Apollo Investment Corp. and Golub Capital BDC Inc: How BDC Lending Can Differ

Today's lending market is characterized by low interest rates and an abundance of available credit. That means that BDCs can borrow more cheaply and lend more cheaply, and it also means that yields, or the returns on debt holdings, are relatively low right now.

This introduces some weird incentives that may or may not undermine your BDC when things change -- and change is always inevitable. Let's take a look at two key risks through the lens of Golub Capital BDC (NASDAQ: GBDC  ) and Apollo Investment Corporation (NASDAQ: AINV  ) .

Credit risk 
Credit risk is simply the risk that a borrower won't pay. Credit risk is lower for secured debt, which is backed by collateral, and for stable companies with an operating history. It's higher for unsecured debt and for intrepid upstarts with little in the way of cash flow. 

But in times of low interest rates (i.e., now), it can be easy even for stable companies to take on too much debt, and it can mean that risky companies pay less than they "should" to borrow money. It might also be easier for companies to mask underlying problems in their business models through refinancing and new debt issues. 

Both of these factors add risk to a debt-focused BDC, especially if it's very concerned about providing high dividends to investors. This might lead a BDC to originate riskier and riskier loans, or to pursue riskier debts that aren't backed by assets.

Both strategies can work well until interest rates rise again, or until an economic shock reveals the true creditworthiness of the borrower. In these situations, a BDC might find that its portfolio suddenly isn't generating income -- or, if it's focused on capital appreciation, that the value of its holdings suddenly drop. 

Case Study: Apollo Investment Corporation's Innkeepers Fiasco 
Apollo Investment Corporation invested in Innkeepers, a hotel REIT, at the height of the real estate bubble in 2007. You might remember that this was also a time of easy financing and available credit. 

So what happened? In a nutshell, Innkeepers buckled during the recession due to falling hotel room occupancy, and the debt loaded onto the company in the takeover brought it to its knees. The company filed for bankruptcy and was eventually purchased -- at about a 27% discount to its 2007 value.

The lesson here? Just because things are great today doesn't mean that they'll be great tomorrow, and a company that looks like a sure thing might very well not be. Innkeepers was much riskier than Apollo gave it credit for, and saddling the company with additional debt just made things worse.

What to do 
Does the BDC you're looking at have a very high dividend yield relative to its peers? Are its holdings appreciating rather quickly? That could be a warning sign that the company is pursuing yield at the expense of resilience. It might also be a sign that the company is diversifying away from a successful, but less glamorous, business model in order to generate returns. 

If the necessary expertise is there, this might not be a bad thing, but if it isn't, as was the case with Apollo, watch out.  

Holding versus buying and selling 
A BDC focused on holding onto its loan book and generating income through interest will have a different set of objectives than a company that buys and sells loans. 

Put it this way: If you originate loans and hold onto them forever, you're probably going to be much more concerned about the underlying quality of those loans than someone who's buying and selling. You'll probably not care as much if the market value of the loan book declines because you know that your borrowers will continue to pay.

On the other hand, if you buy and sell loans for the purpose of capital appreciation, you might take a major hit if something happens that reduces the value of your holdings. You might also find that you're holding onto riskier assets than you realized. This is especially the case with structured products, given that you don't have insight into the underlying assets and the fact that they were sold off by the originators -- meaning that the originators had less reason to be extra diligent.

Case study: Golub versus Apollo Investment Corporation
Golub likes to hang onto its loan book, and the company has a solid track record of lending. It sticks to its knitting and knows what it's good at, and that's the strategy that saw its parent company, Golub Capital, through the recession. The company pursues the same strategy today, and as a result it looks a lot less glamorous than other BDCs.

Apollo, on the other hand, has been willing to take more risk by investing in structured products and buying and selling loans. The jury is still out, as far as I'm concerned, on how good Apollo is at these activities -- either way, it's a notable difference.

What to do 
Understand your BDC's business model. Does it hang onto its loans? Does it transact? This will tell you the particular risks that company is facing. For a holder, you need to be sure that the company can really do its diligence -- bonus points if it came through the financial crisis intact. 

For a transactor, ask yourself if the company has expertise in its business lines, or if it's transacting just to generate better short-run returns. And of course, ask yourself if the additional risk is something you're willing to shoulder. 


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