By Yasin Ebrahim
Investing.com — Business development companies, or BDCs, have taken the investment world by storm as income-seeking investors flock to this asset class that has built a reputation for generating attractive dividend-like returns by filling the middle-market funding gap left by traditional banks.
According to a recent report from Jefferies, the BDC sector has experienced significant growth, with total assets under management increasing from $12 billion in 2000 to over $260 billion by 2023.
What Aare business development companies?
A BDC is an investment company that typically invests in the middle market sector, with a focus on smaller private companies, or companies that generate approximately $5 million to $100 million in earnings before interest, taxes, depreciation, and amortization (EBITDA). BDCs primarily provide debt financing in the form of senior secured loans, but their investment strategy can be more diverse.
BDCs receive coupon payments on debt, loans made, and various fees from borrowers, which are then distributed to investors. While debt financing is their primary focus, BDCs can also invest in equity. When shares of these equity investments rise in value, BDCs can sell them for additional returns. BDCs are required to distribute approximately 90% of their investment income to investors, usually in the form of dividends.
The origin story of BDCs dates back to the 1980s, a period that followed the financial crisis of the late 1970s that led to increased regulation and compliance, forcing banks to tighten lending standards and leaving mid-market companies struggling to gain entry to foreign capital.
Congress was forced into action and created the Small Business Incentive Act of 1980 to “encourage private equity firms to provide that debt capital to these middle market companies,” Dan Trolio, Chief Financial Officer of Horizon Technology Finance (NASDAQ:), told Investing. Yasin Ebrahim of .com in a recent interview.
In addition to a decline in bank lending, smaller companies remain private longer and generally rely on debt to finance their growth.
Private vs. Audience: liquidity is important
BDCs are not all created equal; some are more fluid than others.
Publicly traded BDCs, which trade on public exchanges such as Nasdaq, are at the top of the liquidity scale. In contrast, private BDCs mirror the typical structures of private equity funds, where returns are distributed at the end of an investment cycle, and tend to be less liquid. Perpetual BDCs fall somewhere between public and private BDCs and allow investors to redeem investments during specific periods known as redemption windows.
By purchasing the shares of a publicly traded BDC, investors can gain exposure to the underlying assets and receive income generated from those assets.
“If you buy our shares, you get a very small portion of all those loans spread across the portfolio, and then you receive monthly or quarterly distributions of our earnings in the form of a dividend,” says Trinity Capital Chief. Director Kyle Brown told Investing.com.
High yields by plugging in the financing gap in the middle market
The distributions or dividend yields generated typically range from high single digits to mid-teens incomes, so it’s not surprising that investors are turning to BDCs for their income fix.
The returns generated from BDCs’ underlying assets, primarily senior secured loans, “range in gross returns from the high single digits to mid-teens range for some BDCs,” Brown said.
But how can BDCs generate these attractive returns?
Lever: Most BDCs use their own funds or the capital raised. This increases the returns they can offer investors by borrowing at a lower interest rate and then lending it to their portfolio companies at a higher interest rate.
BDCs are legally allowed to borrow up to twice their equity; for every $1 of equity, they can borrow up to $2. However, Brown added that for most BDCs, including Trinity Capital Inc (NASDAQ:), the leverage is approximately one-to-one.
“That leverage return is the reason returns are slightly higher,” Brown added.
Costs: While leverage provides a crucial boost to returns, fees charged to borrowers also contribute significantly.
The fees charged to the borrower may vary by BDC and may include prepayment fees at the beginning of a loan, prepayment fees if a borrower pays off a loan early, or back-end fees charged at the end of a loan or in certain circumstances. event.
“We [Horizon Technology Finance] have a specific unique product where we get a current pay slip,” Trolio said. “We get a commitment fee up front and we get reimbursements on the back end. All told, we’re usually in a range of about 11% to 14% of income if a company made every payment from day one to month 60.”
Internally managed BDCs have resources to manage investments directly rather than outsourcing them. This allows them to generate additional income through the management of third-party capital.
“Our BDC and some other internally managed BDCs, including Hercules and Main Street, have additional funds under management that benefit our investors because we can charge management fees and incentive fees on other capital pools,” Brown said.
While strong dividend income is attractive, seasoned investors know that risk should always be considered before looking at any asset class.
Understanding the Risks: What Every BDC Investor Needs to Know
When investing in debt instruments, credit risk must be managed. Because BDCs can invest in a variety of companies, from venture-backed startups to late-stage companies, investors should be aware that risk levels can vary significantly.
Horizon Technology Finance invests in development stage companies in the life science and technology sectors, often with negative EBITDA due to high cash burn rates. While these investments carry higher risk compared to companies with positive EBITDA, the returns associated with venture debt investments are often higher to offset this increased risk.
It also helps to take a proactive management approach to identify any problems, Trolio says.
“We look at each of our businesses on a monthly basis, conduct quarterly portfolio reviews and really dig into each of the businesses, their cash position, their performance, the sponsors, the management team… and really try to stay ahead of that,” he added .
For publicly traded BDCs, which are subject to SEC reporting requirements, the “biggest risk” lies in valuations, Brown said. Because publicly traded BDCs are required to value their assets on a quarterly basis, short-term economic changes could impact valuations, impacting the BDCs’ shares even “if the ability to collect on the loan may not have been reduced,” it added he added. .
But for investors whose primary goal is to generate income, fluctuations in valuations are not as concerning as they are for investors looking to “time the market.”
“If you’re an investor looking for yield and income,” Brown added, “this probably doesn’t affect you that much because you stay invested; you continue to collect your dividends while watching valuations fluctuate.”
“But if you’re trying to buy in and out of stocks,” he warned, “market timing can be an issue because valuations can fall.”
Risk to BDCs from lower interest rates or recession?
With the Fed initiating a rate-cutting cycle, many investors are concerned that loan income – which will typically hover above a benchmark rate like the SOFR – could come under pressure.
This raises concerns about the high dividends offered by BDCs.
While returns on these BDC-managed debt investments may decline as interest rates fall, financing costs also fall, mitigating the impact on margins.
“Most core BDC dividends are not at significant risk from Fed rate cuts,” Jefferies said in a recent note. Jefferies highlighted that there are several mitigating factors, including accelerated new production and refinancing fees, and improving credit performance, that should help BDCs maintain their dividend coverage.
Pending further rate cuts, the leveraged loan index’s default rate declined modestly this year, S&P Global said, and could remain near 1.50% through June 2025, down from 1.55% in June 2024.
While lower rates should not have a “dramatic impact on BDCs,” Brown emphasized that it is “important for investors to look at individual BDCs” and understand their underlying assets and their performance during varying economic and interest rate cycles – including the zero interest period.
The art of making deals
As the number of funds within BDCs grows, their ability to tap into quality investment opportunities can give them a competitive edge. “It is absolutely critical,” Trolio said of deal sourcing, emphasizing the importance for BDCs “to put high-quality assets on the balance sheet.”
“Sourcing deals not only give us access but also increase our competitive advantage,” he added. A long-standing management team is crucial to a successful BDC because it provides ‘market access’ to new opportunities.
To BDC or not to BDC?
Regardless of the economic or interest rate cycle, due diligence remains essential for investors considering which BDCs to invest in.
For investors looking at BDCs, “what you really want to focus on is the management team,” Trolio said, asking “how long have they been in the industry and do they understand the market?”
When assessing a BDC’s dividend yield, Trolio believes it is critical that retail investors understand how a BDC has been able to generate income to cover that dividend over time, which is the strength of their portfolio is to continue to cover that dividend and how they have been able to continue to cover that dividend. have they grown over the years?
The access that BDCs provide to private lending opportunities and the ability to build income suggests that this asset class is unlikely to run out of power any time soon.
“I think the outlook going forward is that capital will continue to flow,” Trolio said, praising continued optimism about the future of the BDCs. “We will see more activity and companies that have managed to reduce costs and maintain high enterprise value. .”
