Current Trends: Business Development Companies
Debt Investments or Equity Investments
DEAN CHOKSI: Most BDCs primarily focus on debt investments and they have anywhere from five to 15% of their portfolios dedicated to equity investments. If you think about the BDC business model, the way the sector views equity investments is if you're invested primarily in debt, you're not going to really generate much NAV appreciation or book value growth because debt investments don't really appreciate in value unless interest rates are declining or spreads are tightening. So the sector generally invests a small amount of its capital in equity investments, under the view that appreciation in the equity investments over time may potentially offset any credit losses in the portfolio to leave book value essentially stable.
BDC Versus Bank
CHOKSI: We're not really competing with banks, we're competing around banks. When banks are in cash flow lending, they're very focused on safe loans that are senior in the capital structure and they're not expanding much debt. When banks are in cash flow lending, they're doing it very safe in the capital structure. Banks typically prefer to lend to its assets – real estate receivables, a factory, or some sort of an infrastructure. So when a company such as a professional services company that doesn't have assets wants more debt than a bank is willing to provide, a BDC can step in.
BDCs Positioning for Rising Rates
CHOKSI: BDCs may actually perform relatively well in a rising interest rate environment compared to other fixed-income asset classes. A BDC manager can manage interest-rate risk on both sides of the balance sheet: assets and its liabilities. To manage interest rate risk in its assets, many in the sector have shifted their portfolios from fixed-rate investments to floating-rate investments. When it comes to their liabilities, many managers have done the opposite and have shifted their funding from floating-rate debt to fixed-rate debt. When interest rates do increase, the asset yields will reset higher than their funding costs. You should also be aware that a typical floating-rate loan has a floor of around one to two percent. So LIBOR will have to increase above the floor before the underlying asset yield resets higher. < /p>
Addressing the Threat of Rising Rates
CHOKSI: To protect this portfolio from rising interest rates, Fifth Street shifted its asset mix to floating-rate debt investments. About 70% of our debt investments are floating-rate loans. And on the liability side of the balance sheet, we've extended the maturity of our floating-rate bank debt, as well as issued multiple sources of unsecured fixed-rate term debt.
Financing Lending and Investment
CHOKSI: BDCs can use up to one times leverage. They get debt from multiple sources. The largest source of the debt for the industry is bank funding. These are typically revolving credit facilities and fall anywhere between three to five years in maturity. BDCs can also access the unsecured debt markets by issuing term debt. < /p>
BDCs can use up to one times leverage. They get debt from multiple sources. The largest source of the debt for the industry is bank funding. These are typically revolving credit facilities and fall anywhere between three to five years in maturity. BDCs can also access the unsecured debt markets by issuing term debt.
Using BDCs for Advisors and Investors
CHOKSI: In my position at Fifth Street, I'm talking to a lot of financial advisors and individual investors. Financial advisors are increasingly looking at the sector. They're attracted to the high yields of business development companies, and they're using it to replace a portion of their clients' high-yield bonds as well as equity income allocations. They are attracted to the sector due to the historically high yields, monthly dividends, and the liquidity provided by being publicly-traded investments. < /p>
Institutional Investor Interest in BDCs
CHOKSI: Institutional investors, particularly ones that invest in financial services, are looking at traditional lenders such as banks, and they're seeing stagnant loan growth compressing debt-interest margins, and they're seeing a much tougher regulatory environment where the regulators are clamping down on bank business models and trying to reduce risk across the sector. They're looking for areas in financial services that are positioned to benefit from those trends. So they're looking at non-bank lenders -- one area is BDCs. So I'm spending a lot of time educating institutional investors about what BDCs are, and why they exist, and how they can generate their alpha.
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The views and opinions expressed are those of the speaker and are current as of the video's posting date. Video commentaries are general in nature and should not be construed as investment advice. Opinions are subject to change with market conditions. All performance information is historical and is not a guarantee of future results. For more information about Van Eck Funds, Market Vectors ETFs or fund performance, visit vaneck.com. Any discussion of specific securities mentioned in the video commentaries is neither an offer to sell nor a solicitation to buy these securities. Fund holdings will vary. All indices mentioned are measures of common market sectors and performance. It is not possible to invest directly in an index. Information on holdings, performance and indices can be found at vaneck.com.
Dean Choksi is Senior Vice President of Finance and Head of Investor Relations at Fifth Street Finance Corp. and is not involved in the portfolio management of Van Eck funds.
Please note that Van Eck Securities Corporation offers additional investment products that invest in the asset class(es) included in this video [Market Vectors BDC Income ETF]. Important disclosure for BDC Income ETF Investors: Business Development Companies (BDC) invest in private companies and thinly traded securities of public companies, including debt instruments of such companies. Generally, little public information exists for private and thinly traded companies and there is a risk that investors may not be able to make fully informed investment decisions. Less mature and smaller private companies involve greater risk than well-established and larger publicly-traded companies. Investing in debt involves risk that the issuer may default on its payments or declare bankruptcy and debt may not be rated by a credit rating agency. Many debt investments in which a BDC may invest will not be rated by a credit rating agency and will be below investment-grade quality. These investments have predominantly speculative characteristics with respect to an issuer’s capacity to make payments of interest and principal. BDCs may not generate income at all times. Additionally, limitations on asset mix and leverage may prohibit the way that BDCs raise capital. The Fund and its affiliates may not own in excess of 25% of a BDC’s outstanding voting securities which may limit the Fund’s ability to fully replicate its index. The Fund is currently concentrated in the financial services sector and may depend, to a greater extent, on the overall condition of the sector. The Fund may loan its securities, which may subject it to additional credit and counterparty risk.
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