Managing director and senior equity analyst, Wells Fargo Securities.
Following BDC space since 2006; Chief author of the quarterly publication BDC Scorecard.
Previous experience: Stifel Nicolaus & Company, AG Edwards.
Education: BS, University of Illinois.
Chairman and co-CEO, TPG Specialty Lending.
Originated more than $4.6bn in investments; Investment advisor is TSL Advisers.
Previous experience: Goldman Sachs, Wells Fargo Capital Finance.
Alma mater: BS, California State University, Fresno.
CEO of Golub Capital BDC.
Debt and equity investments in 185 portfolio companies; Investment advisor is Golub Capital affiliate.
Previous experience: Centre Partners, Corporate Partners.
Alma mater: Master of Philosophy, Oxford University; MBA, Stanford University; BA, Harvard College.
Founder, chairman and CEO, Hercules Capital.
Lists $1.4bn in assets; Invests primarily in venture capital-backed companies.
Prior experience: VantagePoint Venture Partners, Comdisco Ventures.
Alma mater: BS, Northeastern University.
Director and CEO, Ares Capital Corporation.
Lists $9.2bn in assets; Managed by Ares Capital Management.
Previous experience: RBC Capital Partners, Indosuez Capital.
Education: MBA, Stanford University; BA, Yale University.
Alternative investment advisory firm with offices in New York and Los Angeles; Research helped create Cliffwater BDC Index and Cliffwater Direct Lending Index.
Prior experience: Wilshire Associates, Wells Fargo Investment Advisors.
Alma Mater: MBA, University of Pennsylvania; BA, Eisenhower College, now part of Rochester Institute of Technology.
October saw a few significant changes in the world of business development companies. Bain Capital finally got its investment vehicle up and running; Icon Investments disclosed in a regulatory filing that the BDC it managed, Cion Investments, would purchase Credit Suisse’s BDC; and Benefit Street Partners is slated to hold a shareholder vote to approve its purchase of Business Development Corporation of America. Long-term shifts are occurring in the industry too, including more institutional investors taking a greater interest in BDCs.
Amid the changes, Private Debt Investor sat down with Jonathan Bock, a BDC analyst and managing director at Wells Fargo Securities; Joshua Easterly, chairman and co-CEO of TPG Specialty Lending; David Golub, chief executive officer of Golub Capital BDC; Manuel Henriquez, founder, chairman and CEO of Hercules Capital; and Kipp deVeer, a director and CEO of Ares Capital Corporation to discuss the space. Steve Nesbitt, CEO of Cliffwater, moderated the conversation.
Steve Nesbitt: What is a BDC, and what are you, as a manager of a BDC, trying to accomplish for your investors?
David Golub: BDCs are yield-oriented investment vehicles that typically provide exposure to middle-market loans, an attractive asset class that investors generally cannot access in traditional ways. As manager of a BDC, our job in a narrow sense is to manage a portfolio of middle-market loans and related assets within that regulatory framework. In our publicly traded BDC we also seek to enable investors to get the benefits of liquidity even though middle-market loans are fundamentally illiquid.
Jonathan Bock: A BDC is effectively a non-bank lender. They are going to lend money out to businesses – sometimes they are sponsor-backed, sometimes they are not. And they’re going to take their interest income, and because it’s a fund under the [Investment Act of 1940] with the SEC, [the BDCs] are going to distribute their earnings in the form of a dividend.
Joshua Easterly: BDCs, created by Congress in 1980 as an amendment to the 1940 Act, give investors a means to invest in the long-term growth of middle-market businesses. Congress incentivised capital formation in the middle market via the pass-through tax structure and thereby eliminated double taxation.
SN: Historically, most investors in BDCs have been retail investors. Why should institutional investors consider these publicly traded BDCs?
Kipp deVeer: I think there’s been real retail interest in the product over time, and I think some of the early BDCs may have started on the backs of retail shareholders. But we actually haven’t. What we found over time is the higher quality managers have tended to get pretty deep institutional ownership in this space.
I would tell you that one of the things institutions find appealing is that they get access to a differentiated set of assets. These are middle-market companies and, specifically, illiquid loans to these companies that are very difficult to access through other investment vehicles. It really is a total-return pitch to institutional investors, where we offer a combination of income and capital appreciation over time and pretty significant downside protection.
SN: How is a BDC created?
Manuel Henriquez: Well, in my case it was an evolution of the capital markets. I’ll never forget in the spring and fall of 2002, it became very obvious to me that the venture capital landscape was going to be changing dramatically over the proceeding 10 to 20 years. And since the capital markets were relying upon defined-benefit pension plans and endowments as a funding source… I saw that the life for that pool of capital was inefficient and there had to be a more efficient form of raising capital.
I decided to create Hercules Capital as a conduit for making illiquid private investments while offering investors liquidity through Hercules Capital’s own eventual public offering or float. I also wanted to create an opportunity for the average Joe and Mary retail investor to be able to access those private, privileged pools of capital in the venture capital marketplace.
SN: What do you look for in a well-managed BDC?
JB: The folks that choose to treat their shareholders fairly, and this could be described a number of ways, often receive the benefit of a substantial premium. It’s not a one-size-fits-all [solution] but the bottom line is treating your shareholders [fairly], and doing so in the context of providing good shareholder risk-adjusted return on equity.
JE: I think a lot of this comes down to culture, but a good governance structure is a strong board. By law you have to have a majority of disinterested board members. Those disinterested board members, by definition, cannot have any interest in the management company. You should have strong people with relevant experience that understand the investment management business and hopefully understand credit as an asset class, and you should have a culture where that management team is accountable to that board.
SN: Many people are a little skittish about BDCs because they believe they are a highly levered vehicle, like CLOs. Can you talk about whether that perception is correct and talk about how you use leverage within your BDC, and at what level?
KD: I think everything is in the eye of the beholder, but I think the common wisdom, and in our mind the accurate view, is that BDCs are one of the least leveraged investment vehicles across the corporate credit space.
A larger-cap CLO, particularly in the world these days, can be leveraged as much as 10:1. We have a limitation of 1:1 leverage. This compares very conservatively with other non-corporate investment vehicles like commercial mortgage REITs and equity REITs, which can be more levered. We typically finance our company to about 0.75:1.
JE: On the face of it, BDCs are not levered as much as REITs, banks, and in some cases CLOs, or other structured vehicles. But you’ve got to peel the onion back. If somebody owns a whole bunch of second lien or private equity in their BDC, obviously there’s much more structural leverage in those underlying assets, which may create volatility in performance.
SN: Does your firm manage its BDC vehicle different than its private credit fund side?
JE: Our firm is a little different in that all US middle-market direct origination credit goes through the BDC first. We do manage US middle-market private credit outside the BDC on an average basis – after it goes through the BDC – in a fund format.
By definition, you have to manage BDCs and private credit funds differently. For instance, in the BDC there’s something called the 5/50 Rule, which requires you to have a very diversified portfolio because 50 percent of your assets on each level can’t be more than 5 percent individually. By definition of being a BDC, one has to manage it with significantly more diversity, especially when one’s getting ramped up, than one has to in the fund format.
SN: Can you talk about BDCs, the nature of their collateral and the financing and the relation of those loans to interest rate movements?
KD: For the most part, BDCs tend to own floating-rate assets, LIBOR-plus loans. We generally have asset-sensitive balance sheets to varying degrees. Companies with assets that are floating rate and liabilities that are also largely floating rate are less asset-sensitive or don’t respond as well to rising rates. However, some of the bigger players like [Ares Capital Corporation] have grown their balance sheets and have diversified their liabilities. With mostly floating-rate assets and a mix of floating- and fixed-rate liabilities, rising LIBOR is a benefit to earnings.
We are not necessarily making an interest rate bet, but just taking advantage of attractive low base rates today to extend the duration on our liabilities. With mostly floating-rate assets and a mix of floating- and fixed-rate liabilities, rising LIBOR is a benefit to earnings.
SN: Is everything about the dividend or is it really all about the assets?
DG: I think it’s all about total return to shareholders – both the dividend payments and the change in net asset value per share. Why? The change in NAV tells you if a BDC’s dividend policy reflects the underlying earnings power of its strategy. A lot of BDCs seem to let their dividend policy drive their appetite for credit risk instead of the other way around. For example, we see some BDCs taking too much credit risk to keep up with a dividend policy that may have been appropriate in the past. When a BDC takes on too much risk in order to juice its net investment income, it tends to end up with high credit losses and a declining NAV per share.
MH: I actually believe that having the courage to cut the dividend, if and when warranted, is the right policy, and is the right thing to do for investors and the company. Having this alignment is critical to avoid reaching for yields while inadvertently increasing risk in the portfolio.
I think a variable dividend policy makes sense and it’s important to communicate that to your investors ahead of time, and make clear that you’re not cutting your dividend because of unexpected events. It’s basically your ongoing policy that you want to match your earnings to your dividend.
SN: Should investors view a sector-focused BDC strategy as more or less risky when compared to other, more generalist BDCs?
MH: I don’t think it’s riskier or necessarily better. I think it’s like a menu for investors to make their capital allocations as to how they want to allocate their capital. For example, when you walk into a Baskin Robbins ice cream shop, you can order from the menu, vanilla, chocolate, strawberry, or multiple different flavours and sprinkles. If you want venture [capital] exposure, to pre-IPO or M&A companies, then Hercules Capital is certainly the largest BDC or pure-play focused on this segment of the market.
DG: If you look at the most successful BDCs, they all have identifiable, compelling and sustainable sources of competitive advantage – not unlike any other successful company. A niche-focused BDC may actually have a bit easier time establishing its sustainable competitive advantage than a BDC that has a broader strategy.
For a generalist, domain expertise is not sufficient. A generalist needs other tools – tools such as market-leading scale, strong sponsor relationships and a large, healthy existing portfolio. We believe the key distinction isn’t niche versus generalist – the key distinction is sustainable competitive advantage versus commodity lender.
SN: Should I be hesitant to invest in a BDC that’s trading at a premium and conversely, should I be focusing on BDCs trading at a discount because there may be extraordinary value there?
JB: It’s a real distinction. I’ve seen a lot of traders lose a lot of hands and fingers and toes and sometimes full body appendages, choosing to focus on heavily discounted BDCs because at times the market trades them there for a reason. A premium to book value shouldn’t be the sole determinant of whether or not to invest. Really, it’s based on the ROE they can generate, what they’re passing through to you and more importantly the underlying quality and incentive alignment of the platform that’s backing that ROE. And many times, that can be a BDC trading above book and be a great return.
MH: As my grandfather always taught me, cheap does not make it necessarily good. Nor does trading at a premium to net asset value make it expensive, each of us in the BDC industry has different models.
So many investors get caught up in cheap-to-premium arguments, and I would encourage them to go beyond the cheap-to-premium argument and evaluate the different BDC business models. Investors need to exercise their judgment and analysis in the different business models of the BDCs, and sustainability on generating healthy return on average equity.
SN: How does a BDC grow without diluting existing shareholders?
KD: That’s pretty easy. Raise stock at or above NAV and invest the proceeds in a manner that is accretive to earnings. The only way we’re able to grow our assets on the left side of the balance sheet is by issuing equity.
So you need to be very cautious and careful as you evaluate those equity issuances, building your capital base over time. Good investment performance helps as well. You can certainly generate NAV increases, and that contributes to accretion at the company.
SN: How do you direct investors to the public vehicle versus a partnership or a private vehicle?
DG: When we start talking to an investor, we try to listen very carefully to what their goals are and to guide them to the right Golub Capital product based on those goals. By way of example, if liquidity is very important to the investor and the amount of capital that the investor is looking to deploy is not too big, the publicly traded BDC is a great option.
If the investor is seeking to put $100 million to work, the publicly traded BDC is probably not an option. So we look at other options, including our non-traded BDC and our private funds. Once we understand the investor’s risk tolerance, liquidity needs, regulatory constraints, tax position and return goals, we can help them assess the pros and cons of different Golub Capital vehicles.
KD: We started at Ares in direct lending with the BDC … simply because there wasn’t meaningful institutional demand for the private debt asset class on any scale from institutional investors. There was no home for it either within the fixed income or alternative allocations, which is where you would see LPs allocating direct lending funds today. Most of the investors that are investing in our private funds today don’t want a daily trading price, which they get with a BDC. They like what they feel is diminished volatility by investing in private funds.
SN: Can you tell us about some specific legislation and regulation, and why you do or don’t support it?
JE: I think there are two separate matters: BDC legislation and changes to the regulatory environment. I actually think what’s more important is changes in the regulatory environment, outside the BDC legislation, that we hope can be done through rulemaking by the SEC. On top of the list in our mind is acquired fund fees and expenses, or AFFE.
AFFE really doesn’t allow for traditional institutional support given that funds have to consolidate all the expenses of a BDC investment into their expense ratios. This makes it very challenging in a competitive mutual fund environment for managers to own BDCs because funds are measured on expense loads.
MH: A bill moving through Congress is ostensibly the BDC bill, which, in short, is raising leverage from 1:1 debt to equity to 2:1 debt to equity, or some flavour or variant thereof. I think it’s highly beneficial to the BDC industry.
The vast majority of the benefit for the increase of leverage in the BDC industry is to facilitate greater capital formation and greater capital deployment to lower middle-market companies. By having higher leverage, a BDC is able to underwrite lower interest rate loans, and still generate the market required ROAE to attract a public investor’s interest, thereby increasing its own access to the debt and equity capital markets.