As high-yield business development companies report earnings, fees are taking center stage. Many BDCs are slashing their distributions to shareholders, even as they pay more and more money to their management teams.
Loyal BDC investors see it as acceptable treatment. After all, managers with Ivy League credentials are not cheap. And managing a portfolio of private debt is much harder than buying bonds from the public market, so one should only expect higher fee levels to compensate the costs of running the fund. That's a generally fair assessment, but I think it lacks perspective on what fees are really costing the investor.
Looking at fees in a different light
Rather than looking at fees in absolute terms, I think the high cost of management fees should be explored through a different lens. How much of the company's assets are at work for the sole purpose of paying management?
We first have to assemble a table of where each dollar of total investment income (essentially top-line revenue; abbreviated as TII) actually goes.
|
Business Development Company |
TII Spent on Management Fees |
TII Spent on Operating Costs (interest, legal, etc.) |
Net Investment Income (profits for shareholders) |
|---|---|---|---|
|
Prospect Capital (PSEC 0.38%) |
28.6% |
25.5% |
45.9% |
|
Medley Capital (MCC 1.95%) |
27.3% |
21.5% |
51.2% |
|
Fifth Street Finance (NASDAQ: FSC) |
30.0% |
23.9% |
46.1% |
Source: SEC filings for the fourth calendar quarter of 2014
The table shows clearly that roughly half of a BDC's total investment income flows to expenses and management fees. The other half flows through to shareholders in the form of earnings, which are paid out as dividends.
Putting fees in perspective
Let's use Fifth Street Finance as an example. You can buy its shares for roughly $7.06 at the time of writing, a big discount to its per-share book value of $9.17.
That seems like an excellent deal, until you look at how much money is actually working for you. If you multiply the percentage of total investment income that becomes profits (46.1%) by the current net asset value ($9.17), you find that only about $4.23 of net assets per share are at risk to produce returns for shareholders. The remaining assets are at risk to pay the bills -- the management team and the direct expenses of keeping its doors open.
You could say that investors are paying $7.06 per share for the value created by just $4.23 in book value.
In effect, the external manager owns three-tenths of the economic value created by Fifth Street Finance without putting a single dollar of its own capital at risk. Management fees tallied to a whopping $22.76 million last quarter alone. Shareholders, who bear all the risk, collectively enjoyed net investment income of $35.17 million.
Is that fair? Well, that's up to you to decide. But I think that if you are responsible for 100% of the risk and receive less than half of the proceeds, you might be getting a very raw deal, indeed.
