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Journal Of Investment Management, Vol. 13, No. 4, (2015), pp. 9–32

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FUNDING TRANSLATIONAL MEDICINE VIA PUBLICMARKETS: THE BUSINESS DEVELOPMENT COMPANY

Sandra M. Formana, Andrew W. Lob,∗,Monica Shillingc and Grace K. Sweeneyd

A business development company (BDC) is a type of closed-end investment fund withcertain relaxed requirements that allow it to raise money in the public equity and debtmarkets, and can be used to fund multiple early-stage biomedical ventures, using financialdiversification to de-risk translational medicine. By electing to be a “Regulated InvestmentCompany” for tax purposes, a BDC can avoid double taxation on income and net capitalgains distributed to its shareholders. BDCs are ideally suited for long-term investors inbiomedical innovation, including: (i) investors with biomedical expertise who understandthe risks of the FDA approval process, (ii) “banking entities,” now prohibited from invest-ing in hedge funds and private equity funds by the Volcker Rule, but who are permitted toinvest in BDCs, subject to certain restrictions, and (iii) retail investors, who traditionallyhave had to invest in large pharmaceutical companies to gain exposure to similar assets.We describe the history of BDCs, summarize the requirements for creating and managingthem, and conclude with a discussion of the advantages and disadvantages of the BDCstructure for funding biomedical innovation.

1 Introduction

The process of translational biomedical innova-tion is becoming increasingly complex, expensive,

aNorthStar Asset Management Group, 399 Park Avenue,New York, NY 10022.bMIT Sloan School of Management and Laboratory forFinancial Engineering, 100 Main Street, E62-618, Cam-bridge, MA 02142, USA. E-mail: [email protected] Rose, LLP, 2049 Century Park East, Los Ange-les, CA 90067–3206, USA.dMIT Laboratory for Financial Engineering, 100 MainStreet, E62-618, Cambridge, MA02142, USA; Of Counsel.∗Corresponding author.

and uncertain. This implies that the traditionalfinancing vehicles of private and public equitywill become less effective for funding biopharmain the future, as the needs, expectations, andrisk profiles of limited partners and shareholdersincreasingly diverge from the new realities ofbiomedical innovation.

In this paper, we describe a specific legal struc-ture, the business development company (BDC),that can be used to raise money in the publicequity and debt markets to facilitate investingin biomedical innovation, especially early-stage

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10 Sandra M. Forman et al.

translational medical projects. A BDC is a typeof closed-end investment fund that can partake ofcertain relaxed requirements under the InvestmentCompany Act of 1940 (the “Investment CompanyAct”), so long as it makes at least 70% of its invest-ments in certain “eligible” portfolio companies.A BDC can elect to be treated as a RegulatedInvestment Company (RIC), under the InternalRevenue Code of 1986 (the “Code”), and thusnot be required to pay U.S. federal corporate-level income taxes on income and net capital gainsthat it distributes to its shareholders as dividendson a timely basis. The BDC, used as a struc-ture to make investments in multiple companiesformed to commercialize biomedical innovation,would allow investors the opportunity to spreadrisk among a number of different drug trials, andthus increase the chances of participating in thelong-term growth of a successful drug, along thelines of the “megafund” proposed by Fernandezet al. (2012).

For the purpose of this paper, we distinguishBDCs formed to make equity investments, whichwe refer to as venture capital BDCs (VC-BDCs),from BDCs whose primary purpose is to makedebt investments, which we refer to as debt-BDCs. This distinction is important for successfulfundraising and trading, since the market recog-nizes that debt-BDCs and VC-BDCs have differ-ent risks and rewards, especially over the shortterm. VC-BDCs are best suited for long-terminvestors who seek to benefit from the returnsassociated with biomedical innovation, and there-fore may be particularly attractive to: (i) investorswith medical expertise who can appreciate therisks of going through the FDA approval process,(ii) “banking entities,” which recently were gen-erally prohibited from investing in hedge fundsand private equity funds by the Volcker Rule,1

but who are permitted to invest, subject to certainrestrictions, in BDCs, and (iii) retail investors,who have traditionally only been able to invest in

large pharmaceutical companies to gain exposureto similar assets.

We begin in Section 2 with a discussion of therecent challenges in the biopharma industry thathighlight the need for new funding vehicles likethe BDC. We present a brief review of the historyof BDCs and their basic structure in Section 3,and then describe VC-BDCs in Section 4. In Sec-tion 5, we describe the organizational structure ofa typical BDC, and in Section 6 we turn to thebasic mechanics of operating a BDC. Some ofthe practical advantages and disadvantages of theBDC structure are presented in Section 7, and weconclude in Section 8. More detailed legal andregulatory aspects of BDCs are provided in theAppendix.

2 Motivation

The life sciences sector is becoming increasinglyparadoxical for researchers and investors alike.At the same time that scientific breakthroughslike gene sequencing and precision medicine areunraveling diseases that have confounded con-ventional medicine for centuries, capital flowshave slowed to a trickle at the early stagesof commercialization in biomedicine, making itincreasingly difficult and risky to translate basicresearch findings into new clinical applications(Sweeney, 2013). Industry professionals havetermed this capital shortage the “Valley of Death.”

While seed-stage biomedical research may beoccurring at the bench, it is not being trans-lated as effectively into clinical applications atthe bedside. The process of the bench-to-bedsideenterprise, of harnessing knowledge from thebasic sciences to produce new drugs, devices,and treatment options for patients, is known as“translational research,” the interface betweenbasic science and clinical medicine, and it is ofthe utmost importance for successful biopharmainnovation (Woolf, 2008). The primary objective

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Funding Translational Medicine via Public Markets 11

of translational research is to arrive at a com-mercial bedside application, often in the formof a New Molecular Entity (NME) or a Bio-logics License Application (BLA), although theresearch can also entail the development of unan-ticipated or “non-derivative” products. However,the importance of this step also means thattranslational research is a bottleneck for futuredevelopment.

For example, early-stage research is the pri-mary source of valuable “first-in-class” NMEsand BLAs, first-in-class meaning drugs that use anew and unique mechanism of action for treatinga medical condition (FDA, 2014). These innova-tions serve previously unmet medical needs, orotherwise significantly help to advance patientcare and public health. Unfortunately, in recentyears the number of medicines approved by reg-ulatory bodies around the world has declined,whether first-in-class or variations on a preex-isting theme. In the past decade, half as manyNMEs were approved compared to precedingyears (FDA, 2014). In 2007, the U.S. Food andDrug Administration (FDA) only approved 19

Figure 1 Relationship between the stages of drug discovery, their financial characteristics, the natural investorsfor each stage, and the most appropriate financing method. Earlier-stage assets are more risky; hence theirfinancing vehicles naturally reflect investors with those risk preferences. Source: Lo and Naraharisetti (2014).

NMEs and BLAs, the fewest number since 1983(Paul et al., 2010). Of the 27 new drugs grantedFDA approval in 2013, only 33% were identi-fied as first-in-class (FDA, 2014). Moreover, thenumber of new NMEs and BLAs has also sharplydeclined per dollar of investment.

Without a drastic improvement in the currentmodel for translational research, the life sci-ences sector cannot sustain sufficient innovationto replace the loss of revenues due to patent expi-rations for successful products (Paul et al., 2010).Only $6 billion was spent on translational effortsin 2012, while $48 billion was spent on basicresearch and $125 billion on clinical developmentin the life sciences sector (Milken Institute, 2012).

One of the main challenges to biomedical innova-tion is the fact that the multi-stage process of drugdevelopment is too lengthy, risky, and expen-sive for any single investor to undertake frombeginning to end. In contrast to the standard anal-ogy of drug development as a marathon, a moreapt analogy given current costs and complexi-ties is a triathlon. Figure 1 depicts the different

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stages of a typical drug development program,and shows that the distinct risk/reward charac-teristics of each stage imply distinct investorsdrawn to the corresponding investment profiles.Early-stage research is much more difficult tofinance with traditional sources of capital (Fer-nandez et al., 2012). Innovative firms cannotsecure capital for a host of reasons: investmentreturns are uncertain, they have little collateral tosecure debt, and their capital is difficult to rede-ploy, since it mostly takes the form of intangibleassets (Carpenter and Petersen, 2002; Hall, 2002).On average, commercializing one drug takes 14years and $1.3 billion, and for each success, thereare 50 failures (WSJ, 2012). This risk profile isunpalatable to many investors.

Early-stage research companies cannot securecapital from public equity markets as easily aslarge pharmaceutical companies. In the earlystages of drug development, it is impossible toestablish future trajectories of sales and profits(Sweeney, 2013). An established company withcurrent earnings and profits is in a much strongerposition to sell equity shares than an early-stagecompany which has yet to demonstrate its poten-tial for upside. At the same time, traditionalfinancial intermediaries are not viable alternativeseither. Banks strongly prefer to make decisionsbased on financial accounting ratios, rather thanfuture expected cash flows determined by inno-vative but highly speculative activity. Loans toearly-stage companies, made against personalguarantees and liquid assets, often require col-lateral exceeding their value threefold. The riskappetite of traditional financial intermediariesis diametrically opposed to the intangible andhigh-risk/high-reward nature of investment inearly-stage, preclinical biotechnology (Sweeney,2013).

What are the current sources of capital for early-stage research? The answer is surprising. Most

early-stage biomedical research occurs withinpublic institutions. In particular, universitiesproduce approximately two-thirds of early-stageresearch (Heller and Eisenberg, 1998). How-ever, these institutions often struggle inordinatelyto commercialize their discoveries (Sweeney,2013). Public institutions possess limited compe-tence in fast-paced, market-oriented bargaining,and limited resources for absorbing transactioncosts, e.g., for patenting and licensing (Thursbyet al., 2000).

A public institution’s obligation to the publicstands in contrast to the statutory duty imposedon the directors of a corporation to act in the bestinterests of its shareholders by maximizing finan-cial return.2 For example, a politically account-able government agency such as the NationalInstitutes for Health (NIH) may further its pub-lic health agenda by leveraging its intellectualproperty (IP) rights to ensure widespread avail-ability of new therapeutic products at reasonableprices. This may serve a laudable social goal, butit also lowers the potential financial returns, cre-ating a vicious cycle that deters further privateinvestment. When the NIH sought to establishco-ownership of IP rights held by Burroughs-Wellcome on the use of azidothymidine (AZT) totreat the human immunodeficiency virus (HIV),its purpose was to lower the price of AZT,and to promote public health.3 In contrast, aprivate-sector firm is more likely to use its IPto maintain a lucrative product monopoly, whichcan reward shareholders and fund future productdevelopment (Heller and Eisenberg, 1998).

Thanks to the many recent breakthroughs inbiomedicine, the amount of innovative biomed-ical research currently exceeds the availablecapital flow for translation into commercializedproducts (Fernandez et al., 2012). This persistentinvestment deficit mandates a more comprehen-sive solution than public funding alone—it is




clear that the life sciences sector needs new finan-cial approaches to early-stage drug developmentand other forms of biomedical innovation. If thecurrent stagnancy in healthcare is to be over-come, greater private investment into biomedicalresearch must be deployed—but deployed care-fully, in a manner conducive to both upstreaminnovation and downstream product developmentand commercialization. Financial incentives canmobilize a broader set of stakeholders and a moreexpansive pool of assets, initiating a virtuouscycle of investor confidence that magnifies thelikelihood of success. What is needed right noware models that break down the value chain tooffer an acceptable return on investment (ROI)through each stage of research and development,effectively spreading the investment risk andreward throughout the entire R&D process.

The key to overcoming the barriers to capital flowposed by traditional sources of financing lies inthe establishment of novel structures capable ofappropriately and successfully tapping into capi-tal markets. One such innovative structure is the“operating company,” which has been used byseveral businesses seeking to invest in biomed-ical innovation, such as Safeguard Scientificsand Arrowhead Research. An operating com-pany refers to a corporate entity that has beenformed primarily to perform all of the activities,and assume all of the accompanying risks, of abusiness.

However, an operating company is not idealfor risky, early-stage investment in biomedicalresearch for reasons best illustrated through anexample of a hypothetical investment in early-stage research on clinical cancer compounds,where the estimated success rate is very low(DiMasi et al., 2013; Retzios, 2009; Pavlou andReichert, 2004; Kola and Landis, 2004). Forfinancing early-stage cancer research, the use ofan operating company to limit risk exposure and

liability is legally possible only if the operat-ing company is not inadvertently operating as aninvestment company. The Investment CompanyAct of 1940 regulates investment companies reg-istered under the act whose shares are offered tothe public, such as mutual funds. However, theInvestment Company Act defines an investmentcompany very broadly, as any issuer that is, orholds itself out as being, primarily engaged in thebusiness of investing, reinvesting, or trading insecurities. Under the Investment Company Act,a company may be deemed to be an investmentcompany if it owns, or proposes to acquire, invest-ment securities with a value exceeding 40% of thevalue of its total assets (excluding governmentsecurities and cash items) on an unconsolidatedbasis, unless an exemption or safe harbor applies.As a result, operating companies can become“inadvertent” investment companies, especiallyif they invest in securities and conduct signif-icant operations through subsidiaries that arenot majority-owned (Glicksman and Callaway,2014).

To avoid registration under the Investment Com-pany Act, an operating company needs to fundprojects through majority-owned subsidiaries,held for the long term. For companies suchas Safeguard Scientific, which access the cap-ital markets through an operating company toinvest in healthcare companies that have “lesserregulatory risk and have achieved or are near com-mercialization,” this is an acceptable tradeoff.4

However, this structure is simply not conduciveto companies developing cancer drugs within theFDA framework for approval, where, due to thebinary outcome of the trials, a security will needto be monetized immediately after the comple-tion of a successful drug trial, or disposed of ifnegative results ensue.

Additionally, the use of the operating com-pany model for investing in multiple operating




subsidiaries requires that the operating companytake a controlling interest in each portfolio com-pany. In the case of funding research with highfailure rates, like clinical cancer compounds,taking a controlling interest in each portfolio com-pany is not feasible. If the investing companyowns a controlling interest, the investing com-pany will have greater exposure to risk due tohigher ownership levels in the business activitiesconducted by the portfolio company.

Other investment company structures have beenused to finance biopharma research, such as thetraditional registered closed-end fund, an invest-ment company registered under the InvestmentCompany Act that is not freely redeemable andtypically trades on a stock exchange. But a reg-istered closed-end fund is more often used forinvesting in later stage, publicly traded bio-pharma companies, generally missing the privateand small-cap companies involved in early-stageresearch. Registered closed-end funds have alsorecently been used for making healthcare invest-ments in publicly traded companies,5 privatecompanies, foreign securities, and private invest-ment in public equities (“PIPE”) transactions.6

However, none of these vehicles offer the samedegree of flexibility as the BDC.

3 A brief history of the BDC

In the 1970s, Congress was pressured by aperceived crisis in the capital markets to pro-vide exemptions from the Investment CompanyAct of 1940 (Tashjian, 1980; Boehm et al.,2004). Private equity and venture capital firmsbelieved that their capacity to provide financingto small businesses was blocked by a limitationin the Investment Company Act, which preventedthese firms from becoming public companieswithout becoming registered management invest-ment companies. It was argued that innovationwas being stifled because registered managementinvestment companies would be subject to the full

regulation of the statute, compliance with whichwould be unduly difficult (BDC Reporter, 2015).These considerations led Congress to enact theSmall Business Investment Incentive Act of 1980(Boehm et al., 2004), which, among other things,amended the Investment Company Act (the “1980Amendments”).7 This legislation was the resultof discussions between Congress, the Securitiesand Exchange Commission (SEC), and the ven-ture capital industry, with the common goal ofremoving burdens on venture capital activitieswhile maintaining investor protections.

The 1980 Amendments led to the creation ofthe BDC, a new form of closed-end investmentfund, in order to facilitate the flow of capital tocompanies that were perceived as less capableof availing themselves of conventional forms offinancing. The legislation also lessened several ofthe restrictions under the Investment Company Actto encourage participation in the regulated portionof the asset management industry, and created anincentive for funds to become BDCs.

Legislators believed that establishing BDCswould lead to the creation of a number of pub-lic vehicles that would invest in private equity,and thus increase the flow of capital to small,growing businesses. In the initial years followingthe 1980 Amendments, a number of BDCs wereformed, including Merrill Lynch Venture Capi-tal Inc. (1981), American Capital Ltd. (1986),and Capital Southwest (1988) (Bristow and Petil-lon, 1999). After their initial appeal in the 1980s,however, the popularity of BDCs declined in thefollowing decade.

BDCs made their way back into the financialmainstream in the 2000s (Smith, 2014). Theincreasing demand for capital by small and mid-dle market companies, particularly because ofincreased regulation of banks stemming fromthe 2008 financial crisis and the demand by thepublic to provide such capital, has resulted in




a new growth of the BDC. As a result, BDCsare emerging as a realistic alternative for main-stream investors with an appetite for investmentsin early-stage research. In harnessing an entirelynew sector of the investment community, theBDC provides a new way of funneling capital tobiomedical innovation.

More formally, a BDC is a type of closed-endfund that benefits from certain relaxed regulatoryrequirements under the Investment Company Actin exchange for a requirement that the BDC willmake 70% of its investments in “eligible portfoliocompanies.” While Section 2(a)(48) of the Invest-ment Company Act enumerates several categoriesof qualifying assets, most BDCs own securitiesthat qualify because they have been issued by aneligible portfolio company. An eligible portfoliocompany must be organized and have its principalplace of business in the United States, and encom-passes all private U.S. companies, as well aspublic U.S. companies with an equity market cap-italization of up to $250 million. A BDC is alsoobliged to “make available significant managerialassistance” to those companies.

BDCs can be structured with internal manage-ment, like an operating company, or with externalmanagement, like a private venture capital firm.They are typically publicly traded on a nationalstock exchange, but they can also be non-traded.If certain requirements are met, BDCs may qual-ify to elect to be taxed as “regulated investmentcompanies,” or RICs, for federal tax purposes.The process is designed to avoid double taxa-tion, whereby both the company and individualinvestors would be taxed. This qualification per-mits them to eliminate taxes on capital gains andincome earned on the BDC’s investments at theBDC level.

BDCs provide mainstream investors access toinvestments in private company investmentshistorically only available to institutional investors

or wealthy individuals through private funds.In contrast to many other forms of investmentcompanies, a BDC is unique in that it providesshareholders with the ability to retain the liq-uidity of a publicly traded stock, while sharingin the benefits of investing in emerging-growthor expansion-stage privately owned companies.In this way, it can be structured similarly to apublicly held private equity or venture capitalfund.

BDCs are exempted from some provisions ofthe Investment Company Act, and certain sec-tions apply only to BDCs. These exemptionsand provisions may make BDCs preferable formaking investments in private companies com-pared to other types of closed-end funds registeredunder the Investment Company Act. For example,pursuant to Section 205(b)(3) of the InvestmentAdvisers Act of 1940, as amended (the “AdvisersAct”), investment advisers to BDCs are permit-ted to charge an incentive fee based on capitalgains. However, registered closed-end funds areprohibited from doing so. Registered closed-endfunds that trade on a stock exchange strike a netasset value (NAV) daily. BDCs are only requiredto value their assets on a quarterly basis, whichis more congruent with valuing illiquid privatelyheld securities.

4 The VC-BDC and translational medicine

Our proposal is to create one or more financingentities, in the form of a VC-BDC, to invest inmultiple biomedical projects throughout variousstages of their development cycles, financed inthe public markets. When sources of private cap-ital are sufficient, reliance on public investorsis unnecessary, but this is clearly not the casefor biomedical research. Increasingly, venturecapital firms are demonstrating interest in attract-ing public investors, who are interested in theupside of start-up and pre-IPO companies. Suchinvestments are coming to be seen as important,




and perhaps even necessary, components of aproperly diversified investment portfolio (Boehmand Krus, 2001). Tapping the public markets toexpand the pool of capital available for life sci-ence investment by bringing together investors isa viable option.

A BDC is superior to an operating companystructure in reducing risk to an investor. Anoperating company can serve to limit liabil-ity, but it does so only in relation to one suchbusiness structure at a time. A BDC, however,affords an even greater degree of risk reduc-tion. Multiple speculative investments require amuch broader set of assets in order to achieverisk reduction, but this is precisely what a BDCis designed to do. By using a BDC to investin multiple biomedical portfolio companies, theinvestor is granted an opportunity to spread riskamong a number of different drug trials, thusincreasing the investor’s chances of participat-ing in the long-term growth of a successfuldrug.

A BDC must invest at least 70% of its assetsin U.S. companies that are either private, orpublicly traded with a market capitalization of$250 million or less. This regulatory require-ment splits the investment universe into two broadgroups. Traditional closed-end funds are gener-ally favored over a BDC for investments in largercompanies and/or foreign investments. For mak-ing investments in biomedical innovation in earlystage, private companies, the BDC is the superioroption.

The BDC facilitates investment in early-stagebiomedical innovation by providing direct accessto public equity and debt markets. Althoughinvestments in BDCs can take the form of equityor debt investments, almost all new BDCs havechosen a debt-investment focus. The VC-BDC isnow a comparative rarity among today’s BDCs.

Nevertheless, we believe the VC-BDC model—with its capacity for providing both permanentcapital and managerial assistance—can morefully realize the original intent of the BDC,and allow institutions which conduct early-stageresearch to gain access to inputs which were pre-viously inaccessible. Given the long-term natureof investments in the biopharma industry andthe inherent regulatory hurdles, the mandate toprovide managerial assistance may help a VC-BDC to maximize the value of its investmentsin a portfolio company (Markovich, 2012). Forexample, a VC-BDC can generate considerablygreater resources for negotiating licenses on acase-by-case basis than can public sector insti-tutions or small start-up firms, and can providethe knowledge required to make those stepswith appropriate measures for mitigating risk andimproving the ultimate commercial viability ofany arising discoveries. We propose that this vehi-cle will be capable of bridging the translationalresearch gap, and meeting a more diverse rangeof risk profiles in the investment community.

The VC-BDC has the potential to play a majorrole as a unique alternative to traditional financ-ing, acting in synergy with the existing biotechventure capital industry to stimulate innovation.A natural business model follows from the binarynature of biomedical companies and the operatingcosts of a publicly traded, heavily regulated vehi-cle such as a BDC, in which an asset managerfunds multiple biomedical start-up companies,thus distributing the costs (and risks) of multi-ple projects, with the objective of allowing gainsfrom successful biomedical investments to com-pensate for companies which fail to survive thetranslational research process.

5 Organizational structure of the BDC

A BDC regulated under the Investment CompanyAct must be organized and have its principal place




of business in the United States, and must be oper-ated for the purpose of making investments inthe types of securities enumerated in the Invest-ment Company Act. For a fuller description ofqualifying securities and a BDC’s legislativelyrequired offer of managerial assistance toward theissuing firms, see the appropriate sections of theAppendix.

BDCs can be externally managed or internallymanaged. An externally managed BDC typicallyhas no employees, and has an external investmentadviser (a separate legal entity) to manage theBDC under the direction of the board of direc-tors. An internally managed BDC has no externalinvestment adviser, and the BDC is managed byits officers, who are typically its employees, underthe direction of the board of directors.

BDCs are permitted greater flexibility regardingleverage, compensation, affiliated transactions,and restrictions for selling shares below NAV thanregistered closed-end funds, which we detail inthis section.

5.1 Leverage

BDCs are less restricted than registered closed-end investment companies as to the amount ofdebt they can have outstanding. A BDC is permit-ted, under specified conditions, to issue multipleclasses of indebtedness and one class of stocksenior to its common stock, if its asset coverageratio, as defined in the Investment Company Act, isat least equal to 200% immediately after each suchissuance, which means that any debt or seniorsecurities cannot exceed one-third of the BDC’stotal assets.8 For example, for each $1.00 of seniorsecurities (debt and preferred stock) issued, theBDC must have $2.00 of assets at issuance. Incomparison, registered closed-end funds are lim-ited to issuing leverage at least equal to 300%immediately after each issuance—for each $1.00

of debt issued, a registered closed-end fund musthave $3.00 of assets at issuance.9

A leveraged strategy of using indebtedness toexpand their assets in investments is often anattractive provision for debt-BDCs. However,because of the risky nature of early-stage invest-ments in biomedical innovation, VC-BDCs maydetermine not to use leverage to the same extentas their debt-BDC peers.

In addition, with respect to certain types of seniorsecurities, the BDC must make provisions toprohibit any dividend distribution to sharehold-ers or the repurchase of certain securities, unlessthey meet the applicable asset coverage ratios atthe time of the dividend distribution or repur-chase. A BDC may also borrow amounts up to5% of the value of their total assets for temporarypurposes.

5.2 Incentive compensation

Managers of closed-end funds are generally pro-hibited from receiving incentive compensationon the basis of capital gains, and are prohibitedfrom having employee profit sharing plans. How-ever, these restrictions have been relaxed underthe 1980 Amendments for BDCs.

Section 205(b)(3) of the Advisers Act permitsexternal investment advisers of BDCs to assessan incentive performance fee of up to 20% on aBDC’s realized capital gains, net of all realizedcapital losses and unrealized capital depreciationover a specified period, typically annually. Likeregistered closed-end funds, a BDC may alsocharge a base management fee, which is typi-cally determined by taking the average value ofa BDC’s gross assets, usually calculated at anannual rate of between 1.50% and 2.00%, paidquarterly in arrears, and an incentive fee basedon income, including interest income, dividendincome, and any other income, which is also




typically paid quarterly. The income incentive feeis typically calculated as the pre-base manage-ment fee net investment income for the quarteras a percentage of average assets managed, andthe return is compared against a pre-determinedhurdle rate (usually 2% a quarter or 8% annually).

Internally managed BDCs are permitted to payincentive compensation either through a profitsharing plan or a stock option plan. Section 57(n)of the Investment Company Act permits an inter-nally managed BDC to operate a profit sharingplan for directors, officers, and general partners,so long as the aggregate amount of profits dis-tributed under such a plan does not exceed 20%of the BDC’s net income after taxes in any fis-cal year. Participation in the profit sharing planby a BDC’s directors or its general partners ispermitted only by an order of the SEC.

Internally managed BDCs that do not operate aprofit sharing plan are permitted to issue stockoptions to their directors, officers, employees,and general partners. Many BDCs have alsoobtained orders from the SEC permitting them toissue shares of restricted stock to their directors,officers, employees, and general partners.10

Internally managed BDCs may have differentforms of compensation to attract and retain per-sonnel, in addition to the incentive compensation.The varieties of compensation arrangements dif-fer by company and include salaries, bonusarrangements, 401(k) plans, and deferred com-pensation plans.

5.3 Affiliated transactions

Registered investment companies are prohibitedfrom entering into transactions with their affili-ates under Section 17 of the Investment CompanyAct. However, Section 57, the analogous sectionfor BDCs, is slightly less onerous than its coun-terpart. Section 57 addresses the ability of BDCs

to engage in certain types of transactions withaffiliates. A BDC may not engage in specifiedtransactions with its affiliates (directors, officers,investment adviser, their designated affiliates, andanyone controlling, controlled by, or under com-mon control with the BDC). Depending on thenature of the affiliation with the BDC, transac-tions involving a BDC and one or more of itsaffiliates require either:

• Authorization by the “required majority” ofthe board of directors, which consists of amajority of the board, including a majority ofdisinterested board members and a majorityof the board with no financial interest in thetransaction; or

• An order of the SEC.

Many BDCs have obtained exemptions fromthe SEC, permitting certain co-investments withaffiliated funds, subject to certain conditions.11

5.4 NAV determination

Traditional registered closed-end funds, whichgenerally invest their assets in liquid investments,must value their assets on a daily basis. In con-trast, BDC assets must be valued on a quarterlybasis, in connection with the issuance of theirfinancial statements. All investment companiesregulated under the Investment Company Act,including BDCs, are required to account for theirinvestment portfolio at value. Value is defined asthe market value of securities for which marketquotations are readily available. For other securi-ties and assets, value is defined as the fair valuedetermined in good faith by the board of directors.

Because BDCs primarily invest in illiquid securi-ties of private companies, they are only requiredto value their assets quarterly, as it would bedifficult to value their assets daily as traditionalregistered closed-end funds are required to do.




The Financial Accounting Standards Board’sstatement ASC 820 (formerly FAS 157) requiresthat public companies’ financial instruments gen-erally be valued at their current market price, thatis to say, they are “marked to market.” Each debtand equity security is separately valued.

There is no single standard for determining fairvalue in good faith. Determining fair valuerequires that judgment be applied to the spe-cific facts and circumstances of each portfo-lio investment, while employing a consistentlyapplied valuation process. Accordingly, valuationof privately held, illiquid securities is a time-consuming, judgment-based process, involvingcopious amounts of documentation to substantiateany claims.

Valuation has important implications for issuingnew shares: Section 63(2) of the Investment Com-pany Act provides that, with the exception of anIPO, a BDC may not sell common stock at a pricebelow NAV, after excluding selling commissionsand discounts, unless a majority of its sharehold-ers that are not affiliated persons of such BDChave approved such company’s policy and prac-tice of making such sales at its last annual meetingof shareholders within one year of the sale ofsecurities.

6 Managing a BDC

In this section we address several issues regardingthe management of a BDC, including compli-ance and reporting, fundraising, portfolio man-agement, and cash management. For a fullerdescription of establishing the BDC as an RICfor tax purposes, and a comparison of debt-BDCsversus VC-BDCs, see the Appendix.

6.1 Compliance and reporting

BDCs are generally subject to the same report-ing obligations of traditional public companies

under the Securities Exchange Act of 1934 (the“Exchange Act”), and must file an annual reportForm 10-K, quarterly reports on Form 10-Q, andall other forms, such as proxy statements and cur-rent reports on Form 8-K. If the BDC is listedon a national exchange, it must also comply withthe requirements of the exchange. BDCs are alsosubject to compliance with Section 404 of theSarbanes-Oxley Act of 2002, which requires man-agement to document and test internal controls,among other things, and for auditors to test andreport on those controls.

(Note: unlike registered closed-end funds that fileN-CSRs and N-SARs, BDCs file their annual andquarterly reports on Forms 10-K and 10-Q.)

BDCs are required to make certain public disclo-sures of portfolio company information. Whenpreparing their publicly filed financial statements,and/or registration statements, which are filed onForm N-2, BDCs must include: (1) value and costof each portfolio company investment; and (2) forcertain portfolio companies in which the BDC hasa controlling interest, the BDC may be requiredto disclose certain financial information of theportfolio company, either in its audited financialstatements or in the notes to the financial state-ments, subject to certain tests required by Rules3-09 and 4-08(g) of Regulation S-X.

6.2 Fundraising for a biomedical BDC

Entrepreneurs seeking to raise funds for spe-cific biomedical research should consult withinvestment bankers in the investment space todetermine the best method for building a portfolioin connection with a public offering. However,some basic background is considered here.

Historically, asset managers with a successfultrack record could raise capital based on a planto make investments in eligible portfolio compa-nies. This practice is sometimes known as a “blind




pool.” However, the tightening of the credit mar-kets in the wake of the recent financial crisisappears to have foreclosed the blind pool optionfor BDC IPOs. The market now requires thateven successful asset managers have a portfolio ofinvestments prior to completing an IPO (Talcottand Kerns, 2014).

However, this is not necessarily a bad thing fora biomedical VC-BDC. Steadily raising capitalover time mitigates the challenges associated withdeploying capital in a blind pool IPO, becausemanagement is able to deploy capital strategi-cally as it is raised, rather than needing to findinvestable assets for the entire fund over a shorttime period.

Partly due to the challenging environment forblind pool IPOs, there has been a proliferationof non-traded BDCs over the last several years.While non-traded BDCs share certain featureswith traded BDCs, they are different in signifi-cant ways. Traded BDC shares are liquid, whilea non-traded BDC’s shares are not traded on anexchange, and have limited liquidity (InvestmentProgram Association, 2013).

Offerings of non-traded BDC shares are onlyavailable to investors who meet suitability stan-dards established by the state where they live inorder to participate in these offerings. (InvestmentProgram Association, 2013). They are typicallysold over an extended offering period throughbroker-dealers and financial advisors, rather thanin a one-time IPO. The up-front fees of a non-traded BDC may be in the range of 11.5% to15%.

Historically, the number of BDC offerings hasbeen limited. Over the last decade it has rangedbetween zero and six each year. In 2012, 2013,and 2014, there were five, four, and five IPOs,respectively. The number of IPOs by BDCs inthe pipeline is unclear, since the Jumpstart Our

Business Startups (JOBS) Act enables prospec-tive issuers to confidentially file their registrationstatements and publicly announce their intentionslate in the registration process.

Selling shares to retail investors can be attractiveto issuers since institutions tend to demand lowerprices during an offering. According to the Cap-ital IQ information service, retail investors havebeen between 14% and 66% of an IPO for recentdebt-BDC offerings, and 57% and 78% of anIPO for the two most recent VC-BDCs, FirsthandTechnology Value Fund (2011) and GSV Capital(2011). Asset managers seeking to raise capital inthe public markets through an IPO should consultwith investment bankers to determine the process,timing, and viability for the offering.

6.3 Investment portfolio management

A key feature of a biomedical BDC is the abilityto invest in a portfolio of assets, where “assets”are defined more broadly than for a traditionalbiotech VC that focuses exclusively on acquir-ing equity or convertible preferred interest in anentrepreneur’s startup. In addition to these invest-ments, a BDC could also acquire royalty interestsin patents, approved drugs, or even early-stageresearch that has not yet filed for patent protec-tion, but for which there are IP rights agreementsbetween the BDC and the owner of the IP rights(see theAppendix for further discussion of patentsand BDCs).12

One of the main benefits of a portfolio of assetsis, if the assets are chosen carefully, the portfoliocan offer investors a more attractive risk/rewardprofile because of the benefits of financial diver-sification (Fernandez et al., 2012). As long as theassets’ returns are not perfectly correlated, com-bining multiple assets into a portfolio can helpreduce the volatility of individual investments.The amount of volatility reduction is inverselyrelated to the pairwise correlations among the




assets’ returns. Consider a simple example of aportfolio of n assets, each with identical expectedreturn µ and return volatility σ. Assume thatthe pairwise return correlation between any twoassets is identical and equal to ρ (where − 1

n−1 ≤ρ ≤ 1). Then an equally weighted portfolio ofthese n assets will have expected return µ andvolatilityσp = σ2

[ 1n+n−1

nρ]. This relation shows

that, as the number of assets n increases, the port-folio volatility σp declines monotonically towardits asymptotic limit ρ.

Figure 2 illustrates this diversification pattern as afunction of the number of assets for various levelsof correlation. For assets that have uncorrelatedreturns, portfolio volatility declines continuouslywith the number of assets, from 50% for oneasset to only 9.1% for 30 assets. However, forhigher levels of correlation, the diversificationbenefits of multiple assets are not as pronounced.For example, with 75% pairwise return corre-lation, even 100 assets yield only a modest 6.6percentage-point reduction in volatility.

σσ σσ

ρ = 0%ρ = 0%ρ = 0%ρ = 0% ρ = 10%ρ = 10%ρ = 10%ρ = 10% ρ = 25%ρ = 25%ρ = 25%ρ = 25% ρ = 50%ρ = 50%ρ = 50%ρ = 50% ρ = 75%ρ = 75%ρ = 75%ρ = 75% ρ = 90%ρ = 90%ρ = 90%ρ = 90%

Figure 2 Return volatility of a portfolio of n identical assets with pairwise correlations of 0%, 10%, 25%,50%, 75%, and 90% for n = 1, . . . , 100.

Therefore, one of the primary objectives of thebiomedical BDC portfolio manager is to selectassets that are as uncorrelated—or even neg-atively correlated—as possible. This objectiveseems obvious, particularly from a financialrisk/reward perspective, but it flies in the faceof industry practices, due to the highly special-ized knowledge required to evaluate and man-age biomedical assets. Managers who developexpertise in one scientific area naturally seekto make use of that expertise over time, andmay not see the value, or have the time andresources, to develop expertise in several areassimultaneously. From the investor’s perspec-tive, however, there is considerable value ina simultaneous approach. Hence the biomedi-cal BDC will have to be organized in parallelteams, each specializing in asset selection withina relatively narrow field, with an additional “assetallocation” team responsible for balancing invest-ments across these specializations to optimize therisk/reward characteristics of the entire portfolio.In this respect, managing a biomedical BDC is




Stage 1: Capital allocation over asset classes

Stage 2: Capital allocation within asset classes

Figure 3 Asset allocation (Stage 1) and asset selection (Stage 2) for a biomedical BDC.

not unlike managing a fund of hedge funds, andFigure 3—adapted from the fund-of-hedge-fundscontext (Lo, 2010, Ch. 8)—illustrates how sucha process might be organized.

6.4 Cash portfolio management

Biomedical BDCs differ in one important respectfrom venture capital and private equity funds:

they receive their investment capital at the timeof their equity or debt offering, but deploy it overtime as they identify sufficiently attractive invest-ment opportunities. Unlike a VC fund that onlyissues capital calls when the capital is needed, aBDC generally receives its capital upfront, andmust decide how to manage it. If it invests thecapital in safe and liquid assets, such as short-term U.S. government debt, the low yield will be




a drag on the BDC’s overall performance, but if itinvests in higher-yielding assets, such as the S&P500 Index or hedge funds, there is a significantrisk of loss due to normal market fluctuations, anda risk of illiquidity when the capital is needed.

One solution is to strike a balance between thesetwo extremes. By using liquid instruments such asstock-index futures, bond futures, and exchange-traded funds (ETFs), one can generate marketexposure as close as possible to the investmentmandate of the BDC, while managing the over-all risk and illiquidity of the cash. For example,a BDC with an oncology mandate might investin a diversified portfolio of publicly traded equi-ties in biotech and pharma companies with cancertherapeutics as their primary business focus. Theoverall risk of this portfolio can be managed byusing a combination of S&P500 Index futures andbiopharma ETFs13 (e.g., the SPDR S&P BiotechETF or the iShares NASDAQ BiotechnologyIndex Fund), to either hedge or accentuate theBDC cash portfolio’s exposures to the biopharmaindustry. As investment opportunities arise, thesepositions can be easily liquidated to free up therequired amount of cash.

Although such “overlay” programs are routinein the institutional investment community, theymay not be as familiar to traditional biotech VCinvestors, and will need to be explained to them indetail. In particular, it will be important to spec-ify to investors in advance all of the parameters ofan overlay program, so as to be as transparent aspossible. Overlays should not be used to generatesignificant amounts of investment return for theBDC, but instead should be seen as a way to man-age the BDC’s cash to facilitate and be consistentwith its mission.

7 Practical considerations

VC-BDCs have many benefits for funneling cap-ital to biomedical innovation, most notably in

the creation of permanent capital for long-termresearch. However, there are also drawbacksto using VC-BDCs for investing in biomedicalinnovation, including relatively high operatingcosts.

The primary benefit of forming a VC-BDC tofund biomedical innovation is the creation ofpermanent capital compared to current venturecapital practices. There are a number of reasonsfor venture capital’s shortcomings in biomedicalinnovation. Small capitalization companies oftenhave longer time periods to IPO than the typicalten-year lifespan of private VC funds (Weild andKim, 2008). Syndicates of VC investors tend tofracture, resulting in the inability to raise capitalfor subsequent rounds of financing, even if thetechnology is ultimately successful. Finally, pri-vate venture capitalists are often hesitant to bringVC-backed companies public at earlier stagesbecause internal rates of return are based on exitvalues due to provisions in limited partnershipagreements that require them to distribute sharesto limited partners at the time of an IPO.An exclu-sive focus on generating returns upon an IPO, inorder to make distributions to limited partners atthe peak of the company’s valuation, may actuallyundermine growth of valuation post-IPO.

Unlike private VC firms, VC-BDCs have patientpermanent capital. They can more easily aligntheir interests with biomedical entrepreneurs thanprivate VC firms, thereby making decisions thatcreate value for the technology. VC-BDCs can tai-lor their investment horizons to suit the programswithin the portfolio. Accordingly, early-stageresearch can be emancipated from financiallydriven business deadlines, and instead permittedto follow the most scientifically productive path.This is of particular importance to the life sci-ences sector, where untimely interruptions dueto financial constraints destroy considerable eco-nomic value. Even potential financial disruptions




can alter the direction of strategic research dur-ing early-stage discovery. Tailoring investmenthorizons eliminates these effects.

The VC-BDC has the additional benefit of giv-ing the venture capitalist access to retail investorswho are otherwise not permitted to make invest-ments in private funds. Federal securities lawsprohibit retail investors from investing in privateequity or VC funds. However, retail investorsare allowed access to this asset class through aVC-BDC.

The VC-BDC has another advantage under fed-eral securities law. Currently, the so-called “Vol-cker Rule” prohibits certain bank investors frominvesting in certain funds.14 The Volcker Rule isintended to curb risky bank practices, and gen-erally prohibits banking entities from investingin hedge funds and private equity funds, includ-ing VC funds, which are referred to as “coveredfunds.” However, registered investment compa-nies and BDCs are specifically excluded fromthe definition of covered funds, and have seenrenewed interest from banking entities. Since therule’s release, several banking entities have filed aregistration statement to sponsor BDCs for invest-ing in debt investments.15 It is our belief that intime, banking entities may elect to sponsor, man-age, or invest in VC-BDCs with objectives similarto private VC funds subject to restriction underthe Volcker Rule. For these investors, the VC-BDC creates liquidity, since it typically trades ona national stock exchange, unlike an investment ina private fund. Moreover, a VC-BDC has greatertransparency than a private fund, owing to thepublic filing requirements.

A VC-BDC can raise permanent capital in thepublic markets, compared with private VC part-nerships that need to separately raise capital foreach ten-year fund. VC-BDCs also have moreflexibility in raising capital in the public marketsthan private equity partnerships, which generally

raise capital in the form of contributions by lim-ited partners. VC-BDCs can raise capital in avariety of manners, in the form of common stock,preferred stock, notes, and rights, and by usingleverage through credit facilities.

However, there are several drawbacks to usinga VC-BDC to invest in biomedical innovation.The primary drawback of BDCs is the expense.Externally managed BDCs have a high fee struc-ture, and internally managed BDCs have highexpenses. Being public is also expensive. TheSEC has estimated that the average cost of achiev-ing initial regulatory compliance for an IPO is$2.5 million, followed by an ongoing compliancecost, once public, of $1.5 million per year.16 Com-panies frequently underestimate the costs asso-ciated with an IPO, which include direct costs,such as underwriter discounts and auditor, legal,and financial fees, as well as longer-term costs,particularly with respect to compliance (PwC,2012). BDCs have additional expenses relatingto the complicated regulatory regime for legaland compliance requirements. Finally, becauseBDCs frequently raise capital in the public mar-kets, transaction costs with regard to bankingfees and transaction expenses are significant. VC-BDCs that raise capital in the public markets canhave a lower cost of capital than other forms offinancing, but only if enough capital is raised toabsorb its operating expenses.

In addition to being expensive, BDCs are heav-ily regulated. Because a BDC is a hybrid ofan operating company and an investment com-pany, it is subject to multiple layers of regulation.BDCs are subject to the compliance rule under theInvestment Company Act, which requires that theBDC adopt policies and procedures reasonablydesigned to prevent violations of federal securi-ties laws. BDCs are also subject to compliancewith Section 404 of the Sarbanes-Oxley Act of2002, which requires management to document




and test internal controls, and for the auditors totest and report on those controls. Additionally,investment advisers to externally managed BDCsare subject to the compliance rule under the Advis-ers Act, which has requirements similar to theInvestment Company Act compliance rule. Likemutual funds, BDCs must adopt codes of ethics.

Lastly, another challenge of operating a BDC isthe difficulty of raising capital by selling sharesbelow its NAV. As described in Section 5, withthe exception of an IPO, a BDC may not sellcommon stock at a price below NAV withoutshareholder approval. While many debt-BDCsdo receive such approval, getting shareholders toagree to such discounts may be more challengingfor a VC-BDC with portfolios of growth stocks.

8 Conclusion

The opportunities for developing novel therapeu-tics have never been greater, but the challengesto the biopharma industry are daunting. Becauseof the increasing complexity, cost, and dura-tion of drug development, investors are shiftingassets toward other investments with more attrac-tive risk/reward profiles. By creating diversifiedportfolios of biomedical projects financed bymore patient capital, biopharma entrepreneurscan improve the risk-adjusted returns of theirventures and tap into new sources of capitalsuch as retail investors, pension funds, insurancecompanies, sovereign wealth funds, and otherinstitutional investors.

These innovations are beginning to emerge out-side of the United States in jurisdictions with moreflexible capital-market regulations. For exam-ple, on March 25, 2015, the Irish life sciencesinvestment company Malin raised 330 mil-lion in an IPO on the Irish Stock Exchange to“acquire majority or significant minority equitypositions in private, pre-IPO, pre-trade sale oper-ating businesses in the life sciences industry”

(Reddan, 2015). Three months later, PureTech—a U.S.-based biotech startup engine that spe-cializes in creating and incubating early-stagecompanies targeting significant unmet medicalneeds—debuted on the London Stock Exchangeand raised $171 million (Garde, 2015). This maybe the start of a new trend in biomedical invest-ing in which the traditional VC funding modelis replaced by permanent capital raised throughpublic offerings, yielding funds that can thenbe deployed more patiently and opportunisticallyover longer periods of time. The BDC structureis ideally suited for this purpose.

A Appendix

In this Appendix, we provide more detailed infor-mation about various aspects of the BDC struc-ture, including restrictions on the type of invest-ments BDCs can make, the relationship it canhave with its portfolio investments, the require-ments for becoming an RIC for tax purposes, acomparison between VC- and debt-BDCs, andissues around patents and BDC IP.

A.1 Qualifying investments

A BDC is required to have at least 70% of its totalassets in “qualifying investments,” which is mea-sured at the time of each new investment. Whilethe Investment Company Act enumerates severalcategories of qualifying assets, by and large, mostBDCs own securities that qualify because theyhave been issued by an “eligible portfolio com-pany.” To be an eligible portfolio company, anissuer must be organized and have its princi-pal place of business in the United States, andencompasses all private U.S. companies, as wellas U.S. public companies with an equity marketcapitalization of up to $250 million.

Investment companies, or companies that wouldbe investment companies but for certain excep-tions set forth in the Investment Company Act, do




not count as eligible portfolio companies. In orderto be a qualifying asset, the securities must bepurchased in transactions not involving a publicoffering.

A BDC has discretion to invest in any otherinvestments with the remaining 30% of its port-folio. BDCs have historically invested in non-qualifying assets that do not fall within the “70%basket” to provide a source of cash flow to theVC-BDC, which otherwise invests in securitiesgenerating little immediate income. BDCs canalso use the 30% basket to diversify the portfolio,which may contribute to attracting capital frominvestors.

A.2 Managerial assistance

A BDC must either control or offer to provide“significant managerial assistance” to portfoliocompanies that it treats as qualifying assets forthe purpose of the 70% qualifying assets stan-dard. As described in the Investment CompanyAct, “significant managerial assistance” meansany arrangement whereby a BDC, through itsdirectors, officers, employees, or general part-ners, offer to provide, and if accepted, doesprovide, “significant guidance and counsel con-cerning the management, operations, or businessobjectives and policies of a portfolio company.”

In practice, the managerial assistance that a BDCprovides can take many forms, and depends onthe particular needs of a portfolio company. Inenacting the requirement, Congress recognizedthat the assistance provided would vary. Com-mon examples of managerial assistance includeassisting portfolio companies in: (1) establishingpolicies and strategy; (2) finding directors andmanagement team members; (3) establishing andmanaging relationships with financing sources;and (4) evaluating acquisition and divestitureopportunities. In many cases, members of a BDC

may attend portfolio company board meetings, oreven hold seats on the board.

Notably, BDCs need only offer such assistance.Whether or not a portfolio company accepts theoffer has no bearing on compliance with therequirement.

A.3 RIC requirements

Like registered investment companies, BDCsmay qualify for treatment as an RIC under Sub-chapter M of the Internal Revenue Code forfederal income tax purposes. In general, an RICis not taxed on its income or gains to the extentit distributes such income or gains to its share-holders. In order to qualify for favorable RICtax treatment, BDCs must, in general, (1) annu-ally derive at least 90% of their gross incomefrom dividends, interest, and gains from the saleof securities and similar sources (the incometest); (2) quarterly meet certain investment assetdiversification requirements; and (3) annuallydistribute at least 90% of investment companytaxable income as dividends. Any taxable invest-ment company income not distributed will besubject to corporate-level tax. Any taxable invest-ment company income distributed generally willbe taxable to shareholders as dividend income.

It should be noted that in the context of mak-ing investments in biomedical innovations whichtypically have revenue-producing IP throughlicensing fees, or royalty interests in late-stagedevelopment biopharmaceuticals with royaltypayments, these licensing fees and royalty pay-ments may not be qualifying assets for the purposeof the income test. Accordingly, BDCs that electto be treated as RICs typically make investmentsin corporations in which the IP is housed so thatthe “bad income” is not attributable to the RIC.

To satisfy the asset diversification requirements,at the end of each quarter, at least 50% of a BDC’s




assets must be invested in cash, cash items, U.S.government securities, securities of other RICsand other securities that, with respect to the BDC,do not represent more than 5% of value of theBDC’s total assets. Furthermore, a BDC cannotown more than 10% of the voting stock of anyone issuer, and cannot invest more than 25% ofthe value of its total assets in the securities of anyone issuer (other than U.S. government securitiesand securities of other RICs), or of two or moreissuers that are controlled by the company andthat are engaged in the same or similar trades orbusinesses, or related trades or businesses.

It should be noted that BDCs set up for biomed-ical research may qualify for an exception forthe method of calculating the asset diversifi-cation tests set forth in Section 851(e) of theCode in the case of an RIC that furnishes capi-tal to development corporations. This exceptionis available only to RICs that have been certi-fied by the SEC (not earlier than 60 days priorto the end of the investment company’s taxableyear) “to be principally engaged in the furnishingof capital to other corporations that are princi-pally engaged in the development or exploitationof inventions, technological improvements, newprocesses, or products not previously generallyavailable.” After receiving certification from theSEC, the BDC is subject to a more lenientasset diversification requirement for tax purposes.This exception would enable a BDC focused onbiomedical research to own more than 10% ofthe voting interest in biomedical companies, pro-vided that the issuer has not held the investmentfor more than ten years.

A.4 Debt-BDCs versus VC-BDCs

Why are most current BDCs debt-BDCs ratherthan VC-BDCs? Prior to 2003, most BDCs wereinternally managed. BDC activity increased in2003 after the successful IPOs of two externallymanaged BDCs: TICC Capital Corp. (TICC),

formerly Technology Investment Capital Corp.,and Apollo Investment Corporation (AINV). Inlate 2003, TICC completed a $130 million IPO,which had a significant impact on the financialmarkets’ perception of an externally managedBDC (Boehm et al., 2004). Following TICC’ssuccess, AINV raised $930 million in less thanthree months, catching the attention of other assetmanagers. These IPOs highlighted the fact thatBDCs made it legally possible to charge two per-formance fees—one based on capital gains andthe other based on income. By May 2004, 13potential IPOs proposing to raise more than $6.7billion had been filed. All of these new BDCs weredebt-BDCs.

Since the proliferation of debt-BDCs in the 2000s,the BDC industry has matured from one that wasinitially dominated by internally managed fundsto an industry of largely yield-driven vehicles thatare externally managed by some of the largestU.S. asset management platforms. In 2000, therewere only seven BDCs, but as of December 31,2014, there are more than 70, with more than $51billion under management. During the two-yearperiod ended Dec. 31, 2014, traded BDCs col-lectively raised $9.5 billion in capital, includingapproximately $5.5 billion in follow-on equityofferings, $1.8 billion in senior note offerings,and $1.2 billion in convertible debt offerings, andnine BDCs completed IPOs raising $1 billion.17

The main challenge of forming a VC-BDC tofund biomedical innovation is creating marketdemand, owing to the poor historical perfor-mance of equity-focused BDCs. There are severalreasons for their poor performance. The most suc-cessful BDCs in terms of price-to-book ratiosare those that have high, consistent dividendyields. Investment strategies more focused oncapital gains, such as VC investments, havemore difficulty in paying a dividend because thereis typically no income stream until a portfolio




company has an exit event such as an IPO oracquisition.

Investments in VC-BDCs are long-term growthplays, and have limited to no dividend distri-butions in their early stages. For VC-BDCs tobecome more widely accepted, market partici-pants would need to shift their expectations andview equity-focused VC-BDCs differently thandebt-focused BDCs.

Another possibility is that VC-BDCs create inno-vative investment objectives that include somesort of dividend yield, quarterly share buy-backs,or the use of the 30% basket to increase incometo either offset the VC-BDCs expenses or paysome sort of dividend distribution. Paying smallerdividends but at an increased pace, such as on amonthly schedule, may also serve to differentiateVC-BDCs from traditional debt-BDCs.

Another reason for the historical lack of returnsfor investors in equity-based BDCs is the absenceof re-marketing. While all BDCs are marketedduring the IPO, the average analyst would nothave the time or capacity to commit to under-standing the multitude of portfolio companies inan equity-based BDC’s portfolio. Both analystsand retail investors find it difficult to evaluatea portfolio of a VC-BDC because the portfoliocompanies are only valued quarterly, and are notmarked to market on a daily basis. Additionally, inthe context of funding biomedical innovation, theanalysts would need specialized scientific exper-tise to understand the technologies. Therefore,particular effort must be made to determine thebest plan of action for the re-marketing of aVC-BDC post-IPO.

Despite these obstacles, there have been signsof a resurgence of VC-BDCs focused on mak-ing equity investments. In addition to Harris &Harris Group (1995) and MVC Capital (1999)—both of which have been operating as VC-BDCs

for quite some time—newer VC-BDCs includeFirsthand Technology (2010) and GSV Capital(2011). The pace at which the VC-BDC industrygrows in the future will depend on the perfor-mance of the existing VC-BDCs, the strength ofthe overall market, and a change in the perceptionof VC-BDCs that are inappropriately comparedwith debt-BDCs.

A.5 Patents

Although a scientific discovery may be ground-breaking, the receptiveness of the business com-munity to its further development will hinge ondifferent criteria. The ultimate profitability of sci-entific research depends on the ability to carve outa monopoly in that space in order to make thatresearch profitable. That monopoly is granted inthe form of a patent.

In order to be granted a patent, an invention mustmeet three criteria: it must be (1) new; (2) non-obvious; and (3) have utility. In order to be valid,the invention must represent something new, overand above the entire knowledge base in a par-ticular area of research (“prior art”), includingpublished papers, products, and other patents. Itmust not be obvious from that prior art, but shouldpresent an “innovative step” above that body ofwork. Finally, a patent is not an abstract idea, likea formula. It must be reduced to an invention orsomething practical in order to qualify for patentprotection.

The ultimate patent application will disclose theinvention to a sufficient degree to enable any thirdparty to read it and recreate the invention with-out assistance. The patent application will alsodefine the scope of the invention in the claims ofthe application, which will describe the idea theentrepreneur seeks to protect. Intellectual prop-erty expertise should be sought throughout thisprocess.




There is one important mistake that entrepreneurscan make in the patent application process, whichmay not be readily apparent: the premature dis-closure of the invention. The patent monopoly isgranted to an inventor in order to make valuableinventions available for public use at the end of apatent term. However, if the invention has alreadybeen disclosed in a published paper or at a confer-ence more than 12 months prior to a patent filing,this defeats the purpose of a patent monopoly. Itis important that inventors do not undermine theultimate commercial viability of their research byprematurely disclosing it. Venture capitalists andinvestors prefer to see that adequate mechanismsare in place to protect against disclosure, such asnon-disclosure agreements (NDAs). These can bediscussed with legal counsel.

Venture capitalists, regardless of whether theystructure themselves as private partnerships orVC-BDCs, also prefer that steps have been takentoward the ultimate commercialization of anentrepreneur’s research. In the biomedical sec-tor, this generally means that steps have beentaken toward the prosecution of a patent. A patentprovides entrepreneurs with several tools in theirarsenal. As long as an entrepreneur is practicingwithin the claims specified in the patent filing,he or she is in a better position to protect himor herself in the event of litigation. Patents canalso be used offensively to exclude competitorsfrom practicing an entrepreneur’s invention, asspecified in the claims of the filing.

Investors like patents for several reasons. First,a patent provides investors with some reas-surance that the entrepreneur’s research hasidentified something new. Second, it signalsthat the entrepreneur has the ability to excludeother competitors from the market, thus render-ing the research more lucrative, and signalingthat the entrepreneur will not be solely relyingon the investors in order to get their product to

market first. Third, the granting of a patent impliesthat certain hurdles have been overcome, whichmakes future obstacles to the commercializationof the research less likely. Fourth and finally,particularly in a risky sector, a patent reassuresinvestors that the entrepreneur has some assets tofall back on if the business plan ultimately fallsshort of its envisioned commercial path.

Entrepreneurs can strengthen their bargainingpositions by taking manageable steps towardthe above process before approaching venturecapitalists. There are three main qualities that ven-ture capitalists look for in early-stage investmentopportunities from an IP perspective: (1) freedomto operate; (2) ability to exclude others; and (3)evaluation of third party agreements.

A.6 Freedom to operate

A new biomedical enterprise cannot normallyafford litigation. Patent lawsuits cost about$500,000 per claim if brought to trial.18 “Freedomto operate” (FTO) is the ability to produce andsell the biomedical research, without infringinganother patent. Investors will seek reassurancesthat no such “blocking patents” exist, or that,if they do, an entrepreneur has adequate licenserights to capture the anticipated body of work,and preclude the viability of any such lawsuit.These license rights commonly come from a vari-ety of institutions. (VC-BDCs commonly workwith entrepreneurs to evaluate and secure the nec-essary license rights through an option agreementor a license agreement.)

To increase their value in the eyes of investors,entrepreneurs may wish to conduct preliminarypatent searches, obtain relevant licenses, or obtainan FTO opinion from legal counsel. An FTOopinion identifies any patents that will block orseverely limit the company’s ability to market aproduct, or establish a dominant patent position.




This assures investors of the entrepreneur’s abil-ity to function in the marketplace in view of thepatent rights of others.

A.7 Ability to exclude others

Investors look for entrepreneurs with an abilityto exclude competitors from the market. Whilea patent prevents someone other than a patentowner from making, using, selling, or offeringto sell what is covered by the claims of a patentapplication, the precise wording of those claimsmay affect the extent to which a patent will con-fer a concurrent ability to exclude others, thusincreasing the chances of a costly infringementlawsuit. In this regard, it is important to seek theopinion of qualified legal counsel, who can assistentrepreneurs with their IP strategy. A robustoffensive and defensive IP strategy aligned witha business plan can stymie infringement suits, aswell as amass a proactive IP portfolio that can belicensed out in order to generate additional rev-enue, and thus render the company more valuableto investors (Braidwood and Ertel, 2005).

A.8 Evaluation of third-party agreements

Finally, investors will seek assurances that thereare no encumbrances on their ability to gen-erate a sufficient return on their investment.These encumbrances are most often found inthe entrepreneur’s existing contracts with thirdparties, including, but not limited to: licenseagreements for background IP, which may estab-lish restrictive boundaries surrounding an appli-cation or “field of use” of the research; oremployment contracts with staff, which mayfail to include “non-disclosure” or “assignment”provisions ensuring that all ideas, inventions,and discoveries developed within the scope ofemployment flow through to the company.19

These provisions may transfer IP rights underterms that dramatically affect investors’ ability

to make a return on their investment, and musttherefore be thoroughly canvassed by IP counsel.In the biomedical sector, where university pro-fessors or graduate students often first developkey technology, agreements should be studied toensure that a university cannot assert its rights tothe IP, or that government actors cannot practicethe invention without compensation. In drug dis-covery and development, where small companiescommonly have pre-existing collaborations withlarger companies, it becomes important to exam-ine contractual rights.20 In order to increase theirvalue to investors, entrepreneurs may seek a legalopinion assuring investors that the path to com-mercialization is clear, prior to delivering theirpitch.

In sum, venture capitalists, including VC-BDCs,are ultimately seeking assurances that their cho-sen investment is a sound one. This is determinedon the basis of the entrepreneur’s legal and IPrights. By assembling some or all of the abovepieces into a coherent IP strategy in line with theirbusiness objectives, entrepreneurs can make theinvestment process significantly easier. Conduct-ing advance due diligence with an IP attorney canclarify and streamline an entrepreneur’s objec-tives, as well as to conduct an inventory of IPassets and documents for inspection, which mayspeed up investors’ due diligence process andclose a deal more quickly.

Notes

1 See Dodd-Frank Wall Street Reform & Consumer Pro-tection Act, Pub. L. No. 111-203, §619, 124 Stat. 1376(2010) (“Dodd-Frank” or the “Act”); Bank HoldingCompany Act, 12 U.S.C. §1851 (2014); and ProprietaryTrading & Certain Interests In and Relationships WithCovered Funds, 79 Fed. Reg. 31 (Jan. 31, 2014).

2 See Cede & Co. v. Technicolor, Inc. 636 A.2d 956 (Del.1993).

3 See Burroughs Wellcome Co. v. Barr Labs., Inc. 40 F.3d1223 (Fed. Cir. 1994).




4 See Safeguard Scientific Annual Report on Form 10-Kfor Fiscal Year ended Dec. 31, 2013 (File No. 001-0562)filed March 7, 2014.

5 See, for example, Tekla Capital Management LLCRegistration Statement, available at http://www.sec.gov/Archives/edgar/data/1604522/000110465914054511/0001104659-14-054511-index.htm; and BlackRockScience and Technology Trust, available at http://www.sec.gov/Archives/ edgar/data/1616678/000119312514351997/d791791dn2a.htm.

6 See, for example, Annual Report on Form N-CSRfor Tekla Healthcare Investors (HI) for the year endedSeptember 30, 2014; and Annual Report on Form N-CSR for Tekla Life Science Investors for the year endedSeptember 30, 2014.

7 See Small Business Investment Incentive Act of 1980.Pub. L. No 96-477, 94 Stat. 2275 (1980).

8 Lemke, Lins, Regulation of Investment Companies§12:06 (October 2014).

9 See http://www.ici.org/faqs/faq/faqs_closed_end#ii.10 See Harris & Harris Group, Inc., Investment Company

Act Release 30027 (April 2012); Hercules TechnologyGrowth Capital, Inc., Investment Company Act ReleaseNo. 29303 (June 2010); MCG Capital Corporation,Investment Company Act Release 29210 (April 2010);Main Street Capital Corporation, Investment CompanyAct Release No. 28768 (June 16, 2009); see also Tri-angle Capital Corporation, Investment Company ActRelease No. 28718 (May 5, 2009).

11 See, for example, Garrison Capital Inc., et al., Invest-ment Company Act Release No. 31409 (January 12,2015); TPG Specialty Lending, Inc., et al., Invest-ment Company Release No. 31379 (December 16,2014); Monroe Capital Corporation, et al., InvestmentCompany Release No. 31286 (October 15, 2014).

12 We note that royalty interests in and of themselves wouldlikely not be qualifying income for the purpose of theRIC income requirement.

13 Section 12(d)(1) of the Investment Company Act, amongother things, restricts an investment company fromowning more than 3% of another investment company.

14 Dodd-Frank Wall Street Reform & Consumer ProtectionAct, Pub. L. No. 111-203, §619, 124 Stat. 1376 (2010)(“Dodd-Frank” or the “Act”).

15 See publicly filed documents for Goldman Sachs BDC,Inc. and Credit Suisse Park View BDC, Inc.

16 Proposed Rules: Crowdfunding, 78 Fed. Reg. 66428,66509 (col. 2) (Nov. 5, 2013).

17 See Dealogic and Prospect News, available at http://www.dealogic.com/login/ and http://prospectnews.com/.

18 See World Intellectual Property Organization, avail-able at http://www.wipo.int/sme/en/documents/venture_capital_investments_fulltext.html.

19 See http://www.buildingipvalue.com/n_us/97_101.htm.20 This list is by no means exhaustive, and will be further

explored in a forthcoming publication.

Acknowledgment

Research support from the MIT Laboratory forFinancial Engineering and the Proskauer RoseLLPlibrary is gratefully acknowledged. We thankJayna Cummings, Lily Desmond, Allen Jones,and Patrick Rosenthal for many helpful commentsand discussion. The views and opinions expressedin this article are those of the authors only, anddo not necessarily represent the views and opin-ions of any institution or agency, any of theiraffiliates or employees, or any of the individualsacknowledged above.

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Keywords: Business development company;megafund; biotech; pharmaceutical; translationalmedicine; Drug Royalty Investment Company;intellectual property; royalties; corporate finance

JEL Classification: G12, G29, C51



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