Should BDCs Get More Leverage?

A new law would allow BDCs to add more leverage to their investment portfolios, and ultimately pay higher dividends. But does it matter?

Mar 27, 2014 at 7:00AM

Source: Flickr / Staffan Scherz.

Business development companies like Prospect Capital (NASDAQ:PSEC)Fifth Street Finance (NASDAQ:FSC), and Golub Capital BDC (NASDAQ:GBDC)  are the new bankers of the small business community. Banks have largely turned away from small businesses, leaving BDCs to fund middle-market businesses that don't have access to Wall Street's deep pockets.

A new bill circulating the U.S. House of Representatives may give BDCs even more power by increasing their leverage limits. BDCs can currently borrow 1:1 with their assets, effectively adding $1 of debt for every $1 in assets.

H.R. 1800, which comes up for vote in November, would allow BDCs to carry 2:1 leverage, or $2 in debt for every $1 in assets.

Does it matter?
Some have argued that higher leverage may leave investors to buy even higher-yielding, higher-risk BDCs. Len Tannenbaum of Fifth Street Finance thinks higher leverage limits would lead a few BDCs to leverage up, increasing their dividends, and effectively forcing other, lower-yielding BDCs to follow.

Lawrence Golub of Golub Capital BDC thinks it should be up to the discretion of the BDC. Higher-risk lenders should use lower leverage. Lower-risk lenders, like those who invest only in senior loans, should be given the chance to add leverage to their balance sheets.

For what it's worth, virtually every BDC has found its own way around the 2:1 leverage limit. Fifth Street Finance owns Healthcare Finance Group which uses more than 1:1 leverage to write asset-backed, health care loans. Golub Capital BDC has a Senior Loan Fund, which it intends to leverage as high as 3:1.

Prospect Capital, one of the highest-yielding BDCs, just bought Nicholas Financial, which is levered at just over 1:1. Its subprime lenders, including First Tower, are likely levered in excess of 1:1. Leverage clearly hasn't been a problem for Prospect Capital, which arguably runs an underlevered balance sheet.

Leverage limits don't truly exist
As it stands now, leverage isn't truly limited. BDCs can buy or create a new portfolio company, and leverage it as high as bankers are willing to go. And under current rules, this leveraged entity could make up 30% of BDC's total portfolio.

I fail to see how increased leverage would put BDCs at risk. What would most likely happen is that it would allow for new competitors to try different models. In particular, new, higher-levered funds could target less risky senior secured loans, or bank loans, with lower interest rates. With leverage, a senior secured loan BDC could match the return of lower-leverage subordinated or mezzanine BDCs.

It's unlikely, however, that mezzanine BDCs, which invest in the riskiest middle-market debt, would get clearance from a bank, or the bond markets, for additional leverage given the inherent risks of mezzanine investing. Bank loans can be more highly levered, as recovery rates are substantial, with recoveries of 64% in one of the worst possible years, 2009.

The bill, while interesting, isn't particularly game-changing for most BDCs. The winners, I believe, would be new funds that come to market after it passes -- funds designed for the explicit purpose of higher leverage. 

Take advantage of this little-known government tax rule
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Money to your ears - A great FREE investing resource for you

The best way to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as “binge-worthy finance.”

Feb 1, 2016 at 5:03PM

Whether we're in the midst of earnings season or riding out the market's lulls, you want to know the best strategies for your money.

And you'll want to go beyond the hype of screaming TV personalities, fear-mongering ads, and "analysis" from people who might have your email address ... but no track record of success.

In short, you want a voice of reason you can count on.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich," rated The Motley Fool as the #1 place online to get smarter about investing.

And one of the easiest, most enjoyable, most valuable ways to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as "binge-worthy finance."

Whether you make it part of your daily commute or you save up and listen to a handful of episodes for your 50-mile bike rides or long soaks in a bubble bath (or both!), the podcasts make sense of your money.

And unlike so many who want to make the subjects of personal finance and investing complicated and scary, our podcasts are clear, insightful, and (yes, it's true) fun.

Our free suite of podcasts

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. The show is also heard weekly on dozens of radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable. Rule Breaker Investing and Answers are timeless, so it's worth going back to and listening from the very start; the other three are focused more on today's events, so listen to the most recent first.

All are available for free at

If you're looking for a friendly voice ... with great advice on how to make the most of your money ... from a business with a lengthy track record of success ... in clear, compelling language ... I encourage you to give a listen to our free podcasts.

Head to, give them a spin, and you can subscribe there (at iTunes, Stitcher, or our other partners) if you want to receive them regularly.

It's money to your ears.


Compare Brokers