There's an interesting dynamic going on in the BDC industry. Prospect Capital Corporation (NASDAQ:PSEC) and Golub Capital (NASDAQ:GBDC) exemplify it best.

These are two very different BDCs, of course. Golub Capital has been adamant about favoring portfolio quality to yield, and offers one of the lowest yields in the industry. Prospect Capital offers one of the highest.

But nothing makes them more different, and more interesting, than the direction of their managers.

Golub's long view
Golub Capital's managers have spent the last several quarters commenting on loan quality, and realigning the portfolio toward better credits. In fact, the portfolio has shifted so far into higher-quality investments that the management team is no longer earning its full fee.

Fees for BDCs come in two parts. The first is the management fee, charged against all assets in the BDC.

The second is the income incentive fee, which rewards management when returns exceed a particular threshold. In Golub's case, that threshold is 2% per quarter or 8% per year. Here's how the incentive fee works:

  • No fee when returns are between 0-8% per year.
  • Management receives 100% of returns between 8-10% per year, called the "catch up."
  • Management receives 20% of returns in excess of 10% per year.

Right now, a shift toward higher-quality assets is putting pressure on management to beat the 8% hurdle rate of return. And, although it would be in the best interest of Golub's managers to take on more risk to earn a higher incentive fee, they aren't doing it.

CEO David Golub said it best on the latest conference call:

That's the deal that we as manager have with our shareholders, I think it's a fair and appropriate deal. One of the ramifications of this is that the decision to go quality here is substantially coming out of the manager's pocket.

Higher yields wouldn't reward shareholders. It would reward management, just by the nature of the management agreement. Alas, Golub Capital isn't interested in boosting returns for management at the expense of shareholders.

Where does Prospect Capital fit in?
I mention Prospect Capital because it's in the opposite situation. The company is challenging a request by the SEC to consolidate some of its operating companies. Management explained that consolidation would be good for shareholders, in part because it would reduce fees paid to management due to the mechanics of its own management agreement.

Yet, Prospect Capital doesn't seem willing to consolidate its operating companies. Instead, it seems willing to challenge the SEC's request at all costs. To be fair, the company does cite some business reasons for its current business practices -- it's industry practice to use holding companies when doing so can secure better third-party financing.

But this whole ordeal doesn't do much for Prospect Capital's reputation as an asset manager. It already has some of the highest management fees in the industry, which would reward its external manager with more than $200 million in fees this year alone. Complying with the SEC's request would be good for shareholders and immediately settle investor concerns about potential accounting issues.

The last word
When it comes to externally managed companies, I think shareholders would be wise to examine how management acts when it's their money on the line. Here we have two very different managers doing two very different things, with different impacts on their shareholders.

As time goes on, the industry gets more competitive, and rates fall, the conversation is going to shift to management fees. After all, what you pay someone to manage your money is one of the most important variables in an investor's total return. There's a case to be made that Prospect Capital is a little too focused on what is good for its management team, whereas Golub is willing to sacrifice its own compensation for the better of its own shareholders. Make of that what you will.