US business development companies continue to improve as changes brought about in 2019 give the market a lot to build upon.
The institutionalisation of the BDC market took a significant step forward, and this will continue in 2020. Large, respected alternatives firms – among them Barings, Bain, Carlyle, KKR, Oaktree and Owl Rock – are running publicly traded BDCs, either through acquisitions or IPOs. They are replacing managers that lacked the skill, scale or governance necessary to attract or retain investors.
Public and private
Other institutional quality managers will posture to get into the mix. Crescent Capital, a private BDC, is seeking to acquire the undersized and poor-performing Alcentra Capital to create a fully scaled and institutional-quality public BDC. Other institutional names, such as Blackstone and TCW, are incubating their private BDCs for IPOs.
Anticipated action by the Securities and Exchange Commission could spur further interest in BDCs and growth in the sector. Foremost among the expected regulatory reforms would be the change in the disclosure of fees and expenses that put BDCs at a disadvantage relative to similar investments, such as real estate investment trusts. A revamp of reporting would motivate index funds and institutional mutual funds to again invest in BDCs, from which they divested five years ago because of concerns over expense ratios. The SEC rule limiting individual shareholdings to 3 percent of outstanding shares, effectively shutting down corporate governance and thereby allowing poor-performing BDCs to continue, is also expected to change.
Strong BDC fundamentals contributing to high yields are a third factor that bodes well for 2020. Despite yield compression across all asset classes, BDCs, represented by the Cliffwater Direct Lending Index, are reporting a combined yield (income after fees but before credit losses) equal to 9.5 percent. BKLN and JNK – indices for popular leveraged loan and high yield bond exchange-traded funds, respectively – report 4.7 percent and 5.8 percent.
Institutional investors are continuing to shift portfolio allocations to private debt to enhance risk-adjusted return and yield. The only question is whether individual BDCs will adopt the higher standards to which institutions are accustomed, and enjoy future growth, or hoard fees, maximise short-term profits and thereby lose assets. Fortunately, more and larger BDCs are institutionalising their practices.
Investors have been predicting a downturn in the credit cycle for several years. Yet history tells us that changes in the cycle cannot be ‘mastered’. The good news for 2020 is that BDCs offer access to private debt, an asset class that is long-term accretive to portfolios. The key is not predicting the future but studying the present, and looking for managers with broad platforms, strong past performance, the right strategies and investor-friendliness. These qualities maximise the probability of good outcomes in up and down markets.
Stephen Nesbitt is chief executive officer of Cliffwater, a US-based research and due diligence firm for alternative investments