Taking a Look at BDCs

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 can see the schedule here.

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.

24 thoughts on “Taking a Look at BDCs”

  1. you get into a speculation situation in the bonds sometimes and they should be treated as such because there is a possibilty for loss. cheap bdc bonds and outcomes would be a very good number for someone to keep track of. maybe everything in the $20 range and under with the outcomes.. Maybe there is a higher degree of risk for the management companies.. no more than 10% speculation is the rule I have borrowed from mining portfolios. (no more than 25% resources)

  2. My 2 cents …………….

    In principle, I like BDCs but that said the implementation is bad in most in cases in MHO. Externally managed entities almost always are run for the benefit of the manager at the expense of the unit owners. Just read the prospectus. There will always be a discussion of conflicts of interest.

    MAIN is the great exception. It’s internally managed and very well managed. It’s a “forever” holding for me. I will add at or near 52-week lows; otherwise I just DRIP. Great holding in a Roth.

    GSBD, for me, is an exception to the externally managed rule. I just don’t see Goldman screwing over the common to its benefit. It’s too small a piece of the pie for them to risk their reputation. There may be other exceptions to the rule but I’ve not done any kind of deep dive to find them.

    I would add that bank loan CEFs are another way to play this asset class. Generally, I prefer them to BDCs. As with any CEF they require close scrutiny. Look first and foremost at the loan portfolio. If you don’t like the portfolio the Z-score, the discount, the fees don’t matter.

  3. Tim
    If I could add a bit to your very helpful introduction to BDCs.

    l. One way to think about them is by the type of business that the focus on.
    this can devide into three groups.
    l. Equity investing with loans. Here you really have Gain and Capital Southwest. Both good and interesting firms.
    2.Then leanders either first or second lien. Here the higher the quality the lower the yield. But first lien lenders such aries do a good job. For me yields of 8 to about 9.5% or 10% generally suggest limited risk depending on othr factors.
    3.Special Situations such as Newt. Newt basically makes very small loans to businesses i.e. average is about 150,00 or so and many are sbac loans which they sell off. The company has lots of moving parts but has done well. I understand in 2008-2009 sbac loans nearly stopped and newt had major problems. They have more diversity now but something to check.

    Also note that because bdc’s have to distribute capital, these are really yield machines with generally limited upside. Not always but often. Many BDCs also regularly issue new capital at or above nav to keep growing. To augment this, several seem to be able to do jvs to provide more liquidity.

    Overall, I try to stay with the higher quality managers to reduce the surprise element. bst sc

  4. Check out the charts for BDCs last year. That one was only fire drill, what if we get a real fire? I do own a couple for yield but am under no illusion the BBB credit rating would protect capital. I have zero interest in buying them at current prices. I just picked up some EE for buyout arbitrage 1 year @ 7% if deal goes through, if not I won a overpriced utility. I like that bet better than buying a BDC.

    1. Hi Gary–hope it was clear. Whole books are written on the subject so this is really just a top line article. I am sure some detail is less clear than I would like.

  5. As I am fairly new to this website I sincerely appreciate all the work you have done and continue to do. It has given me at times a new perspective. I understand the cautious note on the BDCs, agree, and thank you for explaining is so well. I wish I had discovered this informative group sooner.

    1. Ditto. Incredible source of knowledge. Thank you, Tim, and my portfolio thanks you also.

    2. C. Malcolm–always glad to have new folks here. In the end most readers are pretty smart about this stuff–many (maybe most) are a lot smarter than me.

  6. Thanks Tim. You have explained well. I would like to please add one other comment. That is that the “senior securities”, i.e. preferred stock and baby bonds, tend to have limited liquidity themselves. Given a bad 10-Q, 10-K or impairment charge one could expect a plethora of investors with sell orders and few with “buys.” Many buyers are individual retail investors, i.e. NOT institutional. So a BDC market adjustment could be amplified. Then it will be too late.
    Yes, I would have a higher expectation of loan defaults in a business slow down/recession. What is the remedy if the asset ratio falls below 150%? Would the BDC then sell loans with limited liquidity to increase the coverage ratio?

    1. Dave – As I understand it, there would be no choice but to do what’s necessary to get the ratio down by calling or retiring outstanding debt. Though I’ve thought the SBCAA was bad for BDC investors in general, and for baby bond investors even more so, one interesting outcome of the change to 150% is the substantial number of BDCs who have pledge (not obligated themselves) to consider the 150 level as a new way to increase financial flexibility to avoid having to do just that, i.e., being forced to sell at the worst time. Many have told their shareholders that they will aim to not allow themselves to get anywhere near the max allowed in their gameplan, even though they’d increase their leverage from where they were, so that they will be better positioned to absorb recessionary impacts of decreasing credit quality of the leveraged companies they invest in. Of course, the problem with this is you have to take them at their word that they will abide by their self imposed limits below the 150% max, and that, of course, means you have to trust the BDC managers you’re investing in… Tough to do when they’ve been given a giant new ice cream cone and they tell you they won’t eat the whole thing…

      1. ‘Trust but verify’ is an old adage the Russians allegedly say Reagan stole from them. But how can you trust if you can’t verify.

        So, no thanks. I used to own several BDCs in my yield hog days, but it rarely worked out well, so these days I’m sticking primarily with my illiquid ute preferreds. Even though many have lately grown to the sky, I’m holding…

        JMO

        1. camroc–yes I agree with RR. We can go along all fat and happy now–BUT what happens during a recession remains to be written.

        1. Thanks, Tim… I appreciate the link…. In the case of BDCs I hadn’t really given much thought to the selling new equity part of the equation, mainly under the assumption of how difficult that would be, even moreso for a BDC than a Gabelli CEF, in a recessionary environment, but it is another way that the BDC baby bond investor has reasonably strong, yet dimished protection under SBCAA that makes investing in BDC baby bonds a far lesser risk than BDC equity. With the (stupid, irrational) exception in a small position in PFLT, I own no BDC equity and have ceased even buying BDC baby bonds since SBCAA. However, I do own a few that I’m not selling, all essentially of the shorter maturity variety and some with special stories such as GLADN and NEWTZ where the specific language in their prospectuses prevent the companies from utilizing the 150% level without retiring the issues first… I’m also well aware of Gabelli preferreds as I own GLU, GDL and GGO preferreds none of which I consider to be perpetuals.

    2. Dave–good question. Normally they would move into the market and sell common equity to remedy the situation–of course by the time they do that the price has fallen and huge dilution would take place.

      I guess we will know for sure in the next recession.

      I wrote an article on Seeking Alpha years ago about how Gabelli CEFs handled the situation. BDCs and CEFs have similar leverage rules (although the Gabelli funds are all investment grade) and this is how they dealt with plunging equity prices (thus plunging NAV).

      https://seekingalpha.com/article/265958-preferred-shares-of-these-4-cefs-for-a-conservative-outlook

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