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

Heavy
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. 

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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.

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