In finance, boring and safe often go together. There could hardly be a more boring category name than business development companies (BDCs), or a more boring role than their original business model: turning money from mom-and-pop investors into loans to small and family-owned Main Street businesses. So why are private equity stars like KKR, Apollo, Blackstone and Carlyle Group setting up BDCs, and how do loans of $800 million fit in? The transformation is part of a broader set of changes that have led to the rise of so-called private credit, a domain now fast approaching $1 trillion. Along the way, BDCs have seen yields and leverage increase -- even as lending standards have slipped. Could be exciting!
1. What is a BDC?
Business development companies are a type of closed-end investment firm. Their roots go back to the Small Business Investment Incentive Act, passed by Congress in 1980 to give a boost to middle-market businesses -- in today’s terms, typically those with $100 million or less in earnings. The shares of a BDC can change hands like a stock. They’re also designed to give retail investors access to credit markets they are otherwise unable to bet on. In return for supporting small American businesses, the firms enjoy certain benefits, including significant tax advantages if they dole out at least 90% of their income as dividends to shareholders.
2. Who do they serve?
BDCs were originally designed to provide capital to borrowers considered too small or risky by banks or traditional lenders. But the sizes of some checks, and recipients, have ballooned. Ares Capital Corp., a behemoth BDC with $14 billion in assets, last year participated in a $792 million loan for the refinancing of Pathway Vet Alliance, a private equity-backed operator of veterinary hospitals.
3. Why did the market change?
After the financial crisis, U.S. banks facing new regulatory requirements concentrated on the safest kinds of investment. That left an opening for what’s variously known as private credit, direct lending or shadow banking -- money coming from investors outside of the banking system. With interest rates low, private lenders gravitated toward some higher risk, higher yield parts of the field. Private lending is on track to hit $1 trillion by 2020. BDCs have jumped from $23 billion in total assets in 2009 to $101 billion in 2018, according to Deloitte LLP.
4. What’s the appeal?
Dividends. BDCs pay out loan proceeds in the form of dividends that tend to be both stable and relatively high. Over the past year, the stocks on the Wells Fargo Business Development Company index paid an average dividend yield of more than 9%, about double that of a typical junk-bond fund. BDCs are able to hand out the hefty dividends because they invest in riskier parts of companies’ capital structures, like their subordinated debt -- and don’t pay tax on profits. For borrowers, BDCs provide financing for growth initiatives, acquisitions or buyouts that they might not otherwise be able to access.
5. What makes them risky?
Three factors -- one old and two new. Bad bets on loans can send a BDC’s stock plummeting. That tends to have more of an impact on shareholders than the BDC managers, whose fees are tied to the number of assets they hold rather than the firm’s performance. The structure creates an incentive for managers to grow as large as possible without prioritizing the quality of loans they are making. According to research from Wells Fargo & Co., as of Dec. 31, the median compensation and fee paid totaled 51.1% of the funds’ economic profit.
6. Any other risks?
As more money has flooded in and the market has gotten more competitive, protections for investors are weakening and loans are getting riskier. In a May 2019 report, Moody’s Investors Service included BDCs in a review of credit vehicles it said will be hit when an economic downturn arrives, along with mutual funds and collateralized loan obligations. “In a default cycle, higher losses will flow through to entities holding leveraged obligations, including certain mutual funds and BDCs more exposed to subordinated debt,” Moody’s said.
7. How is the industry changing?
In 2018, Congress gave BDCs the green light to boost their debt-to-equity ratios to 2:1, from 1:1, that is, to use twice as much borrowed money. Though low compared to leverage levels of banks, some industry watchers say the change could clear the way for BDCs to invest in riskier assets to juice returns further. It’s still too early to tell how this will play out, as many large BDCs have yet to go through a downturn, and the leverage change is taking effect slowly across the industry.
• QuickTake explainers on direct lending, shadow banking and collateralized loan obligations.
• A Bloomberg feature on BDCs.
• A March 2019 report from Deloitte on the future of BDCs.
• A BDC primer from law firm Mayer Brown.
--With assistance from Heather Perlberg.
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