BDCs have been around since the 1980s but have recently multiplied. More than 50 of them are now listed, with a combined market capitalization in excess of $35 billion (see chart).
BDCs are allowed to borrow as much money as they raise from shareholders, usually through fixed-rate bonds, so the total amount at their disposal is approximately $70 billion. The industry’s total valuation is only a quarter of Citigroup’s, and were they to lend out this entire sum, it would equal just 4% of America’s commercial and industrial loans. In reality, some of their money is invested in shares and some goes into property, so their impact is even smaller.
Still, BDCs are big enough to be receiving attention from businesses hungry for capital and willing to pay interest of 10% or more to get it, as well as from investors hungry for dividends, which can also exceed 10%. That is more than four times the dividend on the average stock and more than double the yield of even a junk bond.
The high payout comes with a caveat, however. Because BDCs are classified as a fund, they pay no corporate tax, unlike a bank. To preserve this status, they must distribute 90% or more of their income each year. As a result, building up their capital base is a slog. So too is finding good customers for loans, since they do not offer the prosaic products like current and payroll accounts through which banks typically acquire their customers. Many BDCs specialize in financing the acquisitions of private-equity firms. That helps to keep down costs, as they make big loans to just a few customers. But it can also suppress returns, as there is lots of competition to back private-equity deals.
Although BDCs limited borrowing makes them safer than banks, they also suffer from higher defaults. As a result, when the financial markets become volatile, and in particular when the market for high-yield debt wobbles, their shares slump and they struggle to raise capital.
Another quirk is that all but a handful of BDCs do not have internal managers; instead, they farm out their management to nationally independent firms. The managers’ compensation under such deals is often opaque but lavish. Indeed, charges akin to the “2 and 20” that hedge-fund managers once typically extracted (a management fee of 2% of assets and a performance fee of 20% of profits beyond a certain threshold) remain common.
We use BDCs within our Global Multi-Asset Income Model and Private Equity Model as an Alternative Fixed Income and Mezzanine Debt allocation, respectively.
(Source: The Economist)
