As yields on middle-market debt come down, business development companies have turned to so-called "senior loan funds" to generate higher returns.

Senior loan funds are nothing new -- Ares Capital (NASDAQ:ARCC) has operated its Senior Secured Loan Program for years after inheriting it from Allied Capital -- but they are growing more prevalent as time goes on. The strategy, once reserved only for the largest BDCs, is now trickling into the toolbox of every BDC, big and small.

I thought it appropriate to explain how a senior loan fund works and discuss the pros and cons for BDCs that deploy them.

Why do BDCs form SLFs?
By law, BDCs are limited to 1:1 leverage on their own balance sheet. However, there is no restriction that prevents a BDC from investing in portfolio companies that use more than 1:1 debt-to-equity leverage.

Thus a BDC, by creating a senior loan fund with a separate balance sheet, can effectively obtain higher leverage than is allowed by statute at the BDC level. 

This gets tricky, so an example may help to explain what's actually going on.

Assume a BDC starts an SLF that it wants to leverage at 2:1. It provides $100 million in equity capital to its SLF, and the SLF secures another $200 million in debt capital from a bank. The SLF now has $300 million in combined debt and equity capital, which it invests in senior loans to businesses.

The BDC will account for its $100 milion equity investment in the SLF on its balance sheet. It won't, however, put the $200 million in debt on its balance sheet; the SLF is the borrower, not the BDC.

So an SLF is a way for BDCs to effectively control more investments and use higher leverage. This is why the ratings agencies like Fitch call senior loan funds a source of "off balance sheet" leverage. The equity investment on the SLF appears on the BDC's balance sheet; the SLF's debt does not.

What are the typical returns?
In a good credit environment, SLFs can generate spectacular, double-digit returns on equity from the spread between their borrowing costs and the return on their assets. In addition, profitability can be juiced by "one-time" fees, including origination and prepayment fees on the underlying loans in the SLF.

I'll refer to a few examples to show the profitability of an SLF:

Source: SEC filings.

In general, after collecting interest from the loans and paying interest on the senior loan fund's debt, BDCs hope to generate "mid-teens" returns on equity. Recently, this has ranged around 14% returns to the BDC, excluding credit losses and returns juiced from origination fees.

What do SLFs invest in?
Because SLFs use more leverage sourced largely from bank credit facilities, they typically hold "safer" investments than a BDC might hold on its own balance sheet. After all, the profitability of a senior loan fund hinges on its ability to borrow cheaply. Lenders will provide the necessary cheap leverage, but only if they feel as though their capital is safe.

Typically, senior loan funds hold first-lien loans (first claim to the assets) and so-called "unitranche" loans (a loan that covers a company's entire debt part of the capital structure).

First-lien and unitranche lenders have more control should negative credit events happen. In addition, their first-lien position reduces the risk of loss, as they're the first debt investors in line for recoveries during a liquidation.

What are the risks?
The most significant risk is that of investment losses on the loans that the SLF holds as assets. When loans within an SLF go bad, the leverage inherent in an SLF can magnify the losses to the BDC. If an SLF is levered at 2:1, the loss of one loan equal to 2% of the total portfolio would result in a 6% loss in the SLF's capital base.

BDCs effectively hold the "first loss" position. When an SLF is leveraged at 2:1, a 33% loss on the underlying loans would result in a complete loss to the SLF's equity -- the BDC would see its equity investment drop to zero.

A total loss is unlikely, but due to the impact of leverage, single-digit credit losses can quickly become double-digit losses for the BDC. Remember, BDCs do not and cannot reserve for credit losses like banks do. So any losses appear in immediate writedowns of a senior loan fund's equity value.

What are the benefits?
Besides the obvious benefits of higher leverage and the potential for higher returns, another fringe benefit is the reduction in operating expenses relative to assets under management.

An SLF levered at 2:1 may manage $300 million in loans with an equity value of $100 million. If a BDC's external manager charges 2% on assets, it will only take a fee of $2 million on the $100 million in equity at the SLF. Meanwhile, if all the assets were on the BDC's balance sheet, it would take 2% of the $300 million in assets, or $6 million in annual fees.

This can be very beneficial to BDC shareholders, because, in this example, shareholders pay a fee on only one-third of the assets used to generate returns for shareholders.

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.