There is good news on fees for investors in public business development companies – listed companies set up to lend to US small and medium-size enterprises that pay little or no corporation tax if they meet certain income, diversity and distribution requirements.
“Fee structures over the last five years have improved,” says Ryan Lynch, managing director in equity research at investment bank Keefe, Bruyette & Woods. “And fee structures over the next five years will continue to improve – which means more total return hurdles, which means lower base fees, which means lower incentive fees.”
This sense that fees have fallen is echoed by other observers, though with a note of caution. “For public BDCs, in the last five years there have been improvements in structure and terms,” says Eric Green, co-head of global private markets at fund manager Muzinich & Co in New York. “Fees have come down modestly. I would not say it’s been substantial.”
Green says that fees for private BDCs are still “meaningfully lower” than those for public BDCs. He thinks this compensates for private BDCs’ long lockdown structures – unlike their public equivalents, they cannot be traded in and out of – and for the much higher minimum investments they require. Muzinich & Co manages a private BDC but does not disclose its fees.
Stephen Nesbitt, chief executive officer of Cliffwater, an investment advisory company in California, compiles fee figures for private BDCs and says they too have fallen. He attributes this to the increasing tendency for private BDCs to go public: to raise enough capital to do this, BDCs are trying to keep fees low.
Nesbitt estimates that fees and expenses for private BDCs have averaged 4 percent over the past year, compared with 5.8 percent for public BDCs. Although the average for direct lending private partnerships is only 3 percent (albeit calculated at a different point, in March 2018), they do not enjoy the same tax advantages. This lower all-in fee for private partnerships largely reflects the fact that the average incentive fee, at 14.2 percent, is notably lower than that for BDCs.
Lynch has found that newly listed BDCs tend to list with progressively more shareholder-friendly fee structures, including incentive fees, and many incumbents feel they need to catch up.
Five years ago, the most common structures at IPO were a base management fee of 1.75 or 2 percent, and an incentive fee of 20 percent. Perhaps half of IPOs at that time included a total return hurdle. Fast forward to today, he says, and most BDCs launch with a base management fee of 1.5 percent and have a total return hurdle. The most common incentive fee has fallen to 17.5 percent, he adds.
Among a sample of 25 public BDCs, Lynch finds that 11 charge lower base management fees on gross assets above a debt-to-equity ratio of 1:1. One manager of a public BDC says that his fellow managers were often forced to agree to better fee terms for shareholders, in return for permission to increase leverage, following 2018 legislation allowing them to increase their debt-to-equity leverage cap from 1:1 to 2:1. “Managers wanted shareholders to vote yes,” he says. “In some cases, it was a quid pro quo.”
A couple of terms need explaining. An incentive fee is levied by management on net operating income. This is only levied once the BDC hits a hurdle rate. This is usually set at 7 or 8 percent, which means income must be at least 7 or 8 percent of gross assets before any incentive fees can be collected. However, usually there is full ‘catch-up’: once this hurdle is met, the incentive fee can be charged on all net operating income – not just net operating income beyond the hurdle rate.
The total return hurdle, also known as a lookback or high water mark, is the fee component about which interviewees have the strongest views – much more than about base management fees. Thirteen of the 25 public BDCs in Lynch’s sample have a lookback, usually of three years. This means that when calculating incentive fees, managers must look at net operating income on a rolling three-year basis, after allowing for losses on loans that have gone bad. By contrast, BDCs without a lookback can charge incentive fees without calculating any penalty for credit losses – even for the quarter in which the loss occurred.
“There has been a lot of noise about total return hurdles,” says Lynch. “Shareholders got very frustrated, because if you don’t have a total return hurdle, your BDC is not affected by credit losses.” He suggests, based on “economics 101, or even psychology 101”, that this adversely affects managers’ behaviour by making them less careful about underwriting and managing credits. “If you’re not getting punished for having credit losses, you’re probably going to be a little more aggressive. If your pay is directly tied to the performance of your investments, you’re going to be a lot more careful.”
Golub Capital BDC – one of the larger public BDCs, with $1.92 billion in assets, and strong investment performance over the years – is a case in point. Golub’s launch as a public BDC in 2010, after a year as a private BDC, is in fact regarded by observers as a crucial early step in the public BDC sector’s journey to lower fees. It was, according to Lynch, the first public BDC to have a lookback clause for its incentive fees.
Quality over quantity
In Golub’s case, this clause goes all the way back to the launch of the fund, rather than a three-year period. The Golub BDC also levies one of the lowest management fees in the sector: 1.38 percent. “We believe we have done a really good job for investors for a really long time,” says David Golub, the firm’s CEO. “One of the reasons is that GBDC’s fee arrangements do a good job of aligning the manager’s interests with our shareholders’ interests.”
However, analysts caution against prizing fees above all else when choosing a public BDC. John Cole Scott, chief investment officer of Closed-End Fund Advisors, an investment advisory firm, speaks of “three bullet points: the quality of the manager, whether their fees are aligned to shareholder interests, and the entry point” – the price at which the investor buys the BDC. The stock price performance of public BDCs can be highly cyclical.
Lynch is more explicit in asserting the role of the manager, regardless of fees. “Whether the BDC has a proper or improper fee structure is not ultimately going to determine its success or failure,” he says. “The vast majority of what drives the success of the BDC is the quality of the manager, and the quality of the credits in their portfolio.”
Lynch emphasises the importance of avoiding a fixation on fees by referring to data showing management fees paid as a percentage of pre-fee net income.
BDCs with fees at more than half of net income are generally vehicles with low gross returns, which have boosted the ratio of fees to total income, says Lynch.