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The Future of BDC Investment in the Commercial Finance Sector

Date: Aug 04, 2015 @ 07:00 AM
Filed Under: Specialty Lending

Over the last few years, business development companies (BDCs) have become significant players in the world of specialty commercial finance. BDCs have provided debt capital to equipment financing companies and other niche lenders. They have invested equity capital or acquired 100% stakes in asset-based lenders and other financial services firms. And today, many banks and finance companies compete directly with BDCs for commercial loans.

Background of the BDC Model

The BDC model, which was created by Congress in 1980 via an amendment to the Investment Company Act of 1940, is most typically a publicly traded investment company that provides financing to small, medium and in some cases large businesses across the United States. Many BDCs specialize in providing first-lien senior loans to cash flow generating borrowers across a wide variety of industry sectors, often in support of a financial sponsor’s buyout. Others specialize in specific industries like technology or healthcare. BDCs are either internally managed by a team of professionals who work at the BDC or they are externally managed by a management company that exists to administer the BDC.  

The BDC model is unique in that it typically pays out at least 90% of its net operating income, like a REIT, without paying federal income tax. As a result, BDCs are attractive investment opportunities for yield-seeking retail and institutional investors –- most BDC stocks generate dividend yields of 8% to 14% -- particularly in volatile equity markets like those that existed coming out of the most recent recession and to some extent exist today. Not surprisingly, the BDC sector raised billions of dollars of capital over the last few years as investors flocked to yield in lieu of the risk that comes from investing in growth stocks.  

While the tax and dividend advantages are attractive, the flip side of the equation is that a BDC’s leverage is capped at a 1-to-1 ratio of debt to equity. Therefore, a BDC does not have the same ability to turn a low return on assets into a high return on equity like a bank or non-bank finance company with access to efficient leverage. Further, limitations exist around the amount of a BDC’s investment portfolio that can be invested into non-BDC eligible asset classes, specialty finance company investments being an example of a “bad asset.” This can be partially mitigated when a BDC structures its investment in a specialty finance company as a portfolio company, much like a private equity buyer would, whereby the equity invested by the BDC can in fact be levered at a greater ratio than the 1-to-1 limitation at the BDC level.

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