Business-development companies (BDCs) defy simple explanation. Unlike most industries, investors don't usually have any direct connection to what BDCs do. Relative to other industries, BDCs are far from transparent, and much of their accounting is based on estimates.

But don't worry! In this week's episode of Industry Focus: Financials, Gaby Lapera and Fool writer-analyst Jordan Wathen get you up to speed on BDCs: how they make their money, where to find their public information, and how to interpret it. They also discuss what questions you want to ask before investing in one.

A full transcript follows the video.

 

This podcast was recorded on Jan. 15, 2016.

Gaby Lapera: The most simple complicated businesses on earth: BDCs. Industry Focus: Financials edition.

Hello, everyone! Welcome to Industry Focus, financials edition. This is Gaby Lapera in the studio, and I am joined by Jordan Wathen on the phone. Jordan is our resident expert on business development companies, which we will be calling BDCs, because that's far less of a mouthful. And he is also an excellent writer-analyst that we have here at The Motley Fool.

This episode goes out to Levi Wadell of South Dakota, the brave soul who requested more information on BDCs. God bless you (laughs)!

There are currently 51 publicly traded BDCs with a combined market capitalization of about $32B. BDCs have proliferated, especially recently. But they started back in the 1980s, when Congress created the legal form for them. They're a very confusing company form. Do you want to tell us a little bit about how to think about BDCs, in general? What exactly are they?

Jordan Wathen: Right. You can think of them something like a real estate investment trust, or a REIT. By law, they have to distribute most of their income in the form of dividends, which results in those huge dividend yields you see: 8%-13%, even. But unlike a REIT, they aren't investing in real estate. So in general, they're making loans to companies to buy other companies, whether it be a private equity firm that wants to buy a target for one of its funds, or a company that wants to sell out to a family member. They're making cashflow loans, riskier loans. So a typical BDC loan might yield 9%-10%, even.

Lapera: So it's a little bit like a REIT and a venture capitalist firm had a baby.

Wathen: (laughs) Yeah, it's a little bit like that -- a little bit of a weird combination like that. Where REITs go in to buy very low-risk, for the most part, real estate, and hold it and lease it, a business development company is going to make loans to a business that's too small for Wall Street, normally. They can't issue bonds; they don't have that mechanism to raise money.

And the regulators have generally deemed these kinds of loans too risky for banks to hold, because, obviously, a lot has changed in the last 10 years with banks, with regulators being happy about what they're lending to. So, that's where the BDCs step into play: They make loans based on cash flow instead of assets. So a bank will loan you money to go buy a car or building. But they can't lend you money to buy a business at a huge multiple of earnings, for example.

Lapera: Right, which is why Congress created them in the first place, to fund these small, private businesses that might eventually one day grow into something big enough to go public. You did mention something earlier, which was private equity and private debt, which are both things that BDCs hold. Do you want to explain for our listeners what those are?

Wathen: Sure. Private equity is kind of in the name. Its ownership of a company that isn't public. So the Blackstones of the world, the KKRs. They raise huge amounts of money from investors, and they have a mandate to go buy companies, whether it's a public company, or a piece of a public company. Kind of a classic case is, not to turn this into a car show or anything, but Ford (NYSE: F) used to own Hertz, the rental-car company. And private equity buyers were saying, "Hertz is so under managed being part of Ford." Ford had a very convenient thing with Hertz. If they made too many cars, they could just push them over to Hertz to go rent them.

And they said, "This company could be better run if it were separated." So private-equity partners came in and said, "Okay, fine, we'll buy this business and use..." --they want to generally use as little money as they can. So a private-equity firm only wants to use very little of their investment capital to buy out a company. They want to borrow as much money as they can to finance the purchase price. The idea being, the less money of your own that you use, the higher the returns on your money that you get. Right?

Lapera: Right. So what about private debt?

Wathen: Private debt, the way to look at it is, it's a loan to a business that isn't publicly traded. This is the really interesting thing about private debt -- there really isn't the market for it, per se. Bloomberg wrote a piece, and they described it as being one of the last remaining areas of finance that's still done over telephones and fax machines. It's kind of archaic in that way.

Lapera: That's crazy.

Wathen: There's no liquid market. A bond, you can sell fairly easily. A private loan to a private company, there's not that much public information about that company. It's not easy to buy or sell. So that's one of the reasons why these tend to be higher-yielding investments for BDCs.

Lapera: That actually leads perfectly into my next question: How do you know what a BDC is investing in? Can you know?

Wathen: You can, to some extent. That's something that makes BDCs difficult to invest in -- although they're very transparent, they're also not transparent at all. So you can open an annual report for a BDC, and find a list for all its investments. They'll show you, "We made a loan to this company for this amount, this is how much it pays, and this is when it's due." But that company might be, for example, a mattress firm. Private equity loves to buy and sell mattress companies. It's kind of a running joke. Mattresses and bowling seems to be popular.

Lapera: That's so interesting (laughs).

Wathen: Yeah, it's kind of weird what they end up buying. So you know the name of the company, you can go google it if you want to, but you're not going to find much about it. You're not going to find its financials. You'll never know what the company has borrowed from other people.

Lapera: Right, because these are small private companies, they don't have publicly available 10-Qs. They don't actually have to disclose anything they don't want to.

Wathen: Right, and generally, the owners have a vested interest in keeping as much private as they can. So if you're a family who owns a small local business and you're making a ton of money, you probably don't want your competitors to know. You don't want people in the local area who could compete with you to know. So, there's that, too. It's part of the reason why you might go and seek a loan from a BDC -- you don't have to disclose all the information that you might have to if you were going to try to sell it to, say, a public bond fund to raise money.

Lapera: So how risky would BDCs be, then? Because you're investing in a company that's investing in another company that you don't really know anything about.

Wathen: Right. So obviously, they're pretty high risk. The way to understand risk, and I think this goes for any financial company, is to look at the past. The past is no ... what's the common phrase? It's no guarantee of the future, or guarantee of future results. So you can look at a BDC, and you can see its performance over time. You can see, they report their realized gains or losses, which will tell you where they've made money, and where they've lost money. It tells you whether, over time, they've had gains in excess of their losses, which is ideal. You want to see a company that's making investments and generating gains. But it's not so common.

Lapera: So what kind of market conditions -- just like REITs have particular market conditions that are really beneficial to them, like right now, the really low interest rates are great for REITs, because they can get loans for super cheap and buy up all this property. Are there particular types of markets that are really good for BDCs, and similarly, are there really bad markets for BDCs?

Wathen: Well, right now is an interesting time to be talking about BDCs and market conditions, because year to date, I think the average BDC is down about 13%. Hasn't been so good. But in terms of market conditions, the most important thing is, really, credit conditions. What is the default rate on your average loan? Right now, that's something the market is trying to understand -- how well will BDCs do in the future? When you look at -- let's throw a different company in here -- a bank like Wells Fargo, they report their loans net of what they expect to lose over time. So let's say we have $1T in loans, but we're going to lose $20B over the next x years on these loans.

BDCs don't do that. They just report their loans as they are. So that's one of the things you have to think about as an investor. It's one of the things that the market is struggling to handicap, kind of, is how much loan losses should we price in? And right now is an especially interesting time, because oil and gas companies are obviously hurting. BDCs financed a lot of oil and gas companies. There's also metals and mining is in a very good space right now. Commodity prices are way down generally. It's one of the things that ...

Lapera: ... it's one of the things that you have to look out for with BDCs. In general, you can generally know what industries they've invested in. And if they're doing poorly, the BDCs are going to do poorly, because those people are going to default on their loans.

Wathen: Right, absolutely. So if you go into a filing for a BDC, they usually break it out by industry. And it's not always perfect, but they'll say, "We have X% of our investments in oil and gas," or "X% in business services," or "X% in lodging," for instance. So you can kind of get a general feel for what their book looks like without going through every single loan item by item.

Lapera: So for BDCs, are rising interest rates something we should be worried about?

Wathen: In a sense. That's something that's difficult, too. As rates go up, obviously, you'll probably have higher defaults. Some companies won't be able to handle the higher interest rates on their loans, because most of the loans that BDCs make are floating rate. So as interest rates go up, the borrowers will have to pay more. But there's also the view that, if interest rates are rising, the economy should be doing spectacularly, because the Fed's not going to raise interest rates if the economy isn't doing so well. So it's a mix and match. It's hard to say, in general. But if I had to say, I would say rising interest rates will be generally good for BDCs. Generally.

Lapera: Interesting. We're entering the final portion of our show, where I just want to ask you for our listeners, what are the top three or so questions you should ask yourself before investing in BDCs about the BDC itself? What should you look for in the BDC?

Wathen: One thing I like to look at especially is their performance on realized investments. You can have unrealized gains or unrealized losses; you can have realized gains and realized losses. I think I got all those. And so the reason why I like realized gains and losses is because it tells you what they made or lost on investments they've already sold. So that's not investments that they're doing guess work on and saying, "Well, this is still a good loan," even if it might not be. That's investments they've sold to someone else, to another buyer, at a price the other person likes. So that's better indication of whether or not that was a good or bad investment -- when you can see a sale.

Lapera: How they're actually doing. That is something I want to point out to our listeners -- a lot of the accounting that goes on with BDCs is generally guesswork.

Wathen: Right, it's completely guesswork. Most of their assets are level three assets, which, if you're not an accountant, that basically says, "Hey, we're doing a bunch of guesswork to come up with this valuation." And a lot of times, they differ from BDC to BDC. It's amazing. Some BDCs will mark a loan at 100% of par value, and say it's perfectly good, and another one will come out and say it's only worth 80% of par because they think it's riskier. So it's kind of a fascinating disconnect there. And that's why I really like the realized gains or losses over time. Unfortunately, most BDCs are relatively new, so there's not a lot of history. A lot of them have only been investing while the market's going up. But for the ones that have been there through full market cycles, say, Ares Capital, for instance, they're excellent. They've had an excellent history of realizing gains in excess of their losses, which preserves book value over time.

Lapera: That's awesome, and that was a really good explanation of that. We were talking earlier about this, and you said one of the things you like to look at is the portfolio composition.

Wathen: Right. BDCs, in general, are making loans. I'd say the typical BDC probably has 90% of its book invested in loans to companies. But the other 10% is typically equity investments in companies. And that debt-to-equity split can be especially interesting and important because, obviously, nothing changes with public vs private. Debt is still generally safer than equity, right?

Lapera: Right. So, what we were talking about earlier about understanding about how the general market is doing, to understand how their stock portfolios along with their loans, are going to do, because if a BDC has a huge stake in a gold company, for example -- don't know why they would, but maybe they do -- if gold, in general, is going down, then that BDC is probably in a lot of trouble, right?

Wathen: Right, especially if it's an equity stake. One of the ways, when we're talking about level three and how they value these companies, one of the best ways is to compare it to a publicly traded company. So when stocks are down, generally, you would hope that a BDC would mark its equity portfolio down, because those companies simply aren't worth as much as they might have been before.

Lapera: So that's something to watch out for. Since BDC accounting is a lot less transparent and a lot trickier, if the whole market is down, yet the BDC's portfolio is still up, it's one of those things where you have to ask yourself, "Are they being 100% honest with themselves about what's going on with their portfolio?"

Wathen: Right. That's one of those things. It's really hard, as an outsider, when you're looking into the portfolio, because they obviously know way more than you, but you also know that they have an incentive to tell you that things are a little better than they might be. And it's not always bad. Markets go up and down. Whether stocks are worth 8% less right now than they were at the start of the year, I mean, who knows? That's something that plays out over time.

Lapera: Right. So one of the big things to look at -- because for any company, you have to look at the management -- but especially for BDCs, you have to trust the management, since they are making these decisions behind a curtain, if you will. So I know that the third thing that we talked about earlier that you really think that you should look at is what kind of management incentives there are.

Wathen: Absolutely. I think, there's not an executive in the world who won't make a decision to make more money. You know? I think that's how you become a CEO of a company, right?

Lapera: Right.

Wathen: You have to be a little greedy. So as you think about which BDCs to invest in, I would definitely take a look at management incentives. And unfortunately, most of the industry is compensated based on the size of their assets, and not necessarily the returns they're generating on their assets, which can lead to some very serious problems. What happens is that companies that are necessarily great investors still manage to raise a whole bunch of money, and they're happy to plow it into whatever they can, because they'd happily collect their 2% management fee every year -- which can be substantial. If you run a $5B BDC, 2% of that is $100M a year. And maybe you have 50 employees -- that's $2M that you can spend per employee. Obviously, they're not. They're taking a lot of it to profit.

Lapera: Right. I know there's two basic types of BDCs. There's externally managed and internally managed. Can you expand on the differences between those two?

Wathen: An externally managed company is more like a fund. So what happens is, there's an external manager. This is going to be a little complicated. There's an external manager who runs the fund. The fund is what you're investing in. And each year, they take a percentage of the assets and the percentage of the returns generated on that fund to pay the external manager. And that covers all the salaries for their analysts, for the accounting staff, whatever. Whereas, with an internally managed company, you have the assets that are managed by people who work inside the company. So you'll see their payroll expenses, etc., and their profit and loss statements. With an externally managed company, you don't see that, because the fees pay for it.

Lapera: So is one probably a little bit more beneficial for an investor to invest in?

Wathen: Speaking very, very broadly, I would say that internally managed companies tend to be better. Transparency plays an important role there. When people can see how much exactly is going to payroll, or how much exactly is going to executive compensation, it puts more of a limit on it.

Lapera: Right. And I know that's something that -- so one of the things with BDCs is that activist investors often get very interested in them. That's just one of the things that I know they tend to go after, is management that is compensating itself incredibly unfairly.

Wathen: Activism now is a huge factor in the industry, and I think it'll continue to be, because as you look out there, it's kind of interesting. There's a lot of BDCs that say, "Hey, our investments and everything else, this company is worth $10 a share, the book value is $10." And then, investors are saying, "Cool, give me $10." And the BDC manager says, "Well, you can go sell it in the stock market for $7." It's like, "No, you said it was worth $10, why isn't this selling for $10?" That's one of the things that activists are increasingly getting involved with is, how can we make sure that a BDC that reports a book value of $10 per share is ultimately selling in the market for $10 a share? And one of the easiest ways, obviously, is to improve the BDC's income. And one of the best ways to improve a BDC's income is to cut expenses.

Lapera: Right, which is a lot of management fees, really (laughs). The salaries.

Wathen: Right.

Lapera: Okay. So we're actually starting to run out of time. Thank you so much. You helped break down a very complicated topic for our listeners. Listeners, thank you very much for accompanying us on this incredibly deep dive into a difficult topic. It's really funny, because I get emails from both sides of the spectrum. Some people say, "Make it simpler!" Some people say, "This is Industry Focus!" And I agree with those second emails, the ones that say, "This is Industry Focus, you should really do these deep dives into financials." And we try to keep a balance. But today was definitely a deep-dive day.

Ultimately, wrapping this all up, BDCs are probably not for the casual investor. They require a lot of research. They're very complicated; they need a lot of monitoring. So unless you're really willing to spend the time understanding this, this probably isn't the investment for you.

Since we're running out of time, but I do want to do two things: I want to plug Jordan's article. He wrote a really great article with 12 predictions for how BDCs will do in 2016. If you want that, just email me at industryfocus@fool.com. And we also recently posted a list -- wait, that's not true. We're not going to post it at all. In fact, if you want this other list I'm about to plug, you also have to email me at industryfocus@fool.com. It's a list of our best articles of 2015. Really cool list. I voted on those articles. I liked those articles. Again, that's at industryfocus@fool.com.

The last thing -- they're just giving me increasingly longer lists of things to plug for every show, so I hope you guys are still with me. The last thing is, we have a mailbag episode next week, so if you have any questions, go ahead and email me. And starting with the new year, I'm supposed to plug the episode that comes after me, so Tuesday's episode will be very exciting. Apparently, they're interviewing David Gardner. Sean O'Reilly and Vince Shen with Consumer Goods Industry Focus. But who wants to listen to them when you could listen to the financials and all these rambling announcements?

Anyways (laughs) ... If you guys are still with me, as always, people on this program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thanks for joining us, and have a great week!

Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool owns shares of Hertz Global Holdings and has the following options: short March 2016 $52 puts on Wells Fargo. The Motley Fool recommends Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.