Over the last few years, business development companies (BDCs) have become significant players in the world of specialty commercial finance. BDCs have provided debt capital to equipment financing companies and other niche lenders. They have invested equity capital or acquired 100% stakes in asset-based lenders and other financial services firms. And today, many banks and finance companies compete directly with BDCs for commercial loans.
Background of the BDC Model
The BDC model, which was created by Congress in 1980 via an amendment to the Investment Company Act of 1940, is most typically a publicly traded investment company that provides financing to small, medium and in some cases large businesses across the United States. Many BDCs specialize in providing first-lien senior loans to cash flow generating borrowers across a wide variety of industry sectors, often in support of a financial sponsor’s buyout. Others specialize in specific industries like technology or healthcare. BDCs are either internally managed by a team of professionals who work at the BDC or they are externally managed by a management company that exists to administer the BDC.
The BDC model is unique in that it typically pays out at least 90% of its net operating income, like a REIT, without paying federal income tax. As a result, BDCs are attractive investment opportunities for yield-seeking retail and institutional investors – most BDC stocks generate dividend yields of 8% to 14% – particularly in volatile equity markets like those that existed coming out of the most recent recession and to some extent exist today. Not surprisingly, the BDC sector raised billions of dollars of capital over the last few years as investors flocked to yield in lieu of the risk that comes from investing in growth stocks.
While the tax and dividend advantages are attractive, the flip side of the equation is that a BDC’s leverage is capped at a 1-to-1 ratio of debt to equity. Therefore, a BDC does not have the same ability to turn a low return on assets into a high return on equity like a bank or non-bank finance company with access to efficient leverage. Further, limitations exist around the amount of a BDC’s investment portfolio that can be invested into non-BDC eligible asset classes, specialty finance company investments being an example of a “bad asset.” This can be partially mitigated when a BDC structures its investment in a specialty finance company as a portfolio company, much like a private equity buyer would, whereby the equity invested by the BDC can in fact be levered at a greater ratio than the 1-to-1 limitation at the BDC level.
When you put it all together, a BDC is generally focused on deriving consistent return on investment in the form of interest income or dividend income off of investments in portfolio or platform companies. Portfolio growth is great, but consistent quarterly earnings might be even more important so that the BDC can keep paying a consistent, or growing, dividend. If a BDC can generate a mid-teens return on their investment capital, whether in the form of a debt or equity investment, the BDC should be able to deliver the proper return to its public company shareholders.
BDCs as a Buyer for Commercial Finance Companies
BDCs offer an interesting prospect for the independent finance company’s management team in a sale scenario. They are, in essence, publicly traded private equity firms who often incentivize their portfolio company management teams with incentive compensation such as stock options, restricted stock or long-term retention bonus pools. Unlike a private equity buyer, a BDC has access to permanent capital via its publicly traded stock, and it typically does not have the investor pressure to sell its investment in a portfolio company the way a financial sponsor typically would.
A 10% to 15% return hurdle is far lower than the typical private equity firm’s hurdle of 20% or more, which means a BDC, if it is so inclined, can be more competitive on investment price and structure than many private equity firms. Like a private equity buyer, many BDC investors will allow a target company management team to continue to run the platform it acquired with minimal operational oversight, providing greater autonomy to the acquired company’s management team.
BDC Dependability on the Capital Markets
In addition to the aforementioned leverage limitations facing the BDC model, a greater issue facing the sector is the substantial dependence on the capital markets for growth. Given the 1-to-1 leverage cap, a BDC needs fresh equity capital to support growth in its portfolio. Thus, the strength of a BDC’s stock is critical when it sets out to raise equity capital.
Currently, the BDC peer group is not only trading about 8% off of where it was in June 2014 on average, many BDCs are trading below tangible book value (average price/tangible book value of 90%), making the prospect of raising equity capital a dilutive proposition (Source: SNL Financial LC). Without fresh equity capital coming into the BDC, a BDC generally cannot grow since it does not retain earnings with which to invest in new assets. And without growth, a BDC will be challenged to grow its earnings which impacts its ability to raise dividends and increase share price. This dynamic is playing out currently with several companies in the BDC sector.
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