In 1980, Congress created a new category of investment companies to channel capital into privately held small businesses. Known as business development corporations or BDCs, these specialized closed-end funds took off slowly, remaining for many years under the radar of most mainstream investors.
That was then. Today, tempting yields of 10% or higher, along with a heightened awareness of alternative investments, have fueled investor interest, rapid asset growth, public offerings and increased attention from investment banks and financial advisors.
This summer, meanwhile, legislation before the House of Representatives to update the original law may come up for a vote. While a long shot for passage this year, HR 1800 would allow BDCs to dramatically increase leverage to make additional loans.
According to Wells Fargo analyst Jonathan Bock, total BDC industry assets under management have increased tenfold during the past 12 years to more than $40 billion. There are now eight publicly traded BDC funds with close to or more than to $1 billion in market capitalization.
Bock wrote in a January 2014 BDC industry review, “We believe the industry...is well positioned to become increasingly relevant in the lending universe in the coming years.”
Business development corporations must invest in the debt or stock of private and very small domestic public companies. So what, exactly, are they investing in?
Triangle Capital Corporation (TCAP) of Raleigh, N.C., defines its sweet spot as the more than 65,000 small businesses in the U.S. with revenues between $20 million and $200 million, of which 90% are privately held. A random sampling of portfolio investments from a Texas-based BDC, Main Street Capital Corporation (MAIN) of Houston, includes a telephone on-hold messaging service company, a business that provides external casing and tubing coatings for the oil and gas industry, and a restaurant and wholesale baker in the Dallas-Fort Worth metroplex.
BDCs participate in “leveraged loans,” a term without a strict definition but generally understood to be a secured loan that is below investment grade. With traditional banks stepping back from lending to smaller companies, BDCs have grown in importance, now accounting for about $1 in every $20 of leveraged loan financing. These loans commanding 5% to 14% in annual interest.
The eight largest BDCs offer yields of 6% to 12%, composed of ordinary income and tax-advantaged long term capital gains. By law, BDCs can use $100 of equity to borrow as much as $100 in debt, but in practice most BDCs rarely borrow more than $70 for each $100 in equity. By maintaining low leverage on their balance sheets, BDCs can borrow at much lower rates than they lend. The 7% to 10% difference (plus or minus realized gains and losses) passes through to investors as yield after fund expenses. And as long as BDCs pay out at least 90% of their profits to investors, they are exempt from corporate income tax.
Steven Lilly, chief financial officer of Triangle Capital, puts it this way: “What we try to do is pay the shareholder as high a dividend as possible that is sustainable and can grow over time.” The yield on Triangle, which concentrates on funding businesses with less than $100 million in total capitalization, was 8.3% in early May.
BDCs usually take an ownership stake in their portfolio companies, in the form of common stock or warrants, and must report quarterly gains and losses. After enduring painful losses in the aftermath of the financial crisis, managements now maintain stricter limits on equity exposure. “Equity ownership has moved down,” says Meghan Neenan, a senior director at Fitch Ratings who rates the debt of seven BDCs. “Ten to 15% of the portfolio in equity is max for most BDCs.”
Fitch rates the debt of six of the BDCs it covers at BBB or BBB- and one, American Capital (ACAS), at BB-.
Because of the illiquid nature of their investments, BDC funds’ net asset value calculation is less precise than that of a closed-end fund that invests in liquid markets with daily pricing. SEC rules require BDCs to disclose net asset value per share every quarter, and a given fund’s management works to report any changes in value in the fund’s loans or stock positions. But establishing fair value, even for the most conscientious management team, can be tough, so the net asset value of a BDC’s portfolio is always going to be a best estimate. BDCs trade above or below asset value depending on the market’s view of fund assets, strategy and outlook. For example, BlackRock Kelso Capital Corp.’s (BKCC) debt was put on negative credit watch by Fitch in April and in early May, and BKCC traded at $8.50 even though its net asset value was $9.54 per share on Dec. 31. In contrast, Hercules Technology Growth Capital (HTGC) traded $3 above its $11 net asset value in early May, reflecting investor optimism for its business model.
BDCs sold off in the first quarter when Russell Investment announced that “BDCs will be ineligible for Russell index membership as a result of issues related to reporting of acquired fund fees per SEC regulation.” When the Russell Global Index is reconstituted this month, BDCs will be removed from the Russell Global Index series.
Advisors can find ample sell-side research on BDCs, but Morningstar does not rate any fund in the category as of now.
The rated debt of BDCs offers another way of participating in the category. Fitch ratings analyst and associate director Katherine Hughes reports that the number of calls she receives on BDC debt is increasing steadily. “Several BDCs have issued institutional unsecured debt in the last few years,” she notes, “A lot more people are noticing them.”
Financial advisors should think about evaluating BDCs in the same way they would choose a fund manager for a client—by examining the fund’s investment strategy, portfolio and track record, says Dean Choksi, executive vice president finance and head of investment relations at Fifth Street Financial Corp. (FSC), the sixth largest BDC. BDCs have more unique characteristics than most funds because their portfolios have little overlap, and understanding the personality of each company is
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