Business development companies can be categorized in any number of ways. Some prefer to divide the industry by the quality of the debt they invest in, from mezzanine to senior loans. Some prefer to slice and dice by the size of their average portfolio company.
As for me, I like to divide and conquer by internal and external management. In the long run, I think there is no more important distinction, and the chart below will show you why.
It's all about incentives
Internally managed firms are simple. They hire analysts, accountants, and lawyers necessary to run the business and put them on the payroll of the firm. Externally managed BDCs are a bit more complicated. The BDC pays an external company a set of management fees based mainly on assets, and the external firm puts all the employees on its own private payroll.
Thus, we can make a general rule about the incentives of external and internal managers. External managers care most about growing assets under management, since it is the key variable in compensation. Internal managers, if incentivized correctly, care not about the size of a BDC's assets, but the size of the return on assets.
And if you agree that the above rule is true, you shouldn't be surprised by this chart from Triangle Capital's (NYSE:TCAP) most recent investor day.
In the long run, the single best way for a BDC to grow is by issuing new shares of stock. Ideally, these shares would be sold at prices above a BDC's net asset value -- book value. In the best possible scenario, new shares would be issued at extraordinarily high multiples of book value, enriching existing shareholders with each share sold.
So, let's go back to the chart. You'll notice that externally managed BDCs have historically issued substantially more shares under their last-reported net asset value than internally managed BDCs. And when they issue shares above book value it's rarely at a big premium -- only a few percentage points. Internally managed firms, by contrast, have issued mainly above net asset value, and at large multiples of NAV.
Why this trend exists
There are three reasonable explanations for the trend above.
First, externally managed BDCs have incentive to raise more money whenever possible. Raising more money for the BDC means a bigger permanent fund on which the external manager can take its lucrative management fees every single year.
Secondly, because the market recognizes the incentives of externally managed BDCs, investors are not willing to pay high multiples for externally managed BDC stocks. Investors fear that a BDC will sell new shares into the market to grow its balance sheet, pushing prices down. Thus, there is a natural limit to the price of an externally managed BDC.
Note that the point above seems to be lost on sell-side analysts eager to win investment banking business from the BDCs they follow. I've seen a number of outrageous price targets that will never be met because the money-hungry BDC would drive down the price with a secondary stock offering if shares were to ever trade at such high prices.
Finally, internally managed BDCs typically have lower costs as a percentage of revenue. All else equal, a BDC that spends 25% of its revenue on expenses should trade at a bigger multiple of book value than a BDC that spends 50% of its revenue on operating costs. Again, all else equal, the lower-cost BDC could trade at a 50% higher price-to-NAV ratio and yet maintain the same price-to-earnings ratio as its less-efficient rival.
How it impacts returns
The ability to issue shares at large multiples of net asset value is a huge advantage. Given the option, investors should prefer to pay a higher multiple of book value, but the same multiple of earnings, for an efficient internally managed BDC.
Over time, the benefits of efficiency are obvious. More of the top-line revenue flows into your pocket. Each investment loss -- and losses will happen -- has a smaller impact on the income of an efficient operator than the inefficient. And the ability to issue shares at high multiples of book value enables a company to deliver spectacular step-function growth in book value over time.
And lest we forget the impact of incentives; managers focused on returns on assets should be better stewards of your capital than managers who focus solely on the size of their assets.