Financials: The ABCs of BDCs (Business Development Companies) *** INDUSTRY FOCUS ***

Financials: The ABCs of BDCs (Business Development Companies) *** INDUSTRY FOCUS ***


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
someone 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 to 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 cashflow
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. It’s ownership of a company that isn’t public. So, 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 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, the 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 is, 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 is 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 if the default rate on your average loan?
Right now, that’s something the market is trying to understand, is, 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. So,
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 3 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, Aries 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 3 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 expound 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 [email protected]
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 [email protected] 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 [email protected] 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 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!

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