BDCs are required to have a majority of independent directors, most of whom must be qualified to opine on financials as well as annually review the BDC’s investment manager. Having blanks in the director section of your insurance application will not serve you well. In addition to ensuring your directors have the aforementioned capabilities, try to choose directors with public company experience and no prior claims/lawsuit history.
3. Identify your investment management team early.
   Just because your fund professionals have been successful in executing one investment strategy (e.g., controlling equity), doesn’t mean their skills are transferable to another (e.g., mezzanine debt). Since the investment parameters of most BDCs are intentionally different from those of the funds that sponsor them, carriers want to see that your managers have relevant experience and acceptable investment track records. If your response to this issue is simply to create meaningful overlap in the investment scopes of the two entities rather than recruit a separate advisory team, see #4.
4. Avoid conflicts of interest wherever possible.
   For a BDC to co-invest alongside an affiliate (e.g.., its private equity fund sponsor), or make a follow-on investment in a company in which an affiliate is already an investor, it must seek a one-time exemption from the SEC (up to a nine month process). If the BDC wishes to avoid such a cumbersome process on a new investment that fits within the parameters of both the BDC and an affiliated vehicle, a decision must be made as to which pool of capital makes the investment. No matter how thorough your disclosure may be on how these situations will be resolved, there will always be the potential for backlash from at least one entity’s investors.
5. Commission and submit relevant expert opinions.
   Has outside counsel issued an opinion that the entity and its proposed investments comply with the Small Business Incentive Act? Have outside auditors written an opinion as to the BDC’s tax structure as a regulated investment company ("RIC"), which enables the BDC to distribute income to investors without being taxed at the corporate level? If not, make sure they do.

Other notable items:

Pricing – Current D&O insurance rates for BDCs and comparable private companies are as follows:

 

	Layer/Coverage Limits
	Primary (Up to $10M)	Excess (> $10M)
BDC D&O per $1M of Coverage	$40,000 - $50,000	80% of primary
Private D&O per $1M of Coverage	$20,000 - $25,000	75% of primary

Timing - While underwriters always prefer more time to review a submission than less, two weeks should be sufficient.

The above list is not intended to be comprehensive. Underwriters will be thorough in confirming that proper controls are in place for ongoing compliance with regulatory requirements and equitable treatment of all classes of investors. However, adherence to these suggestions will undoubtedly make the process run more smoothly and help to ensure a better result.

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Gabriel Levitt is a Director at Equity Risk Partners, the only full service insurance brokerage and risk management advisory firm dedicated exclusively to the needs of the private equity industry and its portfolio companies. For more information, visit www.equityriskpartners.com. Mr. Levitt can be reached at 212-659-7756 or glevitt@equityriskpartners.com.