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1 Chart All BDC Investors Must See

By Jordan Wathen - Sep 23, 2013 at 1:48PM

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This chart is really worth 1,000 words to BDC investors.

As consumers, it's easy to have a jaded view of the banking system because it's easy for us to borrow money. A credit card is a few clicks away. A mortgage just requires some paperwork and a little waiting time.

But for other borrowers -- companies, in particular -- it isn't easy to raise funds.

A chart from Ares Capital's ( ARCC -0.24% ) analyst and investor day presentation really hits to the heart of where business development companies (BDC) are positioned in the financing markets:

Source: Ares Capital 2013 investor presentation.

Making the middle market make sense
The chart focuses on Ares Capital, but it's fitting for all business development companies. When a company generates more than $75 million in annual earnings before interest, taxes, depreciation, and amortization (EBITDA), it can tap the vast public markets for capital. That's where the investment bankers come into play.

Businesses that are smaller than that, though, don't have much choice when it comes to raising new funds. They can borrow from regional banks, but most are only interested in asset-based lending -- think commercial real estate loans.

Any other financing must come from middle-market lenders. This includes companies like Ares Capital, as well as Prospect Capital ( PSEC -1.06% ), the two largest business development companies by market cap.

In the lower middle market, businesses can borrow from the Small Business Investment Company (SBIC) and mezzanine funds. SBICs are funds backed by low-cost financing from the Small Business Administration (SBA), and this is how many of the smaller BDCs get traction in middle-market finance.

Main Street Capital ( MAIN -1.10% ) and Fifth Street Capital (NASDAQ: FSC) each manage two SBIC funds. The SBIC program is a huge driver of profits for smaller BDCs because they can borrow up to $225 million in SBA-backed vehicles at low interest rates. Combined with their equity investment, SBICs can have up to $337.5 million in capital.

The SBIC programs are mostly inconsequential for Ares and Prospect, which have balance sheets that dwarf the maximum capacity of SBICs.

Who's who in middle-market finance
Not all middle-market lenders are chasing the same deals. Some seek bigger middle-market companies, while others seek out the smallest of businesses for the highest yields. Here's how the industry stacks up:

BDC

Portfolio Company Size

Typical Investment Amount

Ares Capital

$10-250 million in EBITDA

$1 million in venture companies and up to $400 million in established businesses

Prospect Capital

Less than $150 million in EBITDA

Less than $250 million

Fifth Street Capital

Revenue of $25 to $250 million

$5-75 million

Main Street Capital

Revenue of $10-$1.5 billion

$3-25 million

As you can see, the largest players, Ares and Prospect Capital, are interested in much bigger deals than smaller BDCs -- they need large investments that can substantially contribute to profitability. The smaller BDCs, including Main Street and Fifth Street, want much smaller investments to fit within their much smaller portfolios.

Untapped opportunity
The truth is this: Middle-market companies have fewer choices as to where they can raise funds, which means BDCs have more pricing power than ever. This pricing power allows the industry to pay out some of the biggest dividend yields on Wall Street.

Investors rejoice!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

Main Street Capital Corporation Stock Quote
Main Street Capital Corporation
MAIN
$43.97 (-1.10%) $0.49
Prospect Capital Corporation Stock Quote
Prospect Capital Corporation
PSEC
$8.39 (-1.06%) $0.09
Ares Capital Corporation Stock Quote
Ares Capital Corporation
ARCC
$20.33 (-0.24%) $0.05

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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