A Check Up on BDCs

Business development companies can yield anywhere from 6-15% and more, but come with so much risk and complication that a lot of investors pass on them.

In this week's episode of Industry Focus: Financials, hosts Gaby Lapera and contributor Jordan Wathen explain to listeners what they need to know about BDCs before buying into them, and then go into some of the biggest shakeups that are happening in the industry today. Find out why there's so much risk involved with BDCs, why the space is especially complicated to research, who the biggest players in the space are and how they work, and more.

A full transcript follows the video.

This video was recorded on Aug. 14, 2017.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped today on Monday, August 14, 2017. My name is Gaby Lapera, and joining me on Skype is Jordan Wathen, The Motley Fool's financials expert and all around wonderful person. How's it going, Jordan?

Jordan Wathen: It's going great after that introduction. How are you, Gaby?

Lapera: Good. I'm glad that I could make your day a little bit better. Today's show is something that I know everyone has been dying to hear, which is BDC earnings. Just in case you're curious, BDC stands for business development company or corporation. I made a mistake once many moons ago on a show to never define what BDC was on that show. So, for all you people out there, business development corporation. Earnings, we're pretty much done with earnings for the season. But that means that we know everything, and we can give you a very cohesive look at what happened in BDCs this last quarter. Are you excited, Jordan?

Wathen: I'm super excited!

Lapera: Me too! OK, so, let's start with a question that, just in case, for listeners who haven't heard any of our eight million BDC shows, what is a BDC?

Wathen: A business development company, one way to think about a BDC is, it's basically a closed-end fund that holds debt and equity investments in private businesses around the United States. Typically, a business development company's core customer will be a business that needs financing for one reason or another, that the business is too small for, maybe, the Wall Street financing machine, and the loan they need is, perhaps, too risky for banks to underwrite. Banks are very limited in the kind of loans that can write now, as a consequence of the financial crisis. So, business development companies have really stepped up to fill the void of financing small businesses that are basically too risky for banks to lend to per the regulators.

Lapera: Yeah, and Wall Street isn't interested in them because they're not some sort of fancy-dancy tech unicorn thing. They're like -- as we've discussed a couple times on the show -- a mattress store in the Midwest or a bowling alley in Pennsylvania.

Wathen: Right. They're typically the kind of companies that private equity firms buy out. Mattress companies are a good one. The biggest mattress company out there has basically shuffled through five or six hands in the past 30 years, and all help to money that was raised privately, not on Wall Street but from companies like business development companies that lend money off the public markets.

Lapera: Yeah. BDCs are also really interesting because about 90% of their portfolios are invested in debt, with about 10% invested in equity stakes and alternative investments. So, as you can imagine, BDCs become kind of risky, because 90% of their portfolio is debt.

Wathen: Right. When you think about how they invest, the companies they invest in, a typical middle-of-the-road loan for a business development company will yield something like 8%, for example. Relative to what you can earn on a 10-year Treasury, which is 2%, when you get four times that yield, you're starting to talk about loans that are pretty darn risky, all things considered.

Lapera: Yeah, definitely. And that's why every time, literally every time, we do a show on BDCs, we're like, "Man, BDCs are really risky. We don't like them. We would probably never invest in them."

Wathen: I mean, they're not the worst things in the world. It just takes someone who's really dedicated to following them and understanding them. They aren't as well-covered as other financial companies.

Lapera: Yeah, definitely. It's just funny, because every time we talk about them, someone writes in and they're like, "I'm really interested in investing in BDCs. What do you look for when you invest in BDCs?" And I'm like, "I don't." And I feel so bad, because I know they want a longer answer, but it's just like, I just don't invest in them. I don't follow them closely enough to ever in a hundred years feel comfortable investing in them.

Wathen: Sure. I think, moreso than other industries, to understand one BDC, you truly have to follow most of them, to understand how they connect and work together. A bank in Missouri has nothing to do with a bank in Florida, generally speaking. A BDC, though, it could operate out of the East Coast and lend on the West Coast and have deals with other BDCs. So, it takes a universal understanding to understand one. 

Lapera: Which gives me the perfect segue into the second part of the show, which is talking about the big players in private finance. I'm just going to list them off. You know what we could do? We could do free word association. I've got three, so I'm going to say their names one at a time, and you told me the first word that comes to your mind. Are you ready?

Wathen: OK.

Lapera: Antares.

Wathen: They're the Goliath.

Lapera: Golub (GBDC 1.27%).

Wathen: Really clean.

Lapera: Ares (ARCC 0.83%).

Wathen: The Goliath of the public markets.

Lapera: All right. I feel like that actually wasn't a bad description of those three BDCs. Antares is actually the old GE Finance. As you mentioned, Antares and Golub are kind of in the same space, which is, like you said, super safe, clean, first lien unitranche corner of the private finance world.

Wathen: Right. Golub and Antares, they work on the higher-end, the really clean loans from big private companies that just want to get a deal done. One of the reasons why someone goes to Golub or Antares is because they can get a deal done with one signature and just be done with it. So, if they need a $400 million loan to acquire another business, for example, a business could turn to Golub or Antares and just get $400 million. They don't have to break it up into, say, $300 million of a first lien loan that banks might take up, and $100 million of a second lien loan. No. It's just a $400 million unitranche deal, and it's done.

Lapera: Can I ask you something really quick, to explain? Can you explain the difference between liens and tranches and all that good stuff for listeners?

Wathen: Yeah, that would be important. A first lien loan is a loan that sits at the top of the capital structure. They get paid back first in the event of business liquidation. So, banks are generally in the business of making first lien loans, unless they're too big, in which case they go to BDCs, because they become a little bit too risky for bank balance sheets. Then, you have the second lien loan, which sits below a first lien loan. This would be the difference between a bond and a subordinated bond. A first lien loan sits on top and it gets paid back first. It's generally less risky, has more support from things like assets that can be sold in the event of liquidation. Whereas a second lien loan gets paid back only after the first lien loan gets paid back in full, in a liquidation event.

Lapera: Then there's there's also something called mezzanine financing.

Wathen: Mezzanine, it's complicated, because mezzanine could be second lien or could sit below a second lien loan. The important thing to know about mezzanine stuff is, that generally sits right on top of the equity. It's last to get paid back of all the debt, just before the stock ownership.

Lapera: Right, exactly. So, you have these different tiers of loans you could get. Then, what is a tranche?

Wathen: Unitranche is basically combining the elements of first lien, second lien, and a mezzanine loan all into one. So, instead of chopping alone into three pieces -- you have the first, the second, and the mezz -- you would just have one unitranche loan, for instance. And that would be the whole bit.

Lapera: Perfect. OK, I feel like everyone is good on vocab. We talked about Antares and Golub, who are interested in these first lien unitranche loans. Let's talk a little bit about Ares Capital, which is more interested in second lien loans.

Wathen: Ares Capital has been pushed into the second lien business, because Golub and Antares fight for the top of the first lien kind of stuff. Basically, they're becoming the niche player here. If you can't get enough money from a bank on your first lien, then you talk to Ares, and they'll pick you up with some more leverage on a second lien loan. Basically, Ares saw the potential to basically be the big fish in this little pond, so they rose to fill that void.

Lapera: Yeah. It's really interesting, because I feel like over the last few years, there's been a fair bit of consolidation, basically, in BDCs. It's interesting, because there's a lot more BDCs than there were before, but the power players have started to emerge. Because, this isn't a very old industry by any means.

Wathen: No, it's not an old industry at all. Really, if you think about it, the people who pioneer the private-equity space have basically pioneered the BDC space. And the people who pioneered private equity in the 80s, they're still around today. This is still just a one-generation business. The people who were big then are still big now. Golub and Ares, they're the two that actually run BDCs, so they're the ones that are basically the giants in the sector that we can invest in as people buying stocks off the stock market.

Lapera: Yeah. And what I was saying earlier was, there are more BDCs today than there were in the past, but the industry hasn't been around for a long time, so it's not that surprising. But, you're starting to see the dynamics of the last couple decades play out, and you've ended up with these three really big power players, which is really interesting.

Wathen: It's cool, because you wouldn't get this if you were just following it, giving it 20 minutes a month, or something. It really wouldn't make sense the way these deals work out. But if you chase these deals across a portfolio, you'll see that Ares will do something and Golub will do something, and it'll get sold on to the rest of the BDCs, and that's something you'll only really notice if you really pay attention to each little portfolio company that these guys invest in.

Lapera: Yeah. Let's get into that. Like you said, Ares and Antares or Golub will make a deal, will do all the work, and then they'll sell the loan down the line to another BDC. This is kind of what banks do with your mortgage, for example, they'll issue you your mortgage, then they'll sell your mortgage to another company.

Wathen: Right. That's a good example. In this corner of the world, what will happen is, Golub or Ares will say, "We can put up $500 million for this loan. " They'll do the loan and then they might only hold on to $50 million of it, for example, and pass on the rest to other BDCs, and collect an origination fee of 1% on it. If you think about how the economics work, you start with a $500 million loan, maybe they take 1% on origination, so they score a $5 million fee there. Then, let's say they only hold on to $50 million of it and the rest of it gets passed on, then they end up earning a $5 million origination fee on what amounts to a $50 million loan, which is basically 10%. That's a huge boost to the economics of the loan for Ares or Golub.

Lapera: Yeah. And it's actually really interesting, because we're kind of talking about private finance here with Antares, Golub, and Ares. But Ares and Golub also have BDCs that they can sell these loans to as well, right?

Wathen: Right. Golub Capital, if you think about its BDC in terms of all the assets it manages, the BDC is a really small part. You're talking about $20 billion of AUM, for example, and then the BDC itself might only have $1 billion. It's a much smaller piece of the whole structure. Same thing with Ares. Ares runs a ton of money, and the BDC, in terms of its income, is really important. But in terms of all the funds it manages, it's not a huge piece of the Ares pie.

Lapera: Yeah. I feel like this can get really confusing to listeners, because you have these private finance companies, these big three that we've been talking about over and over again. And then, those private finance companies sometimes have BDCs attached to them, and sometimes they don't. And then, there's also BDCs that exist independently of them, and do similar work to them, but are BDCs. It can be very confusing.

Wathen: Right. It's on a much smaller scale. The BDCs that operate independently -- Ares and Golub, for instance, they say they benefit from a platform, which is the platform they have at the management company to basically make all these loans. They have piles and piles of money in different formats and different kinds of funds, whereas there are BDCs that are literally just a BDC, and that's all the extent of the money that they have available to lend out.

Lapera: Yes. And listeners, if you're still confused, email us and we will try to give you a better explanation. Let's talk about externally and internally managed BDCs. BDCs are really interesting, because most companies, the management is inside the company, which makes it sound a little bit like, "the killer is inside the house!" But it's actually just like, you have your CEO and your board of directors, and all these people who are managing where the company goes inside the company. BDCs don't necessarily have that.

Wathen: Right. When you think about a BDC -- let's give it something that is similar, Vanguard's index fund, for instance. It doesn't have any people who work and draw salaries from the index fund itself. The people who manage it and take care of it, they're paid by Vanguard, and the index fund just pays fees to Vanguard so that Vanguard can pay those people. So, that's how most BDCs work. They're externally managed, which means they pay a fee for the services of their manager, and then their manager uses that fee money to pay the people who work and make the investment decisions for the business development company.

Lapera: Yes. There are two types. There's also internally managed BDCs. 

Wathen: A very small minority of BDCs are internally managed, and that means that the BDC, rather than pay a fee to an outside management company, it hires its staff and pays them directly from its own income statement. So, there's no asset manager involved. If it needs a credit analyst, it goes and hires them, and the salary it pays them will appear on the income statement as salaries expense, for example.

Lapera: It's really interesting, because there's pros and cons to having an externally and internally managed BDC. But I think it's generally accepted that externally managed BDCs are generally a better idea than internally managed BDCs. But BDCs are, "Internally managed is the way to go."

Wathen: Yeah. This has been debated endlessly. I don't know if there's a perfect answer. I think it really just depends on the ability of the shareholders to actually enforce some consistency. There's one BDC in particular, and we'll pick on it because it kind of bugs me. It's Hercules Capital (HTGC 1.15%). What they do is lend to venture companies. Think, technology companies in Silicon Valley that need debt investment, that's Hercules' bread and butter. Hercules has basically said to its investors that -- they're internally managed to this day -- for a long time, they've cheerleaded that concept. They've said, the internal management structure is amazing because we can keep our costs low, and just like a BDC or an index fund, the lower the expenses, generally, the better. So, Hercules operated with this low-cost model. Recently, in the past year, actually this year, they decided, "No, wait, we don't like internal management anymore, and we're thinking about externalizing, and here's how we're going to do it." Of course, this caught a lot of people off guard, because when you change your tune after singing it for eight years or however long it's been, it really shakes the markets a little bit.

Lapera: Yeah. We talked a little bit about the benefits of being internally managed, like having lower fees or costs being less. But sometimes, with internally managed BDCs, because management gets a cut every time they complete a deal, sometimes they're incentivized to make deals that don't really make sense for investors, which is why some people advocate for externally managed BDCs.

Wathen: Yes. That goes for externally managed BDCs, too. They can do things in ways that reward the manager instead of shareholders. One of the big risks, I think, with internal management specifically is that they have the ability to issue insider stock options from the BDC. One company that did this so badly, to an extent that it was just pathetic, was a company by the name of American Capital. That just got bought out recently by Ares Capital. They had issued hundreds of millions of dollars in stock option deals, whereas with an externally managed BDC, you get the 1%-2% management fee, and the incentive fee, which is 20% of returns, and that's all you get. It's contractual. But with internally managed BDCs, they can really hit the stock option comp pretty hard, and skim a lot of money off the top. But the same is true with an externally managed company. Hercules wants to go externally managed, and their fee structure they put out there, the market said, "This is going to cost more, expenses are going to go up, we don't dig this." So, their valuation just plummeted. If you look at a stock chart, there will be two big drops. It will be when they proposed this idea and, again, when they started talking about it again recently. Investors don't like it, and I think they're right not to like it. 

Lapera: Yeah. Again, circling back to our initial point, this is complicated and this is why I'm like, I'm not interested in BDCs, because I don't follow them anywhere near as close as Jordan, and I'm just like, this is just ridiculous.

Wathen: That's the thing. For a long time -- and, I don't follow Hercules that well. It wasn't one that I followed that closely. But I knew just from following the industry as a whole that they were a big proponent of this internally managed structure, and when they come out and said, "No, we want to go external," and they start talking about how they're underpaid, and they talk about how it's the equivalent to "slavery," it's just one of those things that really catches you off-guard, and all the people you thought were good guys in this industry, you start to wonder again.

Lapera: And also, listeners, just in case you're wondering why I was laughing about Jordan saying "I'm going to pick on Hercules for a little bit," and then I laughed again when he talked about American Capital, is because Jordan, you see right and wrong, you really do. And you're not bashful in saying it. Sometimes, people who represent companies write into us very angrily about things that Jordan has said. But the problem is, you're generally very, very correct whenever you say something. So it's like, "Oh no, what is he going to say? Am I going to get any mean emails?"

Wathen: You're not going to get any mean emails. It just bugs me, because for a long time, these BDCs have pitched this product as an investment that's great for seniors, it's great for retirement income. And it is, and it could be, and it should be. This is an industry that could be really good for a lot of people. But the problem is, you have people wearing suits to work every day who are really educated went to these amazing schools, and when they go to work they lose their morals. It really drives me nuts to think that some guy who just wanted to retire is getting ripped off by someone who already has enough money in the world. It just blows my mind. I don't know, it bugs me.

Lapera: See, this is one of the reasons that I love working with Jordan. I love working with you, I think it's great. I love the fire. It makes me feel alive. One of the things you mentioned is that this could be good for people who are retired, and that's partially because BDCs are a little bit like real estate investment trusts, or REITs, in that they have to pay out a certain percent of their taxable income as a dividend. That's one of the reasons that people are so interested in BDCs. They have these crazy dividend yields, like 14%, sometimes. Which is, generally, a bad idea. I think we've done a show in the past about how you should stay away from high yield things. If not, you should probably stay away from high yield things. There's a whole bunch of reasons, but mostly because they tend to be really risky. That's what you end up with with these BDCs.

Wathen: Right. That's why people are so interested in them. I think the lowest yielding BDC is like 6%-7%, which is already 3x the S&P average. So, the return you're getting from the dividend yield is massive, comparatively speaking. So, it sucks a lot of people in, especially people who see the high-end BDCs that yield 14%-15%, usually from a super levered balance sheet. There's a lot of risk in there, and I don't think it's truly appreciated, how much risk you're taking when you start shopping based on yield.

Lapera: Quick question, did you want to talk anymore about Hercules and the CEO? Or would you like to move on to Fifth Street Finance (NASDAQ: FSC) and Oaktree (OAK)?

Wathen: I think I said enough about him. [laughs] I don't want to push too many buttons.

Lapera: [laughs] OK. Jordan Wathen, button pusher. I'll make a sticker for you that says that next time you come to the office. OK, let's talk about Fifth Street Finance and Oaktree.

Wathen: Fifth Street Finance is an interesting one. How do I start with this?! Speaking of pushing buttons. Fifth Street, their BDCs were terrible performers. There's no way around it. One analyst on another conference call, I could tell that he was pointing at Fifth Street, but he basically said, "I wouldn't trust them to underwrite a loan, and that's the long and short of it." Their underwriting performance has just been disastrous. Then, of course, there were the shareholder lawsuits, the SEC enforcement, whatever, all these people looking into in saying, "Look, this is bad."

So then, it's curious that Oaktree comes in and says, "You know what? We'll take over the management of these BDCs you have, Fifth Street, and we'll pay you $320 million to do it." Of course, if you know Oaktree, if you know anything about them, it was founded by Howard Marks, who's probably the most respected debt investor in the world. And the fact that he would get involved in a deal to pay off Fifth Street's founder is really interesting, from the perspective of who people like and dislike in the credit industry.

Lapera: Yeah. Listeners, this has clearly been a pretty weedsy episode, in the weeds. We're just going to keep going, because it's really interesting, and maybe one day you can listen back and be like, "Wow, that was a really interesting show." But, if you made it this far with us, let's talk a little bit about Howard Marks, and what his possible motivations could be behind this. What do you think he's thinking?

Wathen: I talk to a lot of people in the industry frequently, and no one can really wrap their heads around why Oaktree is doing it this way. One suggestion is that it's really hard to start a BDC today. There were some rules changed in the past that would make it harder to sell high-fee funds like this to retail investors. So, if you want to start or run a BDC today, the only way to really do that is to buy one that exists. The easiest way to do that is buy one that exists. The other reason is, BDCs, this is one of the few areas of finance where you can still make a ton of money. Not that people are underpaid in the financial industry by any means, but we're talking proverbial tons of money, like 2% asset management fees plus 20% of returns. True hedge fund fees, BDCs still charge that, in many cases. So, this is one area where fees haven't gone down, despite the fact that fees are dropping for the rest of the asset management industry. So, it doesn't surprise me that Oaktree wants a piece of it, it just surprises me the way they went into it, to basically pay off someone who people generally regard as a bad guy, just to get its hands on a few funds to run.

Lapera: Yeah. Potentially it's because Fifth Street is kind of in trouble, too. So, maybe it was just a good deal.

Wathen: Yeah, that's the thing. I don't know, it just makes no sense to me. There's another BDC -- if we're going to stay in the weeds, let's just do it -- there's another BDC by the name of TICC Capital, TICC is the ticker symbol. They were rumored to sell that management contract to another asset manager for something like $60 million. It's a little smaller than Fifth Street, but it's not one-fifth the size, because Fifth Street was supposedly, that deal was going to go for $320 million. So, it's really interesting to me, it seems like Oaktree really paid up for this. I don't quite understand it. But of course, remember, we're talking about the management contracts. Oaktree is not buying Fifth Street's assets, they're buying the right to manage those assets, so it's a totally different ball game.

Lapera: I'm really interested to see how this turns out. Listeners, we'll continue to follow this story as it develops. Thank you, Jordan, for bringing the truth as you always do!

Wathen: I try.

Lapera: [laughs] And thank you to Taylor Harris, today's rad producer. He's waving. As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Contact us at [email protected], or by tweeting us @MFIndustryFocus. Thank you to you all for joining us. Everyone have a great week!