Guest comment by Stephen Nesbitt, Cliffwater
Business development company prospects have never looked better with the growth of mid-market direct lending. BDC performance through covid, stretching from 31 December 2019 to 30 June 2021, was very respectable. Return on equity across all BDCs equalled an annualised 7.04 percent over that six-quarter period. By comparison, BKLN, the largest bank loan exchange-traded fund, returned just 1.80 percent annualised over the same period. Investors took notice of both BDC performance and an 8.25 percent average dividend yield over this difficult period, contributing to a 22 percent increase in net BDC assets. Today, BDC assets stand at $156 billion, spread across 79 separate BDCs.
BDC selection can cause a wide disparity in investor outcomes, similar to other private asset classes where managers originate investments rather than buying them from Bloomberg terminals. For example, in the six-quarter covid period, BDC managers ranked in the first and fourth quartiles produced returns on equity equal to 10.62 percent and 3.75 percent, respectively – a wide disparity by public markets’ standards. Many of the weaker-performing BDCs are carryovers from past years that continue because of weak governance structures. Fortunately, that is changing as only the strong performers are able to grow their assets and weaker BDCs get gobbled up through consolidation. This is a trend in the right direction.
Today, investors find BDCs come in four types: exchange-traded, private-to-public, self-liquidating and stay-private. Each has its own dynamic creating different prospects but one factor they all share is the importance of scale. Those without it are least likely to survive, but those bringing scale are more apt to reward investors with better fees, liquidity and performance.
Exchange-traded BDCs are gradually becoming a liquid alternative to traditional bank loan and high-yield ETFs, supported by the higher yields coming from mid-market corporate borrowers as compared with large corporate borrowers whose debt is widely syndicated. This yield difference is significant. On 31 August 2021 the yield on the Cliffwater BDC Index equalled 8.67 percent compared with 3.85 percent for high-yield bonds and 2.95 percent for bank loans. These yield differences also show up in historical returns. For example, the Cliffwater BDC Index returned 8.25 percent for the five years ending August 31, 2021, compared to 2.70 percent for bank loans and 5.10 percent for high-yield bonds.
Unfortunately, the exchange-traded market remains relatively small, with 37 individual BDCs totalling $50 billion in market capitalisation. Growth is hampered by a regulatory/tax requirement to distribute virtually all operating income and restrictions on new share issuance.
Another challenge for traded BDCs is price volatility. Despite the relatively low risk loan collateral held by BDCs, when traded their prices can vary significantly from loan values as reflected in net asset value. This divergence happened during covid when BDC NAV, as measured by the Cliffwater BDC Index, dropped 11.71 percent while BDC prices dropped 50.15 percent. In hindsight, this disparity created a tremendous buying opportunity for some, but shock for most buy and hold investors. Prices rebounded, but it took almost a year for BDCs to trade again at their NAV.
Make no mistake, the exchange-traded BDC market is steadily improving in number, management quality and size, and its performance has rewarded long-term investors. But progress is slow and encumbered by outdated regulation.
Managers sponsoring exchange-traded BDCs sometimes sidestep regulatory restrictions on share issuance by sponsoring private BDCs which later merge into their exchange-traded BDC. Alternatively, managers that want an exchange-traded BDC but don’t have one find it advantageous to start with a private BDC which can IPO later when a portfolio is fully built out. These managers can entice investors with low fees and better terms during the private phase together with the upside optionality of the private-to-public BDC trading at a premium to NAV upon IPO. Several exchange-traded BDCs have been launched by following this path: today, there are 16 with assets totalling $23 billion that fit this category, indicating a strong commitment by managers to grow this business area.
This is the smallest segment with four BDCs with $5 billion in total assets. They are generally created instead of a private partnership because one or more large institutional investors find the BDC structure optimal from a tax (ECI/UBTI) perspective. This demand is likely to remain small.
Stay-private BDCs are the fastest growing sub-category with $15 billion in assets across 19 individual companies. We expect this category to continue to grow rapidly as a growing number of investors, both institutional and high net-worth, are satisfied investing in less liquid vehicles in exchange for lower volatility. Investors also generally enjoy better fees and terms than those found in comparable exchange-traded BDCs.
Taken together, the three private BDC sub-categories represented $43 billion in total assets on 30 June, 28 percent of the entire BDC market.
In addition, all BDCs are changing in portfolio composition to reflect current trends in mid-market lending. First and foremost has been a systemic shift to senior and unitranche lending and away from second lien and mezzanine loans. This has generally lowered the risk in underlying BDC assets as senior loans have lower loss rates and less payment-in-kind income. The lower risk loan collateral, together with a regulatory lift in borrowing limits, has led to a greater use of leverage among BDCs. Aggregate use of BDC borrowing equalled 0.74x NAV five years ago, compared with 1.04x on 30 June. Over the same period senior or unitranche loans have grown from 55 percent to 72 percent of BDC assets.
However, shifting headwinds continue. Any discussion would not be complete without covering fees, which by outsider standards are considered high. Two reasons account for this. The first is that management fees are charged on gross assets not net, which is common in private equity. The second is that a separate incentive fee is charged on interest income that virtually guarantees payment even for bad management. Unfortunately, little has changed in fees for the overall BDC market. Fees and expenses on gross assets total 2.48 percent and 5 percent on net assets as of 30 June. However, we are beginning to see more aggressive fee schedules launched in private BDCs sponsored by institutional quality managers and expect more of the same in the future as competition heightens.
Another legacy regulatory issue that haunts BDCs is acquired fund fees and expenses, or AFFE. Registered vehicles like mutual funds and ETFs that hold BDCs must pass through BDC fees and expenses in calculating their own expense ratios. The same treatment does not apply to REITs, CLOs and other structured finance vehicles, which puts BDCs at a material disadvantage because investors are very sensitive to expense ratio. That is why all the large index fund providers divested from BDCs more than five years ago. Hopefully this accounting treatment will change soon but unfortunately Washington, DC’s priorities seem to be elsewhere.
The future of BDCs is closely tied to mid-market corporate lending, which we believe will see significant growth. If just a few things change, BDCs have the opportunity to grow quickly and fulfil their potential to be the primary financing solution to Main Street America.
Stephen Nesbitt is chief executive officer at Cliffwater, a Los Angeles-based alternative investment adviser and fund manager