When S&P and Russell announced they would remove business development companies (BDCs) from their indices, they may have given the industry a big gift.
Following the announcements, BDCs sold off. Prospect Capital (NASDAQ:PSEC) and Apollo Investment Corporation (NASDAQ:AINV) were some of the hardest hit, as they are included in more indices than the average BDC. But they certainly weren't the only companies affected. The BDC Income ETF (NYSEMKT:BIZD) has traded lower by roughly 5% since the announcement, suggesting losses have been widespread.
Why it may prove beneficial
BDCs are nothing more than shells that move money from Wall Street to Main Street. Unlike banks, BDCs don't take in deposits. They don't provide a service to receive low-cost funds. Rather, they rely on "wholesale" funding, usually in the form of debt financing and equity issuance.
In effect, a BDC's main service is borrowing money from one group (Wall Street) and investing it in another group (small businesses).
Naturally, share prices are very important to BDCs. When share prices are high, BDCs can raise new funds to invest. And when BDCs can raise new funds, more money flows into the middle market.
Competition goes both ways
The middle market is considered illiquid and less competitive than the public market. Financiers still have to source their own deals; there's no convenient or massively liquid market to buy and sell investments in tiny businesses.
But fund flows still have an impact on BDCs. When money chases yields, yields go down. Finance is, after all, a very competitive business.
In the past year, so-called "hot money" has driven down yields. Apollo Investment Corp's average yield on its portfolio fell .5 percentage points, from 11.9% to 11.4%, in the last four quarters. Likewise, Prospect Capital's average yield fell a full percentage point in just three quarters, from 13.9% to 12.9%, during March 2013 to December 2013.
Some have seen bigger yield compression, particularly those that have shifted to lower-risk first- and second-lien debt. Smaller THL Credit (NASDAQ:TCRD) experienced 2 full percentage points of yield compression --13.7% to 11.7% -- in the last year.
Why a drop might help
This quarter, we've seen very little big fundraising activity. Prospect Capital filed for a relatively small offering to sell 20 million shares this quarter, roughly equal to 4% of its balance sheet. Apollo Investment Corp. offered shares to the public at the same time as the index announcements, but it was only for 13.8 million shares, or about 6% of the outstanding share count.
THL Credit likely won't be raising any new cash at all.
On one end, falling share prices are obviously concerning to investors -- no one wants to see their share prices go down. But the truth is, lower prices may help relieve some of the competitive pressures in the middle market that are driving up middle-market valuations. With the indices selling, BDCs don't want to add to it by issuing new shares of stock.
And that could be very good for the middle market. Less money flying around means less pricing competition for deals. It wouldn't be unreasonable to expect that first quarter earnings calls report that middle market yields were higher in the first quarter of 2014 than the fourth quarter of 2013.
That bodes well for the BDCs, even if you have to tolerate lower share prices in the interim.
Are these tax-efficient yields better than BDCs?
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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.