We recently travelled to New York City to meet with executives from a group of business development companies (“BDCs”), a diverse category of “other financials” focused on yields. There are over 30 publicly traded BDCs in our investable universe, with market capitalizations ranging from ~$100 mln to several billion dollars. Yields for these financials are generally over 8%.
For background, BDCs make debt (and occasionally equity) investments in middle-market companies, with investments generally diversified across a variety of industries.[1] Similar to REITs, BDCs pay out most of their earnings as dividends, and are usually taxed in a likewise manner.[2] As yield vehicles, the ability for BDCs to cover their declared dividends is paramount to the market. To take into account investor concerns about the sustainability of the payout (i.e. to be conservative), multiple BDCs retain significant realized gains which can be used to cover the dividend during periods of slowing loan growth and/or diminished margins.
BDCs stand to benefit from rising rates, which places them in contrast with their negatively rate-sensitive competitor sub-sector, mortgage REITS (or mREITs, which are highly levered, take significant interest rate risk, and often suffer large mark-to-market losses/declines in book value when rates rise). By contrast, BDCs generally support their yields by taking credit risk and as a result, the sector would benefit from rising rates, as most loans are priced off of LIBOR, which is directly influenced by the Fed Funds rate – which appears set to rise in the next two years. However, the investment community’s general lack of familiarity with the sector, and specifically the lack of understanding in regards to the positive rate sensitivity, is evident as BDCs often trade down during periods of rising rates.
Along with a group of investors and research analysts, we met with management teams from five different business development companies. This tour offered a great opportunity to dig into company specifics and the industry trends of one of the lesser-known/understood yield focused investment vehicles. All meetings covered the following themes:
Credit Cycle: Most management teams stressed the need to be particularly selective with credit these days, although none of the companies we visited stated that they were seeing an increase in defaults in their portfolios. Multiple executives expressed their desire to stay cautious and defensive, and reiterated their strategy to stay near the top of the capital structure with their investments
Loan Originations: The outlook for origination varied significantly amongst the management teams. Multiple tour participants stated that they were on track for record years of originations, while others took a more lukewarm tone in regards to their growth prospects. The reason for the latter seemed not to be for lack of demand, but in regards to the availability of deployable capital and/or credit concerns. Regulations around leveraged lending will prohibit banks from participating in future refinancing, which along with the exit of other competitors (as one management team noted), could lead to increased demand for capital from BDCs in the coming years. Legislation has been proposed to increase the regulated debt-to-equity ratios of BDCs from 1 to 1 to a still conservative 2 to 1, which if passed would significantly increase growth in the sector.
M&A: Consolidation was brought up in nearly every management meeting, due to TICC Capital Corp’s recent rejection of a takeover bid from TPG Specialty Lending.[3] Each group of executives on the tour was asked for their thoughts on this situation (e.g., would their firm be a buyer of TICC? Are they looking at acquisitions?). One executive stated that they had already analyzed the portfolio in question and would not value the assets as highly as TICC does. Another management team stressed that it was important to view these loans, and those of other potential targets, in the context of their whole portfolio (e.g., are these good for their fund and strategy?), and not just for the fact that they are trading below book value.
One of the larger BDCs in the space stated that they were not interested in a hostile bid for TICC, given the necessary costs in both time and expenses that would be spent on a proxy fight to acquire a much smaller competitor (even if they liked the assets). One manager noted that hostile bids are extremely difficult in this industry, due to the potential lack of clarity on a loan portfolio. If there is an active secondary market for a target’s assets then valuing the portfolio and establishing a credible takeover price is easier, but the illiquidity of many loan books makes hostile bids untenable.
Notes
[1] In 1980, Congress enacted the Small Business Investment Incentive Act, which created the current BDC regulatory structure and purpose, which is to provide capital to small, developing and financially troubled companies that do not have access to conventional forms of financing. BDCs must invest in private or public companies < $250mm market cap, with no investment > 25% of the portfolio.
[2] Also similar to REITs, there is a mix of externally and internally managed companies in the industry, with the majority of BDCs externally managed. Management teams usually charge fees based on assets managed and performance fees based on income generated on the portfolio (in some cases, performances fees are calculated on capital gains in addition to income).
[3] Given the attractive premium, many thought that the management team would accept the offer. The bid from TPG valued the company at below its book value, as TICC was trading at ~0.7x book value pre-announcement. This left TICC’s board with an interesting dilemma: sell for a 20% premium or don’t accept an offer for less than book value. The board of TICC recently recommended that shareholders vote for an investment advisory agreement with Benefit Street Partners (another manager), citing concerns with TPG’s incentive fee structure amongst its reasons for declining the latter’s offer.