Sometimes what seems like a slam-dunk prediction turns out to be dead wrong. While activists made some noise in the business development company (BDC) industry, they generally failed to gain traction outside of the American Capital and Ares Capital (NASDAQ: ARCC) tie-up. Not one BDC needed a bailout by acquisition, and the industry didn't exactly get a free pass for higher leverage. Oops.
In this segment of Industry Focus: Financials, join The Motley Fool's Gaby Lapera and contributor Jordan Wathen as they discuss a few of Jordan's missed predictions for BDCs in 2016.
A full transcript follows the video.
This podcast was recorded on Jan. 9, 2017.
Jordan Wathen: What had happened in the second half of 2015 is that a lot of these BDCs were selling for less than book value. That'd be the equivalent to owning an index fund and it selling for way less than what all the stocks in it are worth. So, activists basically said, "Hey, that's not right. If the market isn't valuing every dollar of assets that you own at a dollar, why are we letting you run it? Let's just shut this down, liquidate it, and cash out." And for a lot of BDCs, they attracted this activist attention.
Whether or not they were successful, I'm going to give myself a failure on this one, I said that activism would flourish. There were a couple of activist targets. Some of them basically didn't pan out so well. There were two BDCs managed by Fifth Street Asset Management. They went after them. Fifth Street Asset Management bought them off. That didn't turn out so well. The one success story was that American Capital was sold to Ares Capital this year. That was the one activist success this year.
Gaby Lapera: OK. Also, for listeners, we're talking about high-yield BDCs. In general, when you see high-yield anything, just assume there's something hinky going on. When companies have high yields like that, it generally means that there's something very risky happening, because high yields don't appear out of nowhere. And when we're talking high yields, we're talking 2X-3X the S&P 500 average.
Wathen: Easily. More like 5X, even. Looking at 10-12%.
Lapera: Yeah, that's a lot. If you see anything in the double digits -- really, anything above 5% -- start asking yourself, "What's wrong with this company? Should I really be trusting them?" This is the exact type of BDC we're talking about. Was there a "BDC takeover" in 2016?
Wathen: There wasn't. Jordan's wrong again. There's not really a reason to spend much time here. What happened was, in early 2016, oil prices crashed. A lot of people thought a lot of these debt investments in oil companies would immediately go to 0. Some did, some didn't. But no, there was no troubled BDC takeover, so mark that as a wrong, too.
Lapera: "Congress will support BDCs?"
Wathen: Also wrong. Everyone has thought this would happen for a long time. One of the protections that investors have in BDCs is that they're limited to one-to-one leverage. So, their debt-to-equity ratio must be less than one-to-one. For a long time, they've talked about increasing that to two-to-one, so you could have $2 of debt for every $1 in equity. For years, I think I've heard about this since 2012, it's been one of the things that would give BDCs a massive lift, if they could use more leverage. To date, it seems to always get stuck with regulators, which I'm not sure is a bad thing, actually.
Lapera: Yeah, I don't think it's a bad thing at all. But we both know how I feel about BDCs. Listeners, if you don't, we have plenty of episodes. Just search Industry Focus BDCs on Google, I'm sure they'll pop up. Do you think that might happen in 2017? A lot of people are gambling on deregulation with the new administration.
Wathen: That's an interesting thing. Someone by the name of Mick Mulvaney -- I don't think I pronounced that right, but that's OK -- he was Trump's pick for the Office of Management and Budget. And he sponsored this bill, and a lot of people think he'll be a birdie in Trump's ear, saying, "Hey, sign this if it comes through." I don't know. I'm not so certain it's such a good thing anyway. I think the good BDCs would use it wisely, and a lot of them would use it in very charitable ways. But when you're making a risky investment, I'm not sure you need more leverage.