Business-development companies were late bloomers that didn’t really begin to mature until they were nearly 40 years old. Conceived as a tool to spur US economic growth, they have been around since Congress passed the Small Business Investment Incentive Act of 1980, thereby amending the Investment Company Act of 1940 and allowing for the new structure. But they didn’t really take off until Congress passed the Small Business Credit Availability Act in 2018, freeing BDCs to boost their yields with more financial leverage.
The first incarnation of BDCs shared some features with closed-end funds, coming to market with a fixed number of shares to trade among investors on an exchange. The second BDC design echoed a “continuously offered closed-end fund” innovation from the 1990s: So-called nontraded, or unlisted, BDCs came on the scene in 2009, allowing investors to buy shares and request repurchases on a limited but periodic basis. The number of shares, in other words, was no longer fixed, allowing asset managers to sell them continuously.
That timing wasn’t a coincidence. Regulatory changes following the 2008 financial crisis made investing in loans to smaller companies less appealing to banks. That opened a crack in the marketplace for nonbank financial companies to fill by selling BDCs to investors and using their assets to extend loans that would have been the province of banks in the precrisis era. Those loans are comparatively small and often held to maturity, which made selling BDCs in a nontraded structure a no-brainer. They still impose significant limits on large, unexpected outflows but allow asset managers to sell as many new shares as often as possible. Picking up the ability to use more leverage in 2018, however, led to massive growth.
BDCs’ similarity to other 1940 Act-sanctioned investments only goes so far, and their differences have the potential to generate higher returns—and much more risk. It’s worth keeping an eye on some of the most important distinctions. Here are eight of them:
A Very Narrow Universe
Unlisted, or nontraded, BDCs do share some features with other regulated investment vehicles, but they also have a very unusual regulatory restriction: They are required to hold at least 70% of their assets in US companies that aren’t listed on a national securities exchange, or if they are, only those with market caps below $250 million; they can invest in distressed, or bankrupt companies, too.
That means their primary hunting grounds are so-called middle-market borrowers. Depending on whom you ask, they can be companies with anywhere from $25 million to $500 million in EBITDA (earnings before interest, taxes, depreciation, and amortization; a commonly used measuring stick for heavily leveraged borrowers). A lot of them tend to cluster somewhere in the $50 million to $150 million EBITDA range, and while there are no rules about where to invest in a company’s capital structure, most nontraded BDCs have a little equity exposure but primarily invest in debt.
BDCs Focus on Private, Direct Lending
Private loans are generally arranged by nonbank financial companies (including many that run BDCs) directly with borrowers, and there’s usually very little publicly available information about them. That means asset managers do all the legwork of sourcing, due diligence, structuring, and other things normally the province of investment banks. That work is all the more important given that they rarely sell those loans once they’re in portfolios, and there aren’t many other outside indicators of how risky they are. That, and the fact that many BDC managers view their work as proprietary, means many guard their portfolio information. On the other hand, more than a third of the assets held in Morningstar’s direct-lending categories are in companies held by five or more distinct funds, and that’s a conservative estimate given the vagaries of investment structures. Private doesn’t always mean exclusive. Either way, the exclusive nature of the sector still means BDCs can also be much harder for outsiders to analyze and monitor.
You’re Shopping in the Scratch-and-Dent Aisle
The private credit industry touts its role as a savior of middle-market lending that banks gave up following onerous post-2008 financial crisis regulations. What they don’t say is that banks gave up on the most indebted slice of that universe—perhaps 25% to 35% of middle-market companies. In other words, these are leveraged companies that, other than their middling size, share as much in common with high-yield bond and leveraged bank-loan borrowers. A lot of private credit marketing also emphasizes deals with big, higher-quality companies that choose to borrow in private markets for strategic reasons or convenience and are willing to pay higher yields than they would in public markets. But big, highly rated borrowers are at the edges—below-investment-grade quality middle-market loans are the core.
It’s a Private Equity World, You’re Just Lending to It
Private equity firms “sponsor” companies in their portfolios, which make up the bulk of private credit borrowers. The private credit investing titans view that as a virtue because those sponsors usually have more external resources or financing options to invest in their companies, rescue them if they run into trouble, or reinvent their businesses. There are plenty of reasons for skepticism about the motives and practices of private equity managers, but most private credit shops cut their teeth building private equity businesses first. They’re true believers.
Buying Shares May Be Easier Than Selling Them
The big-name nontraded BDCs will allow you to buy shares monthly, but many offer to repurchase shares only once per quarter—typically 5% of the portfolio each time, with flexibility to redeem as much as 7% should they choose. If investors request more than that, the company may prorate their repurchases so that everyone who asked gets some back, but not everything they asked for. Unlike interval funds, BDCs aren’t technically obliged to buy shares back, either, and can halt redemptions completely if they believe that forcing the fund to come up with cash will hurt the portfolio.
Your Asset Manager Decides What Your Investment Is Worth
Most use third-party pricing services to validate marks on their private loans, but there’s room for disagreement. Without comparable public trades to use as a proxy, they rely on so-called unobservable inputs not derived from market activity or corroborated by other means. That’s a labor-intensive accounting exercise of judgment; prices are usually estimated once per month, and they tend not to move much. You can tell how prevalent the practice is in your own BDC from regulatory filings reporting how much of the portfolio is classified as Level 3 for accounting purposes. That designation doesn’t mean something is illiquid, but there’s usually a very strong correlation.
Leverage Is the Coin of the Realm
BDCs don’t usually focus on it in their marketing, but to make their payouts attractive, most BDCs borrow against their portfolios to invest additional money (conceptually, like margin borrowing). As long as the cost of that borrowing is less than the income they bring in from the loans, they can bump up a BDC’s dividends to shareholders. It’s a very alluring strategy, especially when investing in high-yielding, floating-rate loans. Their high yields make it possible to earn plenty of income above and beyond borrowing costs, and the interest rates for that borrowing are tied to the same floating-rate benchmarks the portfolio’s loans use. So even if fixed-rate bond market yields are bouncing around, loan rates reset quickly—effectively neutralizing interest rate risk—in tandem with the cost of the portfolio’s financial leverage.
You’ll Pay for the Privilege of Investing in One
The reality won’t be as bad as the sticker shock you’ll get from their headline expense ratios, because those include the borrowing costs of using leverage. When short-term interest rates are high, that can drive those headline numbers up a lot. Even after stripping out leverage costs, your adjusted expense ratio will still be large. In part, that’s because nearly every nontraded BDC charges a 1.25% management fee, plus “incentive” fees that are linked to how much income and capital gains a portfolio generates. A prototypical BDC might charge 12.5% of its income (using a complex hurdle rate calculation that mitigates your fees if interest rates are extremely low), so when you strip out the cost of leverage, your price tag will still look more like 3% to 4%.
Your manager will argue that’s a bargain given the resources, time, and effort they put in. A higher expense hurdle means a lot more to an income-focused fund with comparatively modest return expectations, though. Incentive fees for debt portfolios also encourage managers to take on a lot more risk in exchange for incrementally larger yields.