I know that anytime I write about being careful with your BDC (business development company) income issues I will get a little push back from readers. At a minimum I will generate some questions–no problem–that is what I want to happen–stimulate our collective income investing minds.
Last week I wrote something about being watchful over your BDC investments if it looks like we are heading into a soft economy. Of course a soft economy may lead to a recession and that recession can have all kinds of lengths and depths which may or may not be meaningful to all of us income investors. So as I write this article be mindful that I am talking in generalities, because we have no ability to forecast recessions and certainly we can’t forecast the depth of something we can’t even see coming.
BDCs were originally created in 1980 through amendments to the SEC Investment Company Act of 1940. This is the segment of law which regulates BDCs. The “Act” regulates all regulated investment companies (RICs)–most BDCs are organized RICs.
BDCs typically lend to private companies at generally high interest rates (potential risk equals potential reward)–this alone should speak to the risk to the investor. When we say high interest rates we mean relative to what many public companies can borrow at–meaning the BDC lends at 8% on up.
Some of the basics of BDCs is that they must pay out 90% of their taxable income as dividends–pretty much like a REIT. They must have 70% of the investments in companies that are in the United States and the investments may be either debt or equity. BDCs invest primarily in private companies that normally us little investors don’t have access to for investing–thus they provide us with an added option for our investment dollars. Additionally BDCs are required to provide operational guidance to the companies they invest in. Of course the rules are all more complicated than these very few words.
Publicly traded BDCs are primarily funded through the sale of equity (i.e. common stock), but they are also allowed to sell “senior securities” to fund their investments. “Senior securities” are primarily preferred stock or debt — they are called senior securities because they are senior to the common equity. The BDC uses these senior securities as leverage in the hope of realizing gains that provide a return that is superior to the cost of the leverage.
With the above in mind investors should realize that Business Development Companies did not really begin to take off until after 2000 thus the notation by some that a bdc has never gone broke should be tempered by the very short operating history of most of these companies. While some BDCs were formed in the 1990’s critical mass was not reached until much later.
Here is a random look at a few BDCs and their formation years.
- Gladstone Capital 2001
- Hercules Capital 2003
- Fidus Investment 2007
- THL Credit 2007
- Newtek Mid 1990s as a C Corp converted to BDC 2014
So you can see that these are new businesses–not the food companies or utilities which have been in existence since 1900 (or some such date).
Normally when I write words of caution on BDCs I do so with the limited history of these companies in mind. I also warn that BDCs hold debt/equity of small companies and these assets may not be able to be valued day to day with any degree of certainty. These would be what are called “level 3” assets. Level 1 assets are those traded on a stock exchange or a bond market where asset values can be observed on a regular basis. Level 2 assets are those that don’t have a marketplace where the specific asset can be valued, but values can be assigned by comparing the assets to similar assets that do have an observable value. Level 3 assets–which is what BDCs generally hold –are the hardest to value and are generally very illiquid. The BDC is required to mark to market continuously and thus I call these the “trust me” assets. I mean that we have to trust management to assign the correct value to these assets. If they overstate the value the companies net asset value (NAV) may be incorrect which would mislead us investors. Additionally if the company overstates the asset values they may be in violation of “leverage” rules.
Up until recently BDCs generally were required to maintain asset coverage ratios of 200%. So they needed $2 in assets to cover $1 of senior securities outstanding. This makes us income investors “feel good”. Even if the assets were overstated by the company in theory holders of senior securities are well covered–meaning in liquidation they would be made whole. Now most BDCs are using the newer coverage ratio of 150% ($1.50 in assets for every $1 in senior securities)–in theory the companies are not as safe using higher leverage. Of course each company is different and you will have to check into the status of each company.
So when I caution on these companies it is because of the short operating history of the companies, the level 3 assets they hold and because of the increased leverage they are now able to use.
So how does an investor know what assets the company holds? These BDCs are required to publish a schedule of investments at least quarterly. This means all the data is available in the SEC filings. It is likely you can access the data on the company website as well–but we like to go to the official SEC documents.
Below is a link to the schedule of investments for Gladstone Capital (we use this since we own some of their term preferreds).
You will note that you likely don’t recognize any of the companies listed–these are typically fairly small companies so they are reconized in their own communities, but not globally. You will note also there is a “cost” column and then a “fair value” column. The fair value column is mostly the “trust me” column.
Here is the link to the SEC Edgar company search page. Everything is available here–more than you ever wanted to know.
So in summary BDC baby bonds and term preferreds are, in general, just fine to hold most of the time. In fact a large chunk of what we own are both of these types of investments. BUT if the economy softens as investors we need to watch the financials of these companies closely–not exit the investment–but be aware of issues they are starting to encounter. If we move into a recession (not if really–but when) I believe it is very likely that some BDC will go belly up. Which one that would be I have no idea, but it will be a time where the really skilled management will stand out–and those just riding the economic growth wave will be shown to be inadequate for the task.