Friday Letter: More BDCs anyone?

It's no secret that timing is everything in any segment of the investment industry. It's also no secret that in the US, the publicly registered lending funds that are Business Development Companies (BDCs) have grown in numbers recently. There are over 40 public BDCs now actively trading, with around $40 billion in assets. Many of the major alternative investment firms have launched BDC offerings in recent years. Others are still planning to. And there's also talk in Europe about whether they can be established there as well.

To private debt managers, BDCs often look like a great idea because they provide access to an additional source of capital: retail investors. The capital is also permanent and reduces the need to raise new funds. And investors like them because they are liquid, the fees are lower, and they can be accessed more easily than closed-end funds.

On the flipside, BDCs are complex to administer, in part because they are governed by the multi-dimensional Investment Company Act of 1940. They also introduce an additional layer of accountability for multi-line managers, who are now having to answer to public shareholders as well as to their private fund investors. (Which is why BDCs are often registered as a separate investment advisor, so as to not expose the privately held management company to any greater scrutiny.)

Another issue with BDCs to consider is performance. The S&P BDC index has declined slightly this year: from an open of 86 in January to a close of 79 yesterday, while the S&P 500 has risen. The overall lackluster trend reflects in the trading of some the recently launched BDCs too: a vehicle from the FS Investment Corporation, which launched in April at $10.25 a share, has stayed fairly flat throughout the year and yesterday closed at $10.36. TPG Specialty Lending Inc. came to market in March at $17, peaked in June at $23.45 and yesterday closed at $18.

Because BDCs invest in non-investment grade instruments, they correlate with price changes in the high yield market, amongst other things. “When the high yield bond market sneezes,” as it did this summer, “BDC stocks catch a cold,” says Christopher Nolan, a BDC analyst with MLV & Co.

But because they are publicly traded, it is also possible for any softening of a BDC share price to have little or nothing to do with the quality or performance of the underlying lending portfolios. It can be entirely driven by stock market sentiment.

Irrespective of what the market is doing, a number of new offerings are currently being worked on, including a forthcoming deal from Credit Suisse Asset Management, and another from Goldman Sachs. For these managers and others with BDC aspirations, the question of timing is important: entering into a subdued market at a lower price point may have its advantages, as the likelihood of catching an uplift later on is greater.

However, MLV's Nolan warns that with many BDCs trading below their net asset value at the moment, it isn't a good time for new structures to launch, or existing ones to issue new shares. And with greater levels of volatility very much looking like they're here to stay, it remains to be seen how much new issuance the market will allow.