BDCs: What They Are, How to Evaluate Them, and How They Did This Quarter

A full transcript follows the video.

This podcast was recorded on Aug. 8, 2016.

Editor's note: BDC stands for business development company.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Monday, so you're listening to the Financials edition filmed on August 8th, 2016. My name is Gaby Lapera and joining me on the phone is Jordan Wathen, our resident BDC expert. Hi, Jordan!

Jordan Wathen: Hi, Gaby! How are you?

Lapera: Good, thanks. How about you?

Wathen: I'm doing all right.

Lapera: Are you super excited to talk about BDCs?

Wathen: I'm super excited!

Lapera: That's awesome, because so am I. We are a little bit past the beginning of earning season, but I thought that it would still be really fun to do a show on BDC earnings.

Wathen: Definitely. We can take a deeper look into a few of them that have reported already.

Lapera: Yeah, this is going to be a great show. I thought that we would kick off the show with kind of a look at the types of things that you should look for in BDC earnings, just generally things that you should know about, be aware of, metrics that you should definitely take a look at every quarter. Does that sound good to you?

Wathen: Sounds good to me.

Lapera: Awesome. Let's kick it off with net asset value. As I understand it, net asset value is basically just assets minus liabilities over shares outstanding. This is a term that's used for both mutual funds and BDCs, correct?

Wathen: Correct. Basically, if we were talking about a bank or any other company really, we just call it book value, but because these are funds or closed-end funds, it's called net asset value, sometimes called NAV when you, I guess, speak out the acronym.

Lapera: What's a closed-end fund?

Wathen: A closed-end fund is basically an investment fund that can't accept new investments, at least it's not open to new investments all the time. Your traditional mutual fund is generally an open-end fund, meaning you can add $1,000 or take $1,000 out at any time. With a closed-end fund, the only way to put money in or out is to buy shares of the closed-end fund on an exchange.

Lapera: Okay. How does net asset value work for something like a BDC or an open-ended fund? Are BDCs open-ended funds?

Wathen: I'm sorry?

Lapera: Are BDCs open-ended funds?

Wathen: No, BDCs are definitely not open-ended. They're closed-end funds, and the advantage there is because what BDCs typically invest in is liquids, so the debt and equity of very small private companies is hard to buy and sell, so to run it as an open-end fund would be dangerous because it would have withdrawal requests, for example, that they can't match up with asset sales.

Lapera: I see.

Wathen: They really need to have kind of tighter control over investors' money in order to invest in a more liquid asset.

Lapera: I have a question about net asset value and mutual funds versus BDCs. For net asset value and mutual funds, my understanding is that mutual funds actually trade at net asset value, whereas BDCs don't have to, right?

Wathen: Right, exactly. A mutual fund at the end of the day will add up all their assets and liabilities and come up with net asset value and that's the price at which investors can buy and sell at the end of the day. BDCs and closed-end funds in general definitely do not have to trade at net asset value. They can trade at premiums or discounts, and more recently now the industry by and large trades at a discount to net asset value.

Lapera: Why would we want to look at net asset value?

Wathen: The important thing about net asset value is to really look at how much money a share is worth, assuming that the BDC were liquidated. The important part is to just understand that net asset value is determined by ... It's basically the value of the BDC's asset minus its liabilities, if the assets were sold "in an orderly liquidation", so in an orderly fashion.

Lapera: If a company has a net asset value and now that trades at a discount, that means that they would be ... That you're getting less if they ...

Wathen: Yeah, if it trades at a discount, theoretically, the BDC could close up shop, close the doors down, sell off all its assets, pay off all its liabilities, and thus giving investors back more than the market price they paid.

Lapera: Okay, so you're looking for net asset values that trade at a discount if you can.

Wathen: Well, ideally. I mean, usually there's reasons, right, that a BDC would trade at a discount to net asset value, but yeah if it's all equal, you prefer to pay a discount to net asset value than a premium to net asset value.

Lapera: Or with BDCs you're looking for something that their net asset value matches what it actually is. It's neither a premium nor a discount.

Wathen: Right. I mean, yeah, in a perfect world.

Lapera: Then another metric that we want to look at for BDCs is the non-accrual rates.

Wathen: Right.

Lapera: Yeah, go ahead.

Wathen: Non-accrual rates basically tell you what percentage of the portfolio is not paying interest or the BDC isn't accruing interest for that portfolio. BDCs are primarily debt investors, meaning that they're buying the debt in private companies and if that debt isn't performing or they don't expect to be paid, they'll put it on what's called non-accrual which basically says, "Hey, this debt investment's performing poorly. We don't expect to receive all of our money back so we're going to put this on non-accrual so we don't recognize interest as we normally would."

Lapera: This is basically like the same line in a bank's sheets where it would say non-performing loans or non-performing assets.

Wathen: Right, yeah. Banks are investing in totally different asset class in general. I wouldn't try to compare necessarily what's going on with BDCs to banks.

Lapera: Why not?

Wathen: Well, banks are primarily lending against assets. When a company takes a bank loan from a bank, they might put up collateral say real estate or cars, something of that nature. The banks, in general, what goes on non-accrual they're probably going to recover a lot of ...

Lapera: The value?

Wathen: Yeah, a lot of the value, right. BDCs, they typically don't have collateral in the sense that they have secured assets. Typically they're basically only secured by the value of the company that they're lending to.

Lapera: I think for listeners, just in case you don't know, BDCs generally lend out money to smaller companies. It's basically a way of investing in a venture capital firm. Kind of ... is basically what it is, as opposed to directly funding venture capitalists ... You yourself being a venture capitalist. That's really interesting. I know that the non-accrual rates, the ones that we're particularly going to be wanting to look at this quarter are BDCs that have a lot of exposure to retail and oil and gas.

Wathen: Right. You can imagine those are two kind of troubled industries. Oil and gas companies found it way too easy to borrow money for way too long and a lot of BDCs got sucked into that. Now, obviously loans that they underwrote assuming that oil prices would stay at 90 or $100 a barrel aren't worth nearly as much in an environment where oil trades for $40 or $50 a barrel.

Lapera: This kind of leads perfectly into my next point. One of the other things that you really want to look at when a BDC reports earnings is you want to take a look at what's on their books. What are they actually investing in?

Wathen: Right. Unlike a bank, a BDC will actually break out every single solitary investment that it has on balance sheet and next to it they'll have a description of the business and typically a few words or just one line. Honestly, your best way of understanding it is to simply type one of the portfolio company's name into Google and then checking out their website because what it says next to it, it might say ... This has been a common one that really annoys me, but when it's an oil services company, they might say it's just "business services" but you go look and it's like obviously they're doing something with pipelines. It has oil exposure.

Lapera: Yeah. This is the best way to kind of gauge what kind of external risks the BDC is facing by looking at what their portfolio is made up of.

Wathen: Yeah, absolutely. Really, I mean you wouldn't necessarily need to go down to the hundredth largest company in the portfolio, but even if you look at the top 10 or top 20 names in their portfolio, you'll get a really good sense of what they're doing.

Lapera: Yeah. To summarize my points, or our points, rather, the three biggest things that you should look at when BDC earnings come out are net asset value -- is it trading at a premium or a discount or is it actually what it's supposed to be? -- non-accrual rates, and what the portfolio looks like, the diversification of the portfolio.

Wathen: Right.

Lapera: Just so people know, the books that we're looking at, they all closed on June, 30th so it's kind of old. How much volatility would you say there is in a BDC's portfolio?

Wathen: Outside of oil and gas, there really hasn't been too many problems. There's been a few problems in retail. Obviously, retail hasn't been thought of as ... I think that's kind of a secular thing where it's not a very good place to be to compete with Amazon, for example. I mean, retail's going to be one that's hard pressed. Retail's fairly capital intensive. BDCs are definitely in that space pretty heavily too.

Lapera: Yeah. Let's do an overarching review of things that have happened in the BDC space over the last quarter. I know that we were talking about junk bonds earlier.

Wathen: One good way to get an idea of what's going on in the BDC space is to look at junk bond yields. Actually, the Fed publishes very good data. It's called the Bank of America Merrill Lynch US High Yield Auction Adjustment Thread. That's a mouthful. If you can just type it into Google ... Go back to what I said, type it into Google, you'll get a look at junk bond yields over time. When junk bond yields get really high, you have an idea that the loans that BDCs are going to make are going to be a higher yield. When junk bond yields come in, you have to understand that BDC loan yields are also going to come in.

Lapera: Why is that? Why are they related?

Wathen: Well, they're somewhat similar in the sense that the stuff that BDCs are underwriting are loans to companies that would otherwise be gone for, unrated, assuming that they were rated, they would be junk quality.

Lapera: Fair enough. I guess the wrap up for that is junk bonds are junky this quarter.

Wathen: Well, they were definitely junky. They've gotten less junky, right? Junk bond yields really blew out in February. I think the yields were above 9% for a very short time, which you have to back and look at 2011 to see yields that high. They've recently come back in, thankfully, because oil prices have gone up somewhat in February, but that's definitely something to pay attention to.

Lapera: The last quarter essentially the junk bonds kind of dipped down and leveled out a little bit.

Wathen: Yeah, the yield had come down in the last quarter. Right.

Lapera: Also, in the last quarter it looks like origination fees are down kind of across the board for BDCs.

Wathen: Right. BDC originations in general will go down when junk bond yields go up because when the cost of financing companies goes up, then there's less interest by private equities to go buy out companies and they don't have it. Most BDCs rely on private equity funds for the majority of their loans. If private equity is not going to be doing deals, then BDCs won't be that active doing deal. Originations have been broadly down across the board.

Lapera: Yeah. For our less deep dive listeners, I guess, origination fees are a big deal to BDCs because that basically means that they have been writing new loans to add to their portfolio.

Wathen: Right, exactly.

Lapera: Fewer origination fees means that their business is down, basically. As a result of all these things, most BDCs are trading at a pretty big discount to book value right now.

Wathen: Right, definitely. In some sense, it's kind of investors trying to speculate on future loan losses. BDCs, unlike banks, do not provision for loan losses. They take them as they come, so there's no basically embedded loss rate in the BDCs. The only way to really price in future loan losses is pricing the BDC relative to net asset value.

Lapera: Right, which is why I think a lot of investors look at BDCs and they're like, "Wow, they have really high dividend yield rates, this is great." The other thing to keep in mind is they're super risky because not only are they investing in really small businesses or in things that other people wouldn't invest in, but they also don't really account for what their losses are going to be. They don't really hold stuff back, do they?

Wathen: No, no, no. Basically when you look at a dividend yield it might be in the 10% area, but that's assuming that nothing goes badly, which is just ridiculous if you're underwriting loans that yield 10%-14%. You have to assume that a very good portion of those are going to go poorly.

Lapera: Yeah. I mean, just to give a comparison, most banks, the loans that they write yield around right now between like 3%-7%, which is considerably lower.

Wathen: Probably on average 3%-4%.

Lapera: Yeah, 7% is on the high end for banks. BDCs, much like REITs, they're required to pay out a certain amount of their earnings as a dividend, so it's one of those things that you're taking on a lot more risk in return for a dividend and this is just something you have to be aware of.

I just want to take a quick break to let you guys know that we have a phone number now and if you guys want to be on the show, you can call the phone number and leave us a voice mail and we'll play you on the show. I'm so pumped about this. This might be a little bit ridiculous. The number, just in case you're wondering to yourself, 1-866-677-3665. Again, that's 1-866-677-3665. If you call in, I would really like to hear either questions that you might have about financials or I'm going to go to China, Vietnam, and Cambodia in October so if you have any suggestions for me, definitely call in and leave us a voice mail. Just do it. I'm so excited. I hope that you guys are excited about this, too. The number, again, is 1-866-677-3665.

Okay, so turning our attention to BDCs that have actually reported, first on the list is Apollo Capital.

Wathen: Yeah, Apollo Investment Corp, yeah.

Lapera: I'm sorry, Apollo Investment Corp.

Wathen: No, you're fine. They reported earnings and it's been much the same. It hasn't been good. For the last eight quarters in a row, net asset value at Apollo Investment has actually been down quarter over quarter. Net asset value's down to 6.90 per share from 8.74 and that's just in the last two years, right? Apollo Investment, they're definitely one that got high on the hog with oil and they slowly tried to reduce their oil exposure to the extent that they can, but the damage to the portfolio has already been seen. You've seen where basically net asset value's down for eight quarters in a row. I mean, that would be definitely an outlier in the business development company industry.

Lapera: Yeah. As a result, they're kind of pivoting, they're changing strategy.

Wathen: Right, right. They reduced their dividend, first of all, from $0.20 a share each quarter to $0.15.

Lapera: Which is a responsible thing to do, if you think about it.

Wathen: No, definitely. It was probably a long time coming, right? There's only so long that you can extend a dividend while post value is down because ultimately the amount of money that you have per share in book value will determine the amount of income that you can make, right, per share. The book value and decline, it was very necessary for them to cut the dividend, which they did, and they played out a strategy where now they intend to invest in less volatile securities, I think basically speaking to say, hey, we're done with complex oil and gas investments. We're going to go to straight, standard, normal corporate bets for smaller companies.

Lapera: Yeah. I think one of the other things that they had on their book that was always kind of amusing to me was aircraft leasing.

Wathen: Right. In some sense, aircraft leasing should kind of soften the decline of oil prices because older aircrafts are worth more theoretically when oil prices are lower, but with more than 10% of their portfolio in oil/gas, it really didn't matter.

Lapera: Yeah. I think the other thing that we want to look at with Apollo is that they recently received clearance from the SCC to do deals with their external manager.

Wathen: Right. They received so called exemptive relief, which basically means now they can invest alongside Apollo Global Management and another company by the name of MidCap to basically do loans together. Apollo Global Management can basically feed it deal flow and be like, "Hey, we need someone to underwrite this loan on this buyout," and Apollo Investment Corp can come in and say, "Hey, cool, we can buy it now because the SCC gave us approval."

Lapera: That's awesome. Just real quick, external managers for BDCs, do you want to describe that?

Wathen: Well, yeah. External management basically means the people who make investment decisions on behalf of the fund are not employees of the fund. The people who work to make deals for Apollo Investment Corp actually work for a subsidiary of Apollo Global Management.

Lapera: Yeah. This is really interesting because BDCs can have both external and internal managers. It's generally preferable to have external, correct?

Wathen: Well, I mean, it goes back and forth. You can make a case for internal management in the sense that there's no profits out of an outside firm so you don't have agency costs or conflict of interest between the people who run it and the people who are investing in it. You can also make the case for external management because external managers can't pay themselves ludicrous stock option compensation, which has been a problem with some BDCs like American Capital, for instance.

Lapera: Yeah. That's just really interesting. BDCs are maybe some of the most complicated financial institutions out there. I don't know if institution is the right word.

Wathen: I think that's a fair assessment, yeah.

Lapera: Anyway, so now Apollo can do deals with their external manager, which is good. It should help buttress their business a little bit.

Wathen: Yeah. In general, the more deals the BDC can look at in general, the better its underwriting should be. The more choices you are able to make, then the more deals you can say no to and the fewer you can say yes to is the better thing, I would say.

Lapera: Okay. Overall, although things have been down for Apollo, things might be on the upswing eventually.

Wathen: Eventually.

Lapera: Let's turn our attention to Triangle Capital. They've raised a lot of money recently, haven't they?

Wathen: Right. They recently came to market and issued new stock. It gives them about $120 million in additional capital, plus more because there's an option to sell more stock, but they're looking to raise more capital which is interesting because obviously deal flow and originations have been down and they've basically signaled on their conference call because they expect some activity to pick up in the second half. Triangle Capital typically does deals with private equity sponsors and private equity likes to do second half fourth quarter deals, so we'll have to see if they can put the new money to work.

Lapera: Yeah. Triangle Capital's also really interesting because the type of loans that they tend to specialize in are a type of loan called mezzanine loans or mezzanine financing. Those tend to be much riskier, but they also have much higher yield, a theme that I'm sure you're familiar with BDC investing.

Wathen: Right. Triangle Capital likes to make mezzanine loans, and mezzanine loans basically sit below lower yielding bank debt. A bank will come in and provide the least risky leverage for a buyout and then Triangle Capital will come underneath them and make a loan. Unfortunately, the mezzanine space has been kind of crowded. There was talk on their conference call, too, about how Triangle Capital's average portfolio yield or the average yield on all their loans could come in at 12.3% and that's down from 14.8%.

Lapera: That's because there's so much competition in the space?

Wathen: Right. There's so much competition, especially right now with what U.S. Treasury yields like 1.6%- 1.7%, almost nothing. Everyone's looking for more yield and mezzanine has the yield-iest part ... It's one of the yield-iest (unclear 22:44) out there has obviously attracted a lot of attention.

Lapera: Right, but much like the other BDCs, while there is the potential for higher originations, their origination fees have been hit a little bit because it is so much easier to secure cheaper debt.

Wathen: Right. With Triangle, when you underwrite mezzanine loans, typically you get something that's called an equity kicker, so you'd get a percentage of equity or warrant to buy equity in the company that you're underwriting, which can provide a huge upside in the event that you end up underwriting Google 10 years ago where you end up getting 3% of Google and 15 years later it's a $300 billion company, that'd be amazing. I don't think you'll see that. That's one of the things there.

Another thing with Triangle Capital is they rely on debt from the Small Business Administration. They use what's called the SBIC program and that's basically I think where this new money's going to go to. With the SBIC, you can borrow, very inexpensively, Triangle Capital's ... Be able to borrow $350 million at an interest rate of like 2%. If you can deploy funds that cost you 2% at 12%, there's a huge margin in there.

Lapera: That's incredible.

Wathen: Right. Assuming, of course, no loan losses.

Lapera: Of course, which as we have covered in BDCs is unlikely.

Wathen: Right.

Lapera: Triangle Capital overall is doing interesting things. We're going to kind of wait and see, I think. Ares Capital, they've had some big news this quarter.

Wathen: Yeah, they've agreed to buy American Capital. Combined, once that deal goes through, their performance (unclear 24:34) will be a BDC with a balance sheet of about $13.2 billion in assets.

Lapera: Which is huge. It's huge. It's big news because they're going to be the biggest BDC once they finish with this acquisition.

Wathen: Right. They will by far be able to underwrite the biggest deals in BDC, which kind of gives them an edge, in a sense.

Lapera: Yeah. Are there any other things we should look out for with Ares Capital?

Wathen: Well, with Ares Capital, I think just seeing how this deal goes through with American Capital. It just really creates a behemoth. Luckily the first steps have already been taken. American Capital had a subsidiary, I guess I should say, that managed the mREIT American Capital Agency. American Capital Agency has already bought out its contract, so step one's already done.

Lapera: Right. Just a quick note, mREIT stands for mortgage real estate investment trust, which is a type of REIT that is also kind of risky.

Wathen: Right, yeah. Right. Instead of credit risk, it's REIT risk, but yeah. Step one's done and now it's just waiting to basically see that deal go through.

Lapera: Overall, what's your opinion of Ares Capital? How do you think that they perform in general as a BDC?

Wathen: Well, luckily with Ares Capital, we've had a really long record to judge them by and they've proven to be very good underwriters. They have gains and excessive losses and they've been very smart about allocating capital. Truthfully, I think if you look at the BDC industry, they're probably a star student in terms of what they've done over time. I would only expect it to get a little bit better with a little more capital to play with.

Lapera: Excellent. I think that we've covered everything that we set out to cover, which was things to look at when you get BDC earnings, stuff that's going on in the industry in general, and three particular BDCs that have actually already reported. Anything else you wanted to talk about?

Wathen: No, I think we got it.

Lapera: Awesome. I just want to remind listeners that you should always do your homework when you make investments, but with BDCs you want to be especially careful and make sure you really understand what you're getting into before buying. If you're interested in learning more, there is a tone of content on Fool.com. Feel free to shoot me an email if you want me to send you some articles to get you started.

As usual, people on the program may have interest in the stocks they talk about and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Contact us at [email protected] or by tweeting us @MFIndustryFocus or at our super exciting new phone number at 866-677-3665. Thank you everyone, and I hope everyone has a great week.