Key Takeaways:
· What are BDCs? Business development companies (BDCs) allow small investors access to a private equity-like investment that often sports a high yield.
· How do BDCs make money? Like any capital source, BDCs make the spread between the yield on investments and cost of the debt. BDCs can also make money from well-performing assets that are sold.
· What are the Risks of BDCs? Poor portfolio performance, mismanagement, and interest rate swings are among the main risks to BDCs.
· Why is the Sector under Pressure? Record low SBIC debenture costs could come to an end if interest rates rise. BDC investments start to look less attractive on a relative basis when yields rise.
· Which BDC is Best Positioned? Though we’re not compelled to own any constituent in the group, Main Street (MAIN) is best positioned, given its low cost structure, high insider ownership, and a conservative investment philosophy.
· Valuentum’s Take The industry looks mostly fairly valued, so we aren’t considering adding any BDC exposure at this time.
We continue to monitor developments at business development companies (BDCs), particularly industry bellwether Main Street. In February, we penned a profile of Main Street, and we added the firm to our Dividend Growth Newsletter watch-list (not portfolio) at the time. With shares of Main Street getting clobbered in the past few days, let’s take a deeper dive into the sector’s opportunities and risks.
What are BDCs?
Business development companies (BDCs) help small companies in early stages of development (similar to venture capital firms). They have been around in the US since 1980 when Congress amended the Investment Company Act of 1940. The amendment essentially gave individual investors the opportunity to invest in a publicly-traded private-equity firm. The tax structure is similar to a real estate investment trust (REIT), in that if the company meets certain requirements, it pays little income tax. However, the company then must return a minimum of 90% of taxable income as dividends. The cohort is regulated by the SEC. Though many are not as prominent as firms such as KKR, Bain Capital, or TPG Capital, there are a number of prominent business development companies that are publicly traded.
A list of BDCs: American Capital (), Apollo Investment (), Ares Capital (), Blackrock Kelso Capital (BKCC), CorEnergy (CORR), Equus (EQS), Fidus (FDUS), Fifth Street Finance (FSC), Full Circle (FULL), Gladstone Capital (GLAD), Golub (GBDC), Hercules Technology (HTGC), Horizon Technology (HRZN), KCAP Financial (KCAP), KKR Financial (KFN), Main Street (), MCG Capital (MCGC), Medley Capital (MCC), Monroe Capital (MRCC), MVC Capital (MVC), New Mountain (NMFC), NGP Capital Resources (NGPC), Oxford Lane (OXLC), Pennant Park (PNNT), Prospect Capital (), Solar Capital (SLRC), Stellus Capital (SCM), TCP Capital (TCPC), THL Credit (TCRD), TICC Capital (TICC), Triangle Capital (), Whitehorse Finance (WHF).
How do BDC’s Make Money?
BDCs may seem like complex structures since we compare them to private equity, but the business model is pretty simple: borrow cheap, lend high, and collect the difference. This is commonly referred to as a net income margin (NIM) in banking. In this sense, the business is really no different from any other lending…except BDCs specialize in “junk” debt and high-risk equity.
Image Source: MAIN Investor Presentation, 2013
Along with the cost of financing, the other major cost endured by BDCs is overhead. Therefore, it is crucial for investors willing to dabble in this industry to find BDC managers with interests aligned with shareholders such that costs are adequately controlled and savings are passed to shareholders. This includes executive compensation that isn’t outrageous and limited G&A expense growth.
BDCs play an important role in providing financing to both financially strapped companies and small businesses that need capital. While this implies that lending is exceptionally risky, it isn’t always the case.
We like Main Street founder and CEO Vincent Foster’s thoughts on putting capital to work, and from some recent comments by the firm, we gather that there will continue to be a very steady pipeline of deals going forward. Foster said on the firm’s fourth-quarter 2012 conference call:
“…we have a high fatality rate in diligence. So what drives our lower middle market activity is what we find in diligence. And we have not found a good way to predict that in advance. If we did, it would be great because it we’d save a lot of time and misery. But the good news is we’re — hold your estimate with what you’re seeing, you’re make it through, cradle to grave to close in terms of what you kill for diligence and when you’re — I’d say from cradle to grave, about 1/4 of stuff that we actually would want to transact on. But interestingly, that the — what the input of transaction is about all these — all the teams can handle at any one time. There’s a continuous supply demand imbalance of the amount of businesses that need capital, that need to exit, aging on or partners that don’t get along, you name it. There’s no shortage of it. And we just — we try to pick the ones that are most likely to make it through.”
The Attractiveness of the Lower Middle Market
The chart below shows the lower middle-market that is often the bread-and-butter of BDCs. Revenue and EBITDA at these companies are often small enough to fall under the radar of large companies and private equity funds.
Source: MAIN Investor Presentation, 2013
Several of these middle-market businesses are relegated to junk status, though these loans don’t necessarily carry high default rates. However, some are also over-leveraged, high-risk situations. In addition to credit, BDCs can make equity investments (though much equity comes through convertible debt). These equity investments can be a tremendous source of profits not only because small businesses often have potential for blockbuster success, but also because BDCs can often purchase small businesses at low-mid-single digit PEs and attractive free cash flow yields (making it easier to achieve robust investment returns). There simply aren’t a lot of small-business buyers out there, making the market less liquid and less efficient. Nevertheless, BDCs themselves are highly leveraged vehicles.
The Significance of Capital Allocation Decisions
With substantial leverage comes a lot of capital to invest. The allocation decision comes down to the individual management teams. Prospect (shown below) tends to invest heavily in financial services.
Image Source: Prospect Capital
But other companies prefer more or less diversification. In fact, debt versus equity investments varies by company. Take American Capital, which increasingly shifted away from senior debt to equity over the past few years (shown below).
Image Source: ACAS Q1 2013 Presentation
Ares Capital pursues a different strategy, focusing on first lien senior debt with a relatively low equity position (shown below).
Source: ARES Q1 2013 Earnings Presentation
The capital allocation decision can materially impact returns. American Capital’s portfolio, for instance, will have to rely on equity appreciation to deliver excellent returns to shareholders. Ares, on the other hand, tends to lend out first lien senior debt, making it relatively safer in the event of bankruptcy and other adverse events. All BDC portfolios are not created equal.
What are the Risks of BDCs?
It almost goes without saying that the biggest threat to BDC profitability is movement in interest rates—and not just in one direction. With interest rates collapsing over the past several years, investors of all types have been