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BDC Boot Camp: An Introduction to Business Development Companies

October 1, 2014

privateequityOur firm has been zeroing in on BDCs for most of 2014; adding them to our CEF Universe data and news / SEC filing coverage, our Monthly Best Ideas List, launching a managed BDC account in September or partnering with a UIT provider for a BDC UIT for November. The similarities between traditional CEFs and BDCs are what initially drew us to the structure.  However, it is important to understand both the similarities and differences in order to decide how and/or when to invest in a BDC.  We hope this article will help prepare you to be able to do this.  We will begin by discussing the origin of BDCs. This article is a companion to the video we recently released on BDC funds. www.vimeo.com/johncolescott/bdc-boot-camp

A Business Development Company is a closed-end fund that is publically listed, with exposure to private equity investments.  BDCs were created by Congress in 1980 as an amendment to the 40 Act and are required to own 70%+ of US small to midsized businesses; they can make both debt and equity investments in private or thinly traded companies as long as they are under $250M market capitalization for the 70% exposure.

Like CEFs, BDCs, as regulated investment companies, receive tax beneficial treatment, as defined by the Investment Company Act, as long as they pass on 90%+ of their income to shareholders. They are regulated by the SEC and file 10-Qs, 10-Ks and 8-Ks.  BDCs also must have a majority of independent directors, offer to provide managerial assistance to their portfolio companies, place securities at a custodian and provide and maintain a Fidelity Bond to protect the company from larceny and embezzlement. They must maintain a code of ethics and a comprehensive compliance program, and are prohibited from most affiliated transactions.  Historically on average about 10% of filers get reviewed by the SEC each year. For BDCs, some years it is none and some years it has been half the funds in existence.  We hear the SEC will be increasing audits as more investors use BDCs for their portfolios.  In addition, BDCs are similar to venture capital or private equity as they provide a vehicle for investors to invest in small or private companies without having to be accredited investors.

This introduction to the history of why the BDC sector was created demonstrates how retail investors were the intended benefactors.  However, it is also important to know what characteristics are common among well performing funds, in order to be able to choose the one(s) that are right for your portfolio.  With a rising rate environment around the corner it is better to begin your education on this sector sooner rather than later.

Forty-two of the fifty-one publicly listed BDCs are debt-based, or have 66.6%+ debt investments according to our definition, and have an average yield of 9.7% as of September 19, 2014.  That is why it is important for investors to know what is normal for debt-based BDCs. The average fund is showing 91% dividend coverage from Net Investment Income and 90% debt assets in their portfolio.  The average fund has $696M in market capitalization and trades on average $6.4M dollars a day. When compared to traditional taxable CEFs, the debt-based BDCs are generally more liquid; 44% of traditional taxable funds trade under $1M per day, with an average of $1.3M per day in liquidity versus only 25% of debt-based BDCs trade under $1M per day.  Discounts are currently at an average of par. Premiums are normal for Debt BDCs; current +0% levels vs. a one year average of +4.5% and a three year average of +2.3% demonstrates this claim.  90% of the 9.7% avg. yield of debt-based BDCs is short-term gains and therefore they should not be considered tax-sensitive vehicles.

BDCs handled rising rates well in the past and we anticipate that they will also do so the next time around.  There was a 4.5% yield increases, on average, for the 5 Deb-based BDCs that existed from March 2004 to September 2007 when 30-Day Libor went up over 4%.  The average market price TR was about 32% vs. the S&P 500 was up 42% over the same time period. For some of these funds, like for other dividend-focused investments, when rates rise investors often pull back and prices can initially decline.  Plus, many BDCs have Libor floors that are currently beneficial, but will cause a short-term lag to performance on their portfolios when rates rise.  However, many of the BDCs we like have a significant amount of their leverage that is fixed (normal is about half) and assets that are variable or floating.  Therefore, for most funds, after the first 1% move in Libor, the trends should generally be favorable.

Manager due-diligence and portfolio analysis is important in selecting a BDC because NAV is only updated quarterly.  For example, this quarter there was about a 5 week period from the end of July through the first week of September when NAV/Earrings were updated for BDCs. However, the busiest part of the quarter is the two week period from the beginning of the second month of a quarter when 80% of BDCs announce their NAV/Earnings.  For reference, when looking at the 35 Debt-based BDCs that have been around for over a year, with 4 NAVs posted, the top quartile has an average NAV total return of +16.8% vs. an average of +1.2% for the bottom quartile.

The due-diligence process for a BDC often demands a significant amount of time and money. One of the larger BDCs shared with us that they spend $500K to produce their NAV each quarter and it is a document well over 2000 pages. As the positions held by BDCs are usually non-traded and private in nature, it is hard to have any outside perspective on what it is worth independent of the BDC’s evaluation.  As a result, it is important to select portfolio managers that have experience in how to properly structure deals, to offset the perceived risk of their Fund.

Some of the risks for BDCs are the same as those that need to be considered before investing in CEFs, and some are unique.  Like with traditional CEFs you are buying exposure to active management, permeant capital and getting daily liquidity.  The following figures should give you a basic understanding of a range of data points that can be used to analyze BDCs and what conclusions we take from them.

The average 1 year standard deviation for BDCs is 18, with a range of 11-29.   Seven BDCs are under one year old.  There has been a 20% increase in debt-based BDCs from a year ago.  Over the past 10 years, the average BDC IPO has raised $138M.  This is the first year we have seen IPOs over $1B with $3.3B in 6 deals. Over the last 5 years there has been an average of 4-7 New BDCs or 1-2 per quarter.  The average BDC has added $500M in assets above its IPO (2.5X IPO assets) while paying a high dividend level, generally through the use of secondary offerings to shareholders.

When considering expense ratios, if you use the same formulas for BDCs as are used for Traditional CEFs, total operating cost vs. average net assets, the average cost is 9%, while Traditional Taxable CEFs average 1.7%. But you are getting liquid access to investment typically requiring accreditation and the manager has permanent capital to focus on long-term investment decisions.  Year-to-date on average NAVs are up +6.4%, the 1 year figure is up +10% and the 3 year figure is up +30%, but it is important to note that 90%+ of that is yield.  In addition, market total returns are up +0.6% YTD, the 1 Year figure is up 3% and the 3 year figure is up +46%. This demonstrates that market returns are currently lagging but NAVs have outperformed over a longer period.

How is leverage different for a BDC vs. a CEF?  Leverage figures, for BDCs, average 36-37% with about 5 funds falling under the 20% leverage level and 21 funds having leverage over 40%, even as high as 50%+ if you include their SBIC facilities.  On average, 44% of the leverage used by BDCs is fixed and the rest is variable leverage. About ¼ of BDCs use only variable leverage and ¼ use 85%+ fixed leverage and then the rest of BDCs use a healthy mix of both types of leverage.  The cost of leverage for traditional taxable CEFs averages 1.8%, whereas, at 3.3%, BDCs average about two times that amount.  This is not surprising based on the types of investments they make.

Now is a very exciting time to be interested in this established but underutilized investment structure.  We expect to see valuations for debt-BDCs to average 1.1 times book, or an average of a 10% premium to NAV. This level should be common and sustainable for this group of funds overtime. Tax-deferred accounts, including IRAs, are good vehicles to put BDCs in.  Investors can get access to unique and exceptional managers, five times the current liquidity of traditional CEFs and potential for yield increases in a rising rate environment.

One of the reasons we are optimistic is that we expect the demographics of BDC investors to shift in the next couple of years. Currently 21% of the shares of traditional taxable CEFs are held by 13 filers vs. only 9% of BDC shares.  However, we do see this gap narrowing in the next 2-3 years; we see a 15-20% shift in BDC share ownership, taking 13 filers up to the 25-30% range.  As the number of shares of BDC held by 13 filers increases, we expect to see fee costs trend down as these investors will push harder on BDCs than retail investors and financial advisors typically have.

Disclosure: The views and opinions herein are as of the date of publication and are subject to change at any time based upon market movements or other conditions. None of the information contained herein should be constructed as an offer to buy or sell securities or as recommendations. Performance results shown should, under no circumstances, be construed as an indication of future performance. Data, while obtained from sources we believe to be reliable, cannot be guaranteed. Data, unless otherwise stated comes from the September 19, 2014 issue of our CEF Universe service.

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