RiverNorth's Perspective On Business Development Companies (BDCs)
Portfolio Specialist Allen Webb talks to Senior Investment Analyst Andrew Kerai about RiverNorth's view on business development companies.
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ALLEN: Today I’m joined by senior investment analyst Andrew Kerai to talk about business development companies. So, Andrew, many of our investors and viewers have probably noticed the term business development company, or BDC, on a RiverNorth fact sheet or a pitch book, so can you start off by telling us exactly, what is a business development company?
ANDREW: Sure. So business development companies, or BDCs, are closed-end regulated investment companies formed by Congress in 1980. The purpose was to basically create a fund structure to provide capital to small and mid-size private U.S. businesses, while also providing investors the ability to participate in private capital markets.
ALLEN: Andrew, maybe give us a history lesson on the history of BDCs up through today, and also touch on the size of the market and the number of BDCs that are out there.
ANDREW: Sure. Although the structure was created in 1980, basically BDCs do a lot of what the smaller community banks used to do, which was you had a small mid-size private business in the U.S. They needed a loan to finance an acquisition, etc. They would go to their community banker, who they knew well. It was faster certainty of close, in terms that made sense for both parties. What’s happened in the banking market overall, post-crisis, is that through a number of regulations – Basel III being phased in, the Volcker rule, the amount of capital, or I should say the punative capital treatment for level III assets – banks have largely exited middle-market lending, which has created sort of a lending gap or a void in that market. As a result, BDCs went from, in 2003, a handful of issuers, roughly $4 billion in assets to now what’s about a $60 billion AUM market. Currently, the universe for BDC, as I mentioned, about $60 billion or so in assets, roughly 50 issuers, call it about $30 billion of market cap. Historically, the sector has typically traded around NAV, now they’ve traded at a discount for some time.
ALLEN: Andrew, to make sure I understand, a business develop company is a public security...
ALLEN: ...that is in the business of making middle-market loans to other businesses.
ANDREW: Sure. And, just to clarify, we’re talking about the public universe of BDCs. There is private capital and non-traded private BDCs as well, but what we primarily look at would be the public universe of BDCs, which is 50 issuers and about $30 billion market cap.
ALLEN: So, for an investment manager like RiverNorth or others have interest in closed-end funds, and who use closed-end funds in their strategy, what about BDCs is interesting, and why are they sort of thought of in the same area or arena as a closed-end fund?
ANDREW: I think the structure of a BDC, in and of itself, makes it an obvious cousin of your typical closed-end fund. Again, closed-end structure, the capital is raised through an IPO, follow-on offerings, unlike an open-end mutual fund where there are redemptions directly from the fund, this is capital that is raised in the public markets through investors that is permanent capital. To that extent, closed-end funds and BDCs are very alike in just their underlying structure as a fund. I think what’s interesting about BDCs compared to your typical closed-end fund is the amount of alpha opportunity from diligence in the underlying portfolios. If you’re looking at a bank loan fund, that's just your typical closed-end bank loan fund, the NAV is something that you take as an input, right? It’s struck daily, the assets are liquid. The NAV for BDCs is anything but an input. The NAV is, in my view, the most important estimate that one has to make when buying a BDC, which is just a different way of saying an estimate of what the portfolio is really worth. I think it’s much more of a bottom-up exercise in terms of analyzing the portfolio holdings, and determining a fair value based on 1) the portfolio holdings, and 2) the quality of the manager.
ALLEN: If I hear you correctly, I think you’re saying we know the price, the NAV is published quarterly by the company, but there is some art to valuing that portfolio on your own.
ALLEN: And your ability to do that can create some trading or alpha opportunities just by being either good at that, determining that value, or just doing your homework.
ANDREW: That’s exactly right. Or, said differently, if you find a BDC trading at a large enough discount, the question you have to answer is, is that discount real or is it not? Has something changed in a quarter? Figuring that out can lead to, in my view, significant alpha opportunities that would not necessarily exist in a product with a more liquid portfolio.
ALLEN: As an investor, if I buy a BDC, what am I actually buying? Am I buying a fund? Am I buying a company with a loan portfolio? What would I be buying as an investor?
ANDREW: I think certainly the BDC market is diverse, meaning that you have certain BDCs that are basically purely sponsored - by sponsored, I mean there is a private equity sponsor that owns the underlying portfolio company - of sponsored loans, 100 percent senior secured, and then you have BDCs that are more focused on mezzanine investments, some have equity upsides, some participate in structured products or leveraged products like CLO equity. So I think there’s a diverse range of the BDC market to look at the market overall in kind of a market cap basis, but 70 percent, roughly, is going to be senior secured loans, first and second lien, with the balance being mezz, structured products and equity. Within the BDC market, you have to evaluate fund by fund. Think you’re not only underwriting the portfolio, but you’re also underwriting the manager as well, too. In terms of picking a manager that you like, a portfolio that you like, and of course the valuation level you feel is appropriate. By virtue of transparency, they have to list their schedule of investments that they have to update quarterly, so you can see exactly what you are buying, at least in terms of name by name and position in the capital structure when you invest in a BDC.
ALLEN: So let’s talk about that last piece for a second. Because the investments are publicly listed, is that how you determine the book value or the net asset value for the underlying BDC portfolio?
ANDREW: The challenge with owning a BDC, or what I will call your typical BDC, is that the majority of the assets in the portfolio are non-quoted, there’s no public bid. The challenge is, I guess, as an investor trying to determine the quality of net asset value, which is of course not a challenge for a closed-end fund or a bank loan closed-end fund where you see bids and they strike a NAV daily. The process of valuing or, I guess, just to give some context on how BDCs do strike a NAV every quarter, the typical valuation process is, the BDCs, to the extent that they have directly originated the credit, will get financials from the borrower or you will have a third-party valuation firm come and value the assets. Based on the value of the assets relative to par, that is how the NAV will move. Unlike a bank, which will take a loan-loss reserve, for example, that is based on the expected charge-off rate, the expected 4- or 12-month charge-off rate, a BDC will adjust the fair value of a loan portfolio to reflect what they feel is an appropriate price for each one of the loans based on the yield of market comps.
ALLEN: The BDC is publishing a net asset value quarterly.
ANDREW: That’s correct.
ALLEN: And the market price trades in the marketplace daily.
ALLEN: So I’m assuming that then creates some type of discount or premium mechanism for you to evaluate as a potential investor.
ANDREW: Sure, that’s exactly right. I think one of the challenges, certainly, compared to a bank loan fund, for example, which would probably be the most relevant comp, is that obviously you are trading off a NAV that changes daily for bank loan funds. You have a NAV that is fluid and moving, and you can see what the true discount is. A challenge or opportunity in the BDC market is to figure out relative to where the NAV was a quarter ago, where a true NAV would be today, which is why, for example, during the crisis, when you saw BDC discounts-to-book reach 60 to 70 percent, they really weren’t 60 or 70 percent discounts because the NAV had moved 10 to 15 percent in a quarter. In my view, that’s an opportunity because if you’re there doing the bottom-up diligence work and you can see how that NAV should have moved in a quarter, it creates an opportunity to trade around that when you see misprices in the market.
ALLEN: Andrew, you mentioned the wide discounts in the 2008 credit crisis. Can you give us a sense of the range of discounts to NAV or to book that BDCs have traded historically?
ANDREW: Oh sure, the range is extremely wide. At one point – and again, this is a very limited data set... pre-crisis we had only a handful of BDCs, two of which are actually no longer public - they were acquired during the crisis, but they traded up to 40 percent premium pre-crisis, and traded all the way down to 60 percent discounts during the crisis. Again, these would be discounts, just to be clear, off of the last stated NAV. Obviously, in the crisis you had NAVs that were moving in a pretty volatile fashion. It may not have been a true number that reflected a live NAV.
ALLEN: Andrew, how about some attributes of business development companies from a yield perspective, maybe a leverage perspective and even fees.
ANDREW: If you were to construct a market cap-weighted BDC portfolio, you would effectively be buying, for the most part, a portfolio of loans that are senior in the capital structure, although don’t have as much asset protection, but from a cash flow perspective are going to be inside of what you’re going to find in the liquid markets with much wider spreads.
ALLEN: That would yield what?
ANDREW: The weighted average yield right now for BDCs is about – including OID and origination fees – about 11 percent. The coupon on those assets are about LIBOR +950 [basis points].
ALLEN: Leverage and fees. What type of leverage do you acquire by owning a BDC or BDC portfolio?
ANDREW: In a market cap-weighted basis, which has been the case for a few quarters now that BDCs have basically been out of the capital markets from a valuation perspective, leverage is about .7 debt-to-equity. By regulatory requirement, under the '40 Act, BDCs are not permitted to have more than one times debt-to-equity, which is an advantage from a risk standpoint compared to your typical bank, which is typically going to be levered nine or ten-to-one. Leverage is capped at one times debt-to-equity. The average BDC is at about .7 right now. Fees, certainly a hot-button issue in this sector, and I would say rightfully so. Your fees, again, a pretty wide range. The old BDC model was 2-20, now that is the range from one and three eights on a base management fee to 2 percent. Pretty standard on the incentive fee, 20 percent of net investment income – which is just your net operating income excluding your credit costs - with a 7 or 8 percent hurdle. Another side of the fee structure that is very interesting now is that BDCs traditionally have not put in what I will call a total return high watermark, which means that traditionally BDCs, when calculating the net operating income incentive fee, it would just be on net operating income. Meaning, if you generate an 8 percent return on your equity base and you had a 7 percent hurdle, you would clip the incentive fee regardless of whatever credit losses came in during the quarter. A total return high watermark basically says, we’re going to net what’s known as unrealized depreciation, or realized and unrealized losses, which is a BDC marking to market its portfolio every quarter. That’s netted against your operating income to come up with a total return return-on-equity to determine the incentive you paid to the manager.
ALLEN: Andrew, thanks for joining us today.
ANDREW: My pleasure. Thank you, Allen.
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Video recorded 3.22.2016.
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Past performance is not a guarantee of future results. Diversification does not ensure a profit or guarantee against loss.
Investing involves risk. Principal loss is possible.
The price at which a closed-end fund/BDC trades often varies from its NAV. Some funds have market prices below their net asset values - referred to as a discount. Conversely, some funds have market prices above their net asset values - referred to as a premium.
Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value.
A floating interest rate is an interest rate that is allowed to move up and down with the rest of the market or along with an index.
The financial crisis of 2007–08, also known as the global financial crisis and the 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.
Basel III is a comprehensive set of reform measures designed to improve the regulation, supervision and risk management within the banking sector.
The Volcker Rule is a federal regulation that prohibits banks from conducting certain investment activities with their own accounts, and limits their ownership of and relationship with hedge funds and private equity funds.
Level 3 assets are assets whose fair value cannot be determined by using observable measures, such as market prices or models. Level 3 assets are typically very illiquid, and fair values can only be calculated using estimates or risk-adjusted value ranges.
Market Capitalization (Market Cap) is the total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying a company's shares outstanding by the current market price of one share.
An Initial Public Offering (IPO) is the first sale of stock by a private company to the public.
A follow-on offering is an issue of shares of stock that comes after a company has already issued an initial public offering (IPO).
Alpha is a measure of performance on a risk-adjusted basis. The excess return of a fund relative to the return of the benchmark index is a fund's alpha.
A senior bank loan is a debt financing obligation issued by a bank or similar financial institution to a company or individual that holds legal claim to the borrower's assets above all other debt obligations. The loan is considered senior to all other claims against the borrower, which means that in the event of a bankruptcy the senior bank loan is the first to be repaid, before all other interested parties receive repayment.
A lien is the legal right of a creditor to sell the collateral property of a debtor who fails to meet the obligations of a loan contract.
Mezzanine financing is a hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. Mezzanine financing is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full.
Book value is the value at which an asset is carried on a balance sheet.
A bid is an offer made by an investor, a trader or a dealer to buy a security. The bid will stipulate both the price at which the buyer is willing to purchase the security and the quantity to be purchased.
At par is a term that refers to a bond, preferred stock or other debt obligation that is trading at its face value.
Loan loss reserves are accounting entries banks make to cover estimated losses on loans due to defaults and nonpayment.
Charge-off rate represents the amount of debt that is believed will never be collected compared to average receivables.
An original issue discount (OID) is the discount from par value at the time that a bond or other debt instrument is issued. It is the difference between the stated redemption price at maturity and the issue price.
Coupon is the annual interest rate paid on a bond/loan.
LIBOR is the world’s most widely-used benchmark for short-term interest rates. It serves as the primary indicator for the average rate at which banks that contribute to the determination of LIBOR may obtain short-term loans in the London interbank market. LIBOR+950 refers to the current LIBOR rate plus 950 basis points.
Debt/Equity Ratio is a debt ratio used to measure a company's financial leverage, calculated by dividing a company’s total liabilities by its stockholders' equity. The D/E ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity.
Two and Twenty is a fee structure that charges a flat 2% of total asset value as a base management fee and an additional 20% of any profits earned.
Incentive fees are typically dependent upon the manager's performance over a given period and are usually taken in relation to a benchmark index.
Hurdle rate refers to the rate of return that the fund manager must beat before collecting incentive fees.
A high-water mark is the highest peak in value that an investment fund/account has reached. The high-water mark ensures that the manager does not get paid large sums for poor performance.
Depreciation is a decrease in an asset's value caused by unfavorable market conditions.