CapX Partners

Investment firms known as business development companies (BDC) have been around for years, but today’s BDC is immensely different from how they were first envisioned. BDC’s, having originally invested in equity, now invest largely in the debt of private companies. Sometimes referred to as “the new private equity,” BDC’s appear to be on the rise. We spoke with Jake Savage, Senior Managing Director of BB&T Capital Markets on what the BDC of today looks like and why they’re a growing force in the industry. A BDC is essentially a publicly traded private equity vehicle. But what’s different about or unique to a BDC?

BDC’s come in all sizes and shapes. They lend in almost every industry segments, some to very large private companies, others to very small businesses. What are the common threads running through all BDC’s?

All BDC’s are closed end, non-diversified management investment companies that have elected to be regulated as a business development company (BDC) under the Investment Company Act of 1940. BDC’s are required to comply with various regulatory requirements such as the limitation on the use of debt to finance its investments (asset coverage, as defined in the 1940 Act, must equal at least 200%). Furthermore, most BDC’s have elected to be treated for U.S. federal income tax purposes as a regulated investment company (RIC), under Subchapter M of the Internal Revenue Code of 1986. As a RIC, BDC’s generally do not have to pay corporate level federal income taxes on any ordinary net income or capital gains that are distributed to stockholders if certain source-of-income, distribution and asset diversification requirements are met.

Accordingly, most BDC’s originate and invest in proprietary income producing securities that, when combined with leverage on their balance sheet, and net of operating costs, results in a yield to shareholders in the 7-10 percent range.

Today, there are more than 40 business development companies with $40 billion in assets and $25 billion in market capitalization. Why the surge in BDC creation?

The real triggering event in the growth in the number of BDC’s was TICC Capital Corporation’s IPO in November 2003. TICC was the first externally managed BDC to go public and it opened the floodgates for other externally managed asset managers to create and take public BDC’s. Most of the BDC’s that have come to market since that time have been externally managed. Ten years ago a manager could go public with little to no existing assets under management. Today, a so called “blind pool” BDC IPO would not be received well in the market and we continue to say this to potential issuers who may think there is still a market for them.

The other primary factor that these externally managed asset managers consider when desiring to raise capital in a public BDC structure is the fact that they are infinite life funds. Most of these managers usually raise private capital from investors in a limited partnership structure that has a finite life, usually 10 years. This means they are continually raising new capital and usually never reach maximum available leverage (particularly important for SBIC funds). Accordingly, the BDC structure gives managers a percentage of their AUM with infinite life thus enhancing the value of their management company, which is near and dear to their hearts (and wallets).

Lastly, bank lending during the recession decreased dramatically to lower middle-market companies resulting in a substantial opportunity for BDC’s and other non-traditional commercial lenders. This is reflected by the total assets at BDC’s growing from approximately $21.0 billion in 2008 to over $56.1 billion at the end of the first quarter 2014.

One of the key benefits of BDC’s relative to private funds is the ability to access public retail investors, since private funds are generally restricted to marketing only to qualified or accredited investors. What do retail investors add to the picture?

Generally, retail investors are buy and hold investors. We sometimes refer to them as “lock box” investors since they buy shares and put the certificates in a lock box, figuratively speaking. The negative to this is that since they do buy and hold, they do not trade their shares, thus effectively resulting in lower float and relative trading volume for BDC stocks.

Retail investors buy BDC’s for their dividend yield. Given how difficult it is to find yield in today’s marketplace, BDC’s have become more sought after by retail investors in the past few years. Retail investors are also the primary buyers of baby bonds (denominations of $25, not $1,000, hence “baby” bonds) issued by BDC’s. These bonds generally have a maturity of 5-10 years and are unrated by the rating agencies. These bonds have a fixed coupon and, accordingly, allow the issuer to fix a portion of the capitalization structure resulting in better asset liability management.

Who are a BDC’s typical borrowers?

BDC’s generally invest in the debt of small to middle market businesses ($5 million to $50 million of EBITDA). The smaller the business the less competition there is in the debt capital raise, but smaller businesses are generally riskier than larger ones. In today’s market, many of the transactions requiring debt are buyouts of companies being bought by private equity firms. Many BDC’s do not invest in private companies unless it is in conjunction with a buy out with a known private equity firm. Not all BDC’s follow that model. We believe that proprietary origination of investments is a differentiated model among BDC’s today and generally results in higher investment yields and sometimes better terms, but also slightly higher operating costs.

BDC’s can have up to 30% of their assets invested in non-qualifying investments and, accordingly, are able to invest in equity (minority and control investments), sub-debt, unsecured loans and senior loans of any type company located in or outside the US. Obviously, they then must invest 70% or more of their assets in statutorily defined qualified investments that are generally senior debt issued by U.S. domiciled companies.

Business development companies have been criticized for being too risky, a fact reflected in the typical higher yields. At the same time, Congress continues to look at ways to spare the business development companies from further regulation. What is being done legislatively, as well as by the BDC’s themselves to keep themselves on a more even keel.

When credit spreads gapped out 2,000 bps in 2008, BDC stocks saw their dividend yields gap out as well to an average high of about 25% and price to NAV dropped to as low as 50% of NAV during the same period. Risky, somewhat. Resilient, yes! Given that this was a credit crisis, it is not surprising that credit related stocks were hard hit. However, the resiliency is a result of low balance sheet debt by BDC’s (statutory maximum of 100% Debt to Equity ratio) and rigorous underwriting. Pre-crisis, many BDC’s were operating with 90+ percent debt to equity ratios and when credit spreads gapped out, the fair market value of their investments plummeted. This pushed a few of the BDC’s into technical default (greater than 100% debt to equity ratio) which resulted in a few of them being sold to other BDC’s. However, by and large the industry weathered the storm fairly well and has continued to grow and prosper.

With respect to debt to equity ratios today, BDC’s average approximately 56%, which is up from the nadir of about 35% in 2010, but below the zenith of 65% in 2008.

While it is difficult to comment on anything that is or is not coming out of Washington, there is proposed legislation to allow for higher leverage ratios for BDC’s and changes to allow them to incorporate by reference which will make it easier and cheaper for BDC’s to keep shelf registrations statements up to date. These changes, along with proposed changes to SBICs, would be welcome, but we are skeptical that they will be forthcoming given the political acrimony in today’s Washington. Given how the industry has grown during this recovery (total assets have grown from over $21 billion in 2008 to over $56.1 billion as of March 31, 2014, a compound annual growth rate of 20.6%), a compelling case can be made that BDC’s are doing their share of truly stimulating the economy and are, accordingly, worthy of these statutory changes.

The average fair value to cost of all investments by the industry today is about 99%, and the average non-accrual loan to total investments at fair value is less than 1 percent (0.8%). With BDC stocks trading on average at 107% of NAV (this allows for BV accretive offerings) and dividend yields averaging 8.6% for the industry as a whole, the industry seems relatively cheap, for example, compared to the current U.S. REIT industry average dividend yield of 3.7%. We are not sure that we will get back to the heady pre-crisis days when BDC’s were trading on average with dividend yield ranges between 6.0% and 8.0%, but as time moves on and BDC’s continue to perform well, we would expect yields to drop and, accordingly, price to NAV ratios to rise.

About Jake Savage
Senior Managing Director, Co-Head Equity Investment Banking, BB&T Capital Markets
BB&T Capital Markets is a division of BB&T Securities, LLC, a wholly owned, nonbank subsidiary of BB&T Corporation

As the Co-Head of Equity Investment Banking at BB&T Capital Markets, Mr. Savage co-manages the Equity Investment Banking group consisting of approximately 60 investment bankers and 12 support personnel. For 20 years—the first 10 with Scott & Stringfellow—Mr. Savage has acted as a full-time investment banker and currently is head of the Financial Services Group, which advises banks and thrifts, business development companies and other specialty finance companies on financial, capital and strategic issues. Mr. Savage’s extensive experience in more than 150 completed capital raising and merger transactions brings his clients and protégées a unique skill set from which to execute transactions and teach, respectively.

Mr. Savage graduated from the University of Virginia with a bachelor’s degree in economics. After three years with Bankers Trust Company in New York, Mr. Savage became a registered pharmacist and worked as a consultant pharmacist until joining Investment Corporation of Virginia in Norfolk, which was subsequently purchased by Scott & Stringfellow, LLC. Mr. Savage earned the Chartered Financial Analyst designation in 1994.

BB&T Capital Markets is a division of BB&T Securities, LLC, a wholly owned nonbank subsidiary of BB&T Corporation. BB&T Corp. is the 11th largest financial holding company in the U. S. with more than $184 billion in assets concentrated in investment banking, corporate banking, retail banking, insurance and wealth management lines. The BB&T Capital Markets Financial Services Group provides business development companies, community banks & thrifts, and other specialty finance companies with a full range of capabilities and services, including public and private equity and debt origination and issuance, buy- and sell-side merger & acquisition advisory, fairness opinions, valuations and other advisory services