A BDC, or business-development company, is a closed-end investment company that invests debt and equity in small and medium-sized companies. An externally managed BDC hires a third-party management company to make the company's investment decisions. The management company is responsible for paying its own expenses and is compensated through fees based on the BDC's assets under management and investment performance.
There are pros and cons of hiring a third-party management company
The key distinction between externally managed BDCs and other BDCs is the third-party management company. This management structure comes with positive and negative characteristics.
On the positive side, externally managed BDCs have a much simpler infrastructure setup than their internally managed counterparts. Instead of having requirements for offices, HR departments, teams of analysts, managers, and executives, the company consists of just its invested assets. All the expenses from the infrastructure are outsourced to the third-party manager.
That arrangement does have some drawbacks, though. For example, externally managed BDCs tend to have higher expense ratios than internally managed companies. The difference comes from the fee structures used to compensate the third-party management. Typically, the third-party manager will charge a base management fee of 1.5-2% of the total assets under management. Additionally, the management company will receive a performance incentive of 10% to 20% of the company's profits after a certain rate-of-return hurdle has been cleared. Together, these charges drive a typical range of expense ratios of around 4% to 4.5% of total assets, or 30% to 40% of revenue.
Two big concerns: undisclosed compensation and growth above all else
There are two major concerns related to externally managed BDCs that come up over and over: undisclosed compensation and potential conflicts of interest between shareholders and the management company.
First, BDCs aren't required to disclose the exact structure of the fees paid to the third-party manager. While an internally managed BDC must disclose all its expenses on the income statement and its compensation structures in proxy filings, externally managed BDCs have no such requirement. Investors can see an externally managed BDC's expense ratio, but details beyond that final number are hard to come by. This is a problem, because investors have no way to know how well the management company's compensation incentives are aligned with shareholder priorities.
That leads us to the second major problem -- the potential for conflicts of interest. If the fee structure leans too heavily toward total assets under management, then the third-party managers will prioritize raising new capital to fund growth, regardless of the cost to existing shareholders. Their goal could be to simply increase assets at any cost, which, by proxy, would boost their fee compensation in kind. Growth is a great goal, so long as it's funded in a way that doesn't harm existing shareholders and helps to drive increased profitability. With a poorly constructed compensation plan, however, some externally managed BDCs will pursue growth for its own sake, sacrificing profitability and harming shareholders in the process.
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