Flat Rock Capital

A Floating Rate, Higher Yielding Solution - BDCs

Business Development Companies, or BDCs, provide investors with an attractive opportunity to access exposure to the debt of small and middle market businesses. The Business Development Company was created by Congress in 1980 to encourage investment in small, growing businesses. A BDC can invest in either the debt or the equity of predominantly private, US-based businesses. The US-based investment restrictions can make a BDC more of a pure play on the US economy then other investment strategies. Additionally, most BDCs focus on debt investments that allow for the generation of a dividend yield for investors.

Middle Market Debt: Potentially Higher Yields and Yet Lower Loss Rates

According to S&P LCD data, middle market loans typically possess higher yields than broadly syndicated loans or high yield bonds. These middle market loans also tend to have lower leverage, better coverage ratios, and stronger covenant restrictions. Loan covenants are financial benchmarks that a borrower must meet or else fall into a loan default. They assist middle market lenders in minimizing losses by providing the lender with greater control in the event of a drop in performance exposure to non-investment grade debt. One challenge of high yield bonds, however, is that they tend to have a term of 10 years, are generally unsecured, and rarely have any covenants. The greatest concern to investors in the current interest rate environment, though, is the fact that high yield bonds are fixed rate investments. To gain floating rate, lower duration exposure, some investors have rotated out of high yield bonds and into broadly syndicated loans through loan funds. A concern with loan funds is that investors are paying a significant premium for perceived liquidity and the large private equity firms behind the buyouts that create these broadly syndicated loans rarely allow the lenders to maintain strong covenants that can be critical to minimizing losses.

Middle market loans provide the low duration, floating rate exposure of broadly syndicated loans, but offer higher yields due to a perceived illiquidity premium. These middle market loans also tend to have larger equity buffers against losses and provide lenders with stronger covenants. If a middle market borrower encounters some financial distress, a covenant violation (or threat of a covenant violation) often allows the middle market lender to avoid losses by forcing the borrower to quickly make operational changes to improve the company’s financial situation. Prequin, one of the leading data sources for alternative investments, recently noted that direct lending funds launched in the period 2008-2011 have attained internal rates of return of between 10% and 14%. It’s these types of returns, less correlated to the equity markets, which have driven the growth of direct lending BDCs from $5 billion in assets under management in 2002 to over $80 billion today. Jonathan Bock, research analyst for Wells Fargo Securities, further points out in a January 6, 2016 research report that the BDC industry has had average losses since their IPOs of 24bp versus average losses for bank C&I loan portfolios of 224bp.

Caution Before Investing

While BDCs may seem like an efficient solution to the search for lower risk yield, not all BDCs are the same. BDCs can invest in anything from a company’s first lien, senior-secured debt to second lien, mezzanine debt or equity. Fortunately, BDCs provide excellent transparency into their portfolios. They are required in their quarterly filings to provide a list of every investment and most provide portfolio summaries showing investments broken out into various categories. While these investment categories provide some sense of the relative risk of a given BDC, a more accurate way to measure the risk in a given BDC portfolio is to look at the average yield of the portfolio.

For example, according to Wells Fargo’s Q32016 BDC Scorecard, Golub Capital (GBDC) has a weighted average portfolio yield of 7.1%, while Black Rock Kelso’s (BKCC) portfolio has a weighted average yield of 10.9%. While portfolio yield alone does not determine the quality of a BDC investment, it is an excellent measure of the underlying risk of the portfolio

Beyond understanding a BDC’s underlying portfolio quality, there are numerous red flags a BDC investor should take note of before investing. The most important attribute in a BDC is a commitment to cover the dividend through net operating income with an allowance for some adjustments. If a BDC’s dividend yield is being paid in part through a “return of capital,” then the BDC’s net asset value and ultimately its stock price will decline as a result of that return of capital.

Failure to cover the dividend also potentially puts pressure on the BDC management to stretch for yield as they seek higher yielding, riskier assets to assist in covering the dividend. As Jonathan Bock, Wells Fargo Securities equity analyst pointed out, “We continue to prefer the highest quality BDCs with very sound dividend coverage.” For Bock, these BDCs include Golub Capital (GBDC), New Mountain Capital (NMFC) and TPG Capital (TSLX), among others.

In fairness, as market conditions change, even a high quality BDC management team may find itself unable to cover the dividend in any given quarter. However, well managed BDCs can address this issue by waiving a portion of the fees paid to the advisor. New Mountain Capital has done this in the past as an example. This fee waiver puts money back into the BDC investor’s pocket by increasing operating income and allowing the BDC to meet its dividend obligation.

Most investors and, unfortunately, BDC management teams view a BDC’s dividend as fixed. The problem with this view is it places the dividend yield as the one hard coded element of a BDC’s strategic plan, forcing every other aspect to become a variable adjusted to meet this fixed dividend. The result can force BDCs to be wrongly motivated in a number of areas: seeking high-yielding investments during riskier economic environments; increasing leverage at the wrong time; creating off-balance sheet leverage as a means of offsetting lower yields; or seeking equity investments hoping for a “homerun” return to offset lower yields.

High quality BDC management teams should adjust their dividend if a longer term, lower yield environment persists. While investors’ dividend declines, they will find in the long run that management has protected their net asset value. In the end, every BDC’s return is equal to their total economic return, calculated as a BDC’s earned dividend yield plus or minus the BDC’s change in net asset value over time.

Proceed With Caution, But Proceed

Middle market debt is an underappreciated asset class that can potentially provide investors with higher yields, yet lower losses than alternative non-investment grade debt. BDCs provide a unique investment vehicle that allow investors to capture this middle market debt illiquidity premium. However, an understanding of a BDC’s underlying portfolio quality is an important first step in underwriting a potential BDC investment. Beyond portfolio quality, dividend coverage is paramount to the long term performance of a BDC.

About the Author

Robert Grunewald is CEO and Founder of Flat Rock Global, LLC.
Mr.Grunewald has over 25 years of experience with middle market finance, BDCs and asset management. Within the finance industry, he has participated as a lender, investment banker, M&A advisor, private equity investor and hedge fund manager. Flat Rock Global, LLC is an alternative asset manager. The firm develops yield-driven investment strategies focused on asset classes deemphasized and currently underserved by the banking sector. Flat Rock Global expects to launch its initial fund, Flat Rock Capital, in early spring, focused on making first lien, senior secured loans to middle market companies.