Since the global financial crisis of 2007-2009, the size of the private credit market has grown dramatically and is now over $1 trillion. Antti Suhonen is the author of the study “Returns on Direct Loans''. Financial Analyst Journalinvestigated business development companies' returns, risk exposure, and sustainability of performance. A BDC is a closed-end investment vehicle created by an act of Congress and organized under the Investment Company Act of 1940. BDC has the following characteristics:
- They typically invest in small and medium-sized businesses through debt and, to a lesser extent, equity and derivative securities.
- They are required to invest at least 70% of their assets in private equity and debt of U.S. companies.
- Eligible investments also include U.S. government securities, cash, and publicly traded securities of companies with a market capitalization of less than $250 million.
- Diversification requirements apply to BDC investment holdings.
- Currently, senior secured loans make up the majority of BDC portfolio assets, but we may also hold subordinated debt, equity warrants, and direct equity ownership in portfolio companies.
- BDCs are allowed to use up to 200% leverage. Virtually all BDCs take full turn (100%) leverage. Using leverage increases your risk and drawdown, while also increasing your expected return.
- 90% of a BDC's income comes from dividends and interest, and 90% must be distributed to shareholders.
- Managers are typically compensated through a combination of fixed management fees and incentive-based management fees (a percentage of net interest income and realized profits).
- BDCs are not permitted to issue shares below their net asset value to the public without annual shareholder approval.
BDC: Risky and expensive
Suhonen's database consisted of 47 BDCs (approximately $112 billion in assets at the end of 2021) and covered the period from December 2009 to June 2022. The following graph shows the market capitalization-weighted asset allocation of the 47 BDCs in our sample.
Below is a summary of Suhonen's key findings.
- The BDC portfolio yield averaged 10.8% (or USD average 3-month Libor plus 10%) over the sample period. Yields compressed by 4 percentage points from a high of 12.8% in 2012 to 8.6% in Q1 2022, before widening in the final quarter of the sample. This compression may partially reflect improved seniority in BDC loans (see chart). The average BDC yield spread for leveraged loans during the sample period was 5.7%, with a range of 0.9% to 7.9%.
- Since 2019, the debt-to-equity ratio has averaged 102%, compared to an average of 61% from 2009-17. The leverage increase is a result of Congressional action that raised the leverage cap from 1.0 to 2.0 in 2019.
- The average annual management fee expense (including incentive fees) during the sample period was 3.19% of total assets, equivalent to 5.46% of net assets. By comparison, private direct lending funds have average management fees of 3.14% of net assets per year.
- The average financing cost was 4.36% per annum of total debt, or 3-month LIBOR plus 3.58% considering the average LIBOR interest rate of 0.78% over the period.
- At the market cap weighted index level, the BDC industry's total return was 8.63% for the year, with a Sharpe ratio of 0.38. The Sharpe ratio was significantly lower than comparable benchmarks such as leveraged loans (0.61) and high yield bonds (0.63).
- BDC market value returns are best explained by a combination of liquidity leveraged loan performance and stock market, size, and value factors.
- When we bundle the equity factors together by using the Equity Small Cap Value Index as an explanatory variable alongside leveraged loans, the two regressors explain 81% of the variation in the BDC Market Value Index in monthly data; The result was a negative but statistically insignificant alpha.
- BDC volatility roughly matched that of small-cap stocks. However, their returns showed greater negative skewness and excess kurtosis than the equity benchmark, although they were lower than the leveraged loan index.
- Individual BDCs varied widely in their performance, with the difference between top and bottom quartile returns exceeding 15% per year across various performance metrics.
- Based on the NAV return metric, BDC performance showed strong year-over-year persistence, especially in the bottom quartile and top quartile of historical returns.
- There is a statistically significant relationship between valuation (price/NAV) and performance, with BDCs with higher price/NAV premiums (or lower discounts) performing better than BDCs with lower premiums (larger discounts). Performance was excellent on return metrics. *
Key points for investors
When traded on a public market, a BDC reflects the volatility of the common stock and may deviate from its fundamental value due to investor risk aversion or changes in market liquidity. As a result, they are riskier than the assets they own, and their use of large amounts of leverage compounds the problem. In addition, fees are very high (over 5%) relative to the investor's net worth, especially when there are lower risk and cheaper alternatives like Cliffwater Corporate Lending. It is difficult to make the case for investing in a BDC. Fund CCLFX and Cliffwater Enhanced Loan Fund CELFX. High expense ratios are especially egregious when applied to total assets (rather than net assets). This is because total assets include leveraged assets whose average cost is approximately 3.6% above LIBOR. As a result, investors end up paying the full fee on the leveraged asset, even though the borrower does not receive the full yield paid. In contrast, Cliffwater's fees apply to net assets.
*When I discussed this finding with Cliffwater CEO Stephen Nesbitt, he said that while this finding is valid as a buy-and-hold strategy, his research shows that He told me that a strategy of regular rebalancing to lower prices per book turned out to be important. It yielded higher profits than the buy-and-hold strategy.
Larry Swedlow is director of financial and economic research at Buckingham Wealth Partners (collectively known as Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC).
For educational and informational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may be outdated or replaced without notice. Reference to specific securities is for educational purposes only and does not constitute a recommendation for inclusion in a portfolio. Individuals should consult a qualified financial professional appropriate to their circumstances. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy of, or reviewed the appropriateness of this article. The opinions expressed herein are their own and may not accurately reflect the opinions of Buckingham Strategic Wealth, LLC or Buckingham Strategic Partners, LLC, collectively Buckingham Wealth Partners. LSR-24-627
Larry Swedlow is a freelance writer. The opinions expressed here are those of the author. Morningstar respects diversity of thought and publishes a wide range of viewpoints.