A Street model portfolio discussion: business development companies

Investors searching for yield have recently discovered private lending businesses that currently yield approximately 7-10%. We at A Street Investments have been following this space for quite some time and have been allocating to business development companies (“BDCs”) since 2009. Contrary to popular opinion, the highly publicized low-yield environment fostered by Ben Bernanke and the Federal Reserve exists only for firms large enough to borrow in public markets. For small and mid-sized businesses, loans are increasingly hard to secure and have been anything but cheap. This is a direct result of the banking industry’s attempts to repair its balance sheets (following mortgage related losses) and the new regulations that force the banking industry to improve capital ratios. This means fewer risky loans, which in turn creates the perfect void for BDCs.

Times have rarely been better for providers of capital into the small-and-mid size segment for two primary reasons: (1) supply and demand dynamics favor lenders, and (2) the crop of businesses is healthy as the weakest have been thinned out by the recent recession.

It appears that the current underwriting environment will persist as the formation of new entities (BDCs, CLOs, private equity funds, hedge funds, etc.) and raising capital to lend into this market can only progress so fast. Unlike banks, the alternative providers of credit are limited to the extent they can leverage their balance sheets, i.e., a $1 raised by a private equity fund does not go as far as $1 raised by a bank in terms of loans originated. Accordingly, it is going to take years for there to be enough capital chasing the borrowers to force pricing in line with the public markets.

Increasing the appeal of BDC loan books is the fact that they tend to be relatively senior among borrower obligations and their terms predominantly call for floating interest rates. When the Federal Reserve finally changes course and rates find their natural level, which will inevitably be higher than where they currently stand, BDC loans by and large will not be affected.

Investors must keep in mind, however, that BDCs are not without risk. They use leverage, with a legal limit of 1:1, which amplifies the effects of excessive risk-taking. Furthermore, pricing volatility can sometimes disconnect from underlying performance of their loan books. During the financial crisis of 2008, for example some BDCs were exposed for their overly aggressive lending practices, and their investors suffered large losses. It should be noted, that during this time many prudent lenders also saw their prices plunge. It was left to the investor to determine which variety (prudent or risky) she had invested with and whether or not to stay the course. Since 2008, however, the environment has changed dramatically and scrutiny of BDC loan books has risen, making today’s distributions and valuations more fundamentally sound.

What makes leverage attractive is the fact that many BDCs can presently borrow at around 6% (or 3.5%, if they use government-subsidized funds for small businesses) and lend at 10%. We believe leverage can be a great asset when in the hands of experienced and talented managers. Some BDCs have exhibited prudent lending track records, and industry wide BDCs have managed to keep loan-loss rates at about 0.7% a year of capital deployed, a figure below that of commercial banks.

Recent mentions of BDCs in the press:

“The Federal Reserve’s campaign to drive interest rates into the ground is only partially successful. True, Chairman Bernanke has succeeded in snatching the “income” from “fixed income” and the “yield” from “high yield.” But he has not entirely suppressed the interest rates at which small and medium-size businesses borrow from non-banks.”

– Grant’s Interest Rate Observer, October 19, 2012

Timothy Walsh, Chief Investment Officer of the $70 billion New Jersey Pension Fund recently presented at the Grant’s Spring Conference and had this to say about today’s interest rate environment: “Dodd- Frank, Basel III, the implosion of the bank balance sheets, I call it the gift that keeps on giving to pension funds like ourselves. We participate in this in a couple of ways. Number one, we’ve been pretty active in direct lending. One of my biggest regrets is [that] we didn’t have a ‘1’ or ‘2’ in front of that $600 million we did 18 months ago, because it’s been wildly successful. We have a current yield, very conservatively estimated at 10%. You can participate through public BDCs.”

–Grant’s Interest Rate Observer, April 19, 2013

High-yield bonds aren’t the only way to get decent income these days. The stocks of “business-development companies” can offer higher yields and greater safety.

Business-development companies, or BDCs, make loans to small and midsize businesses and pass the interest on to shareholders as income. They trade like stocks, much like their pass-through investment siblings, real-estate investment trusts and master limited partnerships. Many BDC loans are “senior secured” debt, meaning that in the event of bankruptcy, they must be paid before [less senior obligations]. Also, many BDC loans carry floating interest rates. That puts them at lower risk of price declines if rates broadly rise.

In addition, BDCs have relatively little competition. Their customers are generally too small to tap the bond market, and commercial banks are finding such lending less attractive in the wake of new capital requirements.

–“A Smart Alternative to Junk Bonds”, Barron’s, April 22, 2013

A Street Long-Term Model Portfolio asset allocation as of May 1, 2013\

Asset Class Allocation

Alternative Strategies15%

Equities35%

Fixed Income:31%

Core Bond Market8%

Asset Backed Securities8%

High Yield / Opportunistic5%

BDCs/Private Lending 4%

Treasuries & Cash4%

Emerging Market Bonds2%

Real Assets19%

BDCs currently in the A Street long-term model portfolio:

Ares Capital / ARCC
Golub Capital / GBDC
Blackrock Kelso Capital / BKCC

** The opinions expressed in this article are for informational purposes only and should not be construed as investment advice. The article is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. The research for this article is based on public information that we consider reliable, but we do not represent that the research or the report is accurate or complete, and it should not be relied on as such. The views and opinions expressed in this article are current as of the date of this article and are subject to change.

*** The targets described on the above are subject to change. A Street Investments may at any time adjust, increase, decrease or eliminate any of the targets, depending on, among other things, conditions and trends, general economic conditions and changes in A Street Investments’s investment philosophy, strategy and expectations regarding the focus, techniques and activities of its strategy.