Six things we learnt about BDCs in 2018

Favoured for their relative liquidity, versatility and tax efficiency, Business Development Corporations are an increasingly prominent segment of the private debt market. Here are key developments from the past six months.

1. How credit quality is deteriorating

Multiple BDCs have had troubled credits pop up into their portfolio. Management teams have acknowledged problematic loans in their books and faced tough questions from analysts and shareholders on their earnings calls.

Covenant-lite deals continue to proliferate, which has many credit managers and investors concerned. While many BDCs invest in companies outside the broadly syndicated loan market, one dominant theme in recent years has been borrower friendly terms moving down market.

Earlier this year, two investment bankers told PDI that each had seen more covenant-lite deals coming through the restructuring groups at their firms. According to the two sources, it is now getting harder to rescue value once lenders reach the negotiating table.

2. Why BDCs could be increasing their leverage

One of the biggest changes to hit the industry in some time was the budget approved by US Congress in March. The package – signed off by President Donald Trump – includes a last-minute provision that allows BDCs to increase their leverage from a 1:1 debt-to-equity ratio to 2:1.

Managers have taken diverging approaches. Some, like Goldman Sachs BDC, put the issue to a shareholder vote and lowered fees. Other firms, like Ares and Apollo Investment Corporation, won approval from their board of directors and cut their fees. Other firms, like TCG BDC, have sought approval from both their board and shareholders but kept their fees the same.

Certainly, it will take a while for BDCs to lever up – at least for those who choose to – but investors can certainly expect a different landscape. This will be particularly true if some BDCs pursue a strategy of using the extra leverage to invest in lower-risk assets and still meet their return targets.

Watch our explainer video on BDC leverage.

3. Why it doesn’t always take an IPO to get a public BDC

Barings got its own public BDC earlier this year when it paid $85 million for the management contract of Triangle Capital Corporation. Triangle simultaneously sold its loan portfolio to Benefit Street Partners for $982 million.

The latter sale will give new owners Barings a cash reserve of $606 million, net of debt, to put to work with new investments. Barings will make an additional $100 million commitment. In total, the BDC will have more than $700 million to build out a fresh loan portfolio, unencumbered by the problem credits that remained in Triangle’s book. Barings also managed to bag ex-Wells Fargo managing director and BDC guru Jonathan Bock. Bock is set to be the vehicle’s new chief financial officer.

The BDC also set up one of the more shareholder-friendly fee structures: a 1 percent management fee that steps up to 1.4 percent in 2020. The firm is charging a full 20 percent incentive fee with an 8 percent hurdle rate and a three-year look-back option that will kick in by 2020.

4. How to make one of the world’s largest BDCs

KKR and FS formed the world’s second largest BDCs after merging their two publicly traded vehicles, Corporate Capital Trust and FS Investment Corporation. FSIC was the surviving entity. The deal was first announced in December, 2017. New York-based KKR and Philadelphia-based FS joined in April when the latter parted ways with its former sub-advisor, GSO Capital Partners. KKR and FS became joint advisors to KKR’s two BDCs (one public, one private) and FS’s four BDCs (one public, three private) focused on corporate credit.

The combined entity will have $8.34 billion in total assets and will be second only to Ares Capital Corporation, which has $12.7 billion in total assets. The new vehicle will charge a 1.5 percent management fee and a 20 percent incentive fee over a 7 percent hurdle rate. As of March, it will have some 221 portfolio companies. Most of its portfolio – about 70 percent – will consist of senior debt. KKR and FS have touted the ability to take down larger hold-sizes as one benefit of their partnership.

5. How to make a comeback

Months after parting ways with FS Investments, Blackstone’s credit arm, GSO Capital Partners, is nearing an initial close on a new direct lending platform. The platform will comprise separately managed accounts for institutional investors along with a BDC that will target retail investors. The firm set a $10 billion target for equity and debt contributions. Such a haul would immediately place GSO among the largest BDCs. Looking at GSO’s final closes of a $6.5 billion mezzanine fund last fall and a $7 billion this spring, the big surprise would be GSO not meeting that goal.

6. Who is the new kid on the block

BC Partners has filed papers to launch a BDC. The London-headquartered private equity firm, which also operates out of New York, is hoping to break into the direct lending space with BC Partners Lending Corporation, which will invest in companies with $10 million-$100 million of EBITDA. The vehicle will be externally managed by BC Partners Advisors. The BDC will charge a 15 percent incentive fee over a 6 percent hurdle and a 1 percent management fee on gross assets. It will invest in senior secured debt, both first lien and second lien, along with unitranche loans, unsecured debt, equity and structured products.

The BDC plans to leverage BC’s private equity platform to source deals. It also plans to provide managerial assistance by tapping the private equity business’s operations team along with the knowledge base of its senior advisors and network of chief executives. BC Partners Credit managing partner Ted Goldthorpe will be the chief executive and president of the BDC. Previously, he was president at Apollo Global Management’s BDC, Apollo Investment Corporation.