The High Cost of High-Yield BDCs

John Bogle revolutionized and democratized investing when he founded Vanguard and pioneered the low-cost index fund.

Thanks to his firm, investors can buy broad market funds with microscopic fees measured in basis points.

Unfortunately, there isn't yet a Vanguard of the middle market. Those who want to invest in small, middle-market companies through business development companies will have to pay up!

BDCs and their fees
I went back through SEC filings and shareholder presentations to see just how the industry stacks up on cost-efficiency. After all, investors who own a BDC should know just how much they're paying to invest in a business development company.

Here's a table comparing 4 different BDCs and their fee schedules:

BDC name

Management and incentive fee schedule

Fifth Street Capital (NASDAQ: FSC  )

2% of gross assets (minus cash and cash equivalents), plus 100% of all returns between 8% and 10%, plus 20% of all gains past 8% per year.

Prospect Capital (NASDAQ: PSEC  )

2% of gross assets, plus 100% of all gains between 7 and 8.75% per year, plus 20% of all gains past 8.75% per year.

Ares Capital (NASDAQ: ARCC  )

1.5% of gross assets, plus 100% of gains from 7-8.75% per year, plus 20% of all gains past 8.75% per year.

Apollo Investment Corp. (NASDAQ: AINV  )

2% of gross assets, plus 100% of gains from 7-8.75% per year, plus 20% of all gains past 8.75% per year.

Not all BDCs are the same -- how they calculate fees varies by company, as does the amount investors pay. For instance, Fifth Street Capital amended its fee schedule so that it does not collect management fees on its uninvested cash. That way, Fifth Street Capital investors don't pay a management fee on idle funds.

No other BDCs in the table has that provision. Prospect Capital, Ares Capital, and Apollo Investment Corp., include cash in their gross assets. Thus, if Prospect Capital and Ares Capital have an average of $200 million in cash over a span of one year, investors will have to pay $4 million and $3 million, respectively, on money that's just sitting around doing nothing. You'll notice far many more complaints about uninvested cash on Prospect Capital's and Ares Capital's earnings call than on an earnings call for Fifth Street Capital. Even the worst banks in the world don't charge you 2% per year to store cash.

Of course, it's not as simple as who is charging fees on cash and who isn't. Ares Capital has the lowest base management fees of the externally managed companies at 1.5%, so even some cash drag doesn't make it automatically more expensive. Fifth Street Capital has the highest hurdle at 8%, so its managers have to create a bigger return for investors before getting their cut of profits.

Is the fee worth it?
Unfortunately, investing in middle-market companies is inherently expensive. Most are unrated, so asset managers can't just buy or sell middle-market debt or equity based on an opinion from Moody's or Standard & Poor's. Also, since these are small, non-public companies, BDC managers have to spend money to find investments -- there isn't a stock market for small companies where managers can just shop investments 24/7. And you won't find a middle-market company's financials on the SEC website for public viewing.

All that effort to make investments costs money. Whether the money spent is worth it to the investor is up to them. Since their IPO, every BDC in this article has generated a positive return -- after fees -- to investors. But one can't help but think that positive returns might be a heck of a lot larger if managers didn't take such a big cut of the profits.

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