Introduction to Business Development Companies
FRAN RODILOSSO: I am Fran Rodilosso, head of fixed-income ETF portfolio management at VanEck, and I am speaking today with Chris Testa, an equity research analyst specializing in business development companies and registered investment companies at National Securities Corporation. We are here to talk about business development companies, and perhaps Chris can start us off by defining what is a BDC, a business development company.
CHRISTOPHER TESTA: Essentially, BDCs came out of the Investment Company Act of 1940. That was the first act in the United States that essentially regulated companies that are primarily engaged in investments, and gave them a beneficial tax treatment as long as they distributed 90% of net operating income. Fast forward to 1980: Congress essentially created specific business development company legislation. Now, the difference was that BDCs were designed to invest in middle-market companies in the United States. And they were granted more leverage in doing so, with the same restrictions in that they had to distribute in terms of net operating income to maintain that tax-advantaged status.
RODILOSSO: How primarily do BDCs invest in those middle-market companies?
TESTA: They invest in them primarily through debt. They will use equity, mostly as a kicker. BDCs will attach equity components to the debt because, unlike a bank, they are unable to provision for loan losses. This is seen as somewhat of a substitute to that.
RODILOSSO: How do BDCs typically fund themselves?
TESTA: BDCs typically fund themselves through debt and equity. They need to constantly issue equity because, as previously mentioned, there is a one-to-one debt-to-equity limit on them. When BDCs get near that limit, they need to issue equity, of course, which is why they are consistently issuing it in order to grow. On the debt side of things, it is usually through credit facilities, term loans -- some new securitizations. Baby bonds have become very popular, and that is because of the enhanced liquidity, unsecured fixed-rate debt, and this liquidity comes from the fact they are usually traded by ticker symbols on the NYSE. That liquidity further lowers the coupons. The other program that has become very popular is the SBA, Small Business Administration licenses. These allow 10-year unsecured fixed-rate funding with no prepayment penalty after the first six months for BDCs. And what's worth noting is that the SBA debentures do not count towards the regulatory leverage limits, so they enable BDCs legally to go above the one-to-one debt-to-equity limit, provided it's through SBA debentures.
RODILOSSO: At the end of the day, how levered is a typical BDC?
TESTA: Most BDCs tend to be debt-to-equity of about 0.75 times to 0.8 times. They won't traditionally push it up towards one-to-one for a couple of reasons. One is, if they are investment-grade rated, they traditionally do not want to lose that rating, which they have the potential to do if they push above 0.8 times. The other reason is because of potential volatility in NAV per share from fair value marks - that could potentially push them over the limit and make them out of compliance with the BDC leverage test.
RODILOSSO: What kind of interest rate margins do BDCs tend to achieve?
TESTA: If you look at a traditional bank – which cannot make leveraged loans anymore without the OCC [the Office of the Comptroller of the Currency] and numerous regulators coming down on them -- their net interest margins, as I have seen, have ranged anywhere from 3% to perhaps 3.8%, if they are taking on some more risk. That is because they have a low-cost to deposit, but also very low-yielding loans -- residential real estate, owner-occupied commercial real estate, etc. With BDCs, you are looking at net interest margins of roughly 9 to 11%, which is a function of their cost of funds being obviously higher. They cannot take deposits. Also because they're making more leveraged loans, they are riskier, and so they are earning yields, including fees, of anywhere from 9.5% to 10%, and if they're subordinated, through 14% or so.
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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. Mr. Christopher Testa and National Securities Corporation are not related to Van Eck Securities Corporation or its affiliated entities. We believe this information to be reliable, but do not warrant its accuracy or completeness. The views and strategies may not be suitable for all investors. The material is for informational purposes only and is not intended to provide, and should not be relied on for accounting, legal, or tax advice. Any forecasts contained herein are for illustrative purposes only and are not to be relied on as advice or interpreted as a recommendation. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions.
Please note that Van Eck Securities Corporation offers investment products that invest in the asset class(es) in this video. There are risks in investing in BDCs. 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.
A BDC’s incentive fee may be very high, vary from year to year and be payable even if the value of the BDC’s portfolio declines in a given time period. Incentive fees may create an incentive for a BDC’s manager to make investments that are risky or more speculative than would be the case in the absence of such compensation arrangements, and may also encourage the BDC’s manager to use leverage to increase the return on the BDC’s investments. The use of leverage by BDCs magnifies gains and losses on amounts invested and increases the risks associated with investing in BDCs. A BDC may make investments with a larger amount of risk of volatility and loss of principal than other investment options and may also be highly speculative and aggressive.
Investing involves substantial risk and high volatility, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise. An investor should consider the investment objective, risks, charges and expenses of the Fund carefully before investing. To obtain a prospectus and summary prospectus, which contains this and other information, call 800.826.2333 or visit vaneck.com/etfs. Please read the prospectus and summary prospectus carefully before investing.
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