Business development companies are a well-established statute-defined entity in the US marketplace. There are well over 100, more than 50 of them publicly listed, and they are all aimed at providing capital to mid- or small-sized US operating companies. But are they all the same? Are they providing a fungible service to the investing public?
According to the SBIA BDC Council, a trade body, BDCs represent over $180 billion in assets under management. Nobody wants to be in a competitive industry with no barriers to entry and with fungible products/services for sale. Everybody’s business model involves differentiation, and the creation of “moats” to protect one’s position. This is the case in debt finance, and it is certainly the case in the world of BDCs.
A BDC can present itself to investors as different from others in a number of ways: in the use of ESG criteria, for example. Richard Horowitz, a partner at law firm Dechert, who provides legal counsel to BDCs, said in March that one of Dechert’s clients focuses specifically “on the ‘E’ and the ‘S’ of ESG,” the environmental and social issues.
A BDC can also make a case to prospective investors for the significance of its headquarters location. Michael Ewald, of Bain Capital Credit, said last month: “We think being headquartered in Boston is an advantage. We’re not in the New York fray so we can tune out the buzz around some of the same deals everyone else is talking about in those circles.”
BDCs can also distinguish themselves on the seniority of their loans. Dean D’Angelo of Stellus Capital says: “Most BDCs are focused on senior lending, and given the economic climate, it is at least a little counterintuitive to go heavily into junior debt.” But, he adds, “there may well be a subset of investors to whom that appeals”.
“We’re not in the New York fray so we can tune out the buzz around some of the same deals everyone else is talking about in those circles”
Bain Capital Credit
Jay Alicandri, global finance partner at Dechert, says: “Some people are just junior capital allocators and are really good at that. A shrewd investor can find that a successful way to make the economics work.”
But perhaps the elephant in this room is the distinction between sponsored versus sponsorless lending.
Lending to firms with or without sponsors
It remains the natural move for BDCs to lend to companies that are owned or controlled by a private equity sponsor. There are some obvious advantages here. One of them is access to the sponsor’s own expertise and network. The BDC entering into a relationship with the operating company will often gain access to a suite of professional due diligence reports and a high level of sophistication in management and financial reporting.
Alicandri makes this point, too, in saying that “what many co-investors like among the sponsored private companies is a level of sophistication, and fewer personal affiliation issues. One is less likely to encounter the inflexibility that comes with ‘my father ran this company, and his father before him’”.
Indeed, the managers of some BDCs make a point of this. As we reported in February, TIAA’s investment manager Nuveen and its affiliate Churchill created a new BDC, one that seeks to distinguish itself in part through its allocation to private equity co-investments.
A spokesperson described the use of PE co-investments as an expression of the new fund’s flexibility “to remain selective and choose the best of the best deals”.
Managers of BDCs that lend to sponsored portfolio businesses, even if not strictly co-investments, might well say the same. Relationships and networking become the tools for the assessment of opportunities.
On a related point, Thomas Friedmann, head of Dechert’s permanent capital practice, says simply: “In a downturn, the sponsor can be a deep pocket in the clutch.”
What, if anything, might be said on the other side of this distinction, in favour of lending to unsponsored businesses?
How to find a diamond in the rough
There is concern in some quarters that the portfolio companies to which one is led by sophisticated PE sponsors tend to be very much akin to the portfolios to which other BDCs are led by their sophisticated PE sponsors. There is concern that PE industry buzz becomes just another way of flocking together into the latest hot thing. This is the problem to which Ewald suggested a geographical cure. But there might be another one – abandoning sponsors and getting granular with one’s research, despite the trouble and expense that can generate.
Indeed, there has been some movement in the unsponsored direction over the course of at least the last six years. In 2017, an article in ABFJournal, a periodical aimed at secured lenders, quoted Michael Finkelstein, the CEO of The Credit Junction, a data-driven asset-backed lending platform. “Many of the companies we finance are entrepreneur owned and seeking a flexible debt structure to spur the growth necessary to graduate to the middle market,” he said.
In other words, one cannot find the “diamonds in the rough” unless one is willing to travel out into the rough. And the rough is unsponsored.
As a related but distinct point: there is some concern that when a BDC firm is co-investing along with private equity, it can “end up with a lot of smaller positions”, as Ewald puts it. That can prove to be a big cost for non-fungibility.
Accepting the playing field
There is little point bemoaning the features of a BDC that are built into the structure.
BDC managers need to operate with the regulatory parameters, and 90 percent of income distributed as dividends, for example, can limit flexibility. But such limits must be accepted as inherent in the playing field.
D’Angelo says: “On the plus side, BDCs are not ‘taxpayers’ as the corporate entity, so their investors don’t suffer through the ‘double taxation’ of dividends they encounter with most other common stock investments.” The constant dividend flow and absence of double taxation are, D’Angelo says, “two of the main factors that make BDCs such attractive options for income-oriented investors”.
Bain Capital Credit is paradigmatic of another point one hears often in speaking with figures in the BDC world: they have the resource of looking at many more deals than they close on. Putting covid years aside, Ewald says: “We generally see about 700 deals a year. We close on anywhere from 30 to 50 of those, so we’re looking at around a mid-single-digit closing rate. We are in a position to be selective.”
The position that Bain does select, it selects on a big scale. Ewald says: “We like to maintain control of our tranches. In roughly 75 percent of our portfolio, we hold at least 50 percent of the debt tranche.”