BDCs Get Approval to Use More Leverage

Business development companies (BDCs) are important conduits of capital. They issue stock and bonds on Wall Street, using the capital to invest in private businesses that are too small to raise money from the public and too risky to borrow from traditional regional banks.

Most BDCs are structured as registered investment companies (RICs) and thus have a requirement that they pay out 90% of their taxable earnings to shareholders each year as dividends, resulting in yields that frequently rise into the double-digits.

By passing the $1.3 billion spending bill on Friday, lawmakers gave the industry a lot more flexibility by enabling BDCs to borrow twice as much money as they could before. This is a really important development for people who invest in the industry. Here's why it matters.

More leverage means more investment choices

BDCs have always been limited to 1:1 leverage, meaning they were only legally able to borrow $1 for every $1 in equity capital on their balance sheet. This leverage limit is much lower than limits on other lenders, particularly banks, which can leverage themselves by 10 times or more, many taking in $12 in deposits for every $1 of equity capital to generate returns by making lower risk loans.

BDCs have long complained that the 1:1 leverage limitation was too restrictive. BDC shareholders generally expect returns on equity of 8%-12%. To generate those returns with low leverage, BDCs were limited to investing in the riskiest, highest-yielding debt. 

Table source: Author.

In theory, more leverage affords BDCs the opportunity to make lower-risk loans and put more leverage on them, enabling them to generate the returns on equity that shareholders expect. Using 2:1 leverage on loans that yield 6% may enable BDCs to earn roughly the same returns as using 1:1 leverage on loans that yield 9%, for example.

We already know how higher leverage might help BDCs venture into lower-yielding debt. Golub Capital BDC currently uses roughly 2:1 leverage on a senior loan fund to earn an 11.4% return on equity from a portfolio of loans that yields only about 6.8%. A "loophole" in the law previously limited a BDC to using higher leverage on only about 30% of its balance sheet. The spending bill that was recently signed into law enables BDCs to use 2:1 leverage across the entirety of their balance sheet.

Good or bad?

It's easy to be very critical of a policy that would allow BDCs to take on more risk, but the simple truth is that a 1:1 leverage limit was probably too safe. If, over the passage of time, you loaned money to every BDC in existence and bought every single bond a BDC ever issued, you would have never, ever lost money to defaults or credit losses. 

It's mind-blowing, but it's true. If a BDC breaks through the legal leverage limit, it has to suspend dividends or raise more equity capital, two actions that protect a BDC's lenders against losses. Lending money to BDCs is one of the safest bets around, something credit investors seem to be slowly realizing as BDCs increasingly borrow at lower interest rates relative to risk-free U.S. Treasuries. 

Importantly, BDCs are, on average, pretty good about regulating themselves. Even though BDCs can leverage their equity at 1:1, few actually did that. According to data compiled by Thomson Reuters BDC Collateral, the industry as a whole uses about $0.69 of debt for every dollar of equity capital, far below the 1:1 limitation.

BDCs don't make full use of the leverage rules for many reasons. First, ratings agencies typically require a debt-to-equity ratio of less than 0.85 as a prerequisite for an investment-grade rating. Second, most BDCs like to have a cushion for losses in their portfolio. Finally, BDCs like to have "dry powder" available for making an opportunistic investment since having investment capacity gives them optionality value to profit off the occasional "fat pitch" deal.

What's next?

There are a few safeguards for BDC shareholders who are fearful that BDCs will ramp up their leverage and take more risks to generate higher returns. A BDC manager cannot decide unilaterally to start using more debt to finance its balance sheet. BDCs will need approval from shareholders, lenders, and the ratings agencies to borrow more money.

1. Shareholders -- The law requires BDCs to get specific approval from their shareholders to take their leverage up to 2:1. BDCs that are prone to act in ways that aren't friendly to shareholders may find it difficult to get shareholder approval. 
2. Lenders -- Most BDCs source leverage from banks and the bond market. While the bond market has been wide open to BDCs, banks who lend to BDCs through credit facilities typically require covenants relating to how much leverage a BDC can use across its balance sheet. Bank debt is cheap, and BDCs want to keep banks happy to have access to the cheapest source of financing.
3. Ratings agencies -- In a commodity industry, access to capital is everything, and ratings agencies have a big impact on which BDCs can borrow and at what price. How will S&P and Fitch treat higher-leveraged BDCs? That remains to be seen. But their credit models have a big impact on how BDCs behave. If the ratings agencies say "jump," BDCs will ask "how high?"

Putting fee structures in focus

In and of itself, more leverage isn't inherently bad. It's all about whether or not the benefits of more leverage will actually flow to shareholders rather than a BDC's managers or borrowers.

Some BDCs are better positioned to create value for their shareholders by using more leverage than others. Business development companies typically compensate their management teams with a "2-and-20" fee structure, where the BDC pays its manager a fee based on a percentage of assets under management plus an incentive fee for good performance.

When it comes to what constitutes "good performance," calculations vary. Golub Capital BDC calculates its incentive fee based on a metric that takes credit losses into consideration. In contrast, Ares Capital Corporation's manager earns an incentive fee based on a calculation that generally excludes such losses. Ares Capital could therefore pay its manager an incentive fee even during accounting periods in which its shareholders lose money. 

Data source: Company filings, author.

In my view, shareholders should be selective in whether or not they vote to approve a BDC to use more leverage. Managers who are compensated based on total returns are less likely to abuse the right to use more leverage than managers who are compensated on income before credit losses. More leverage is almost always good for managers who are not penalized for losing money.

Evidence of a changing landscape

More leverage has been the talk of the industry for years. In 2016, I wrote a few predictions for the industry, one of which was that a BDC "modernization" bill would pass, opening the doors for BDCs to borrow more money. For years on end, it seemed almost certain that BDCs would get authority to ramp up their portfolios, but the proposals would always sputter out...until now. 

The BDC industry may be little-followed and underloved, the result of the fact that BDCs aren't allowed into any stock indexes like the S&P 500 or Russell 2000, but I see the newly adopted leverage rule as a sign that BDCs have more clout as household name asset managers enter the fray.

Virtually every major credit investor and private equity firm -- Blackstone, BlackRock, TPG, Golub, Ares, Apollo, KKR, Oaktree, and many more -- now has a publicly traded BDC or has managed one in the past. One of the benefits of institutionalization is that the industry now counts some of the most politically powerful and influential financiers as allies.

We'll have to see how this shakes out, but more leverage just reinforces the importance of the three pillars that separate the "good" BDCs from the "bad" -- a shareholder-friendly management team, a shareholder-friendly fee structure, and access to good deal flow.