The continued tightfistedness of banks, combined with investors’ desire for a high-yield product, has led to the rise of an alternative fund: the business-development company (BDC).
A BDC is a closed-end investment fund that makes debt or equity investments in small- to medium-sized private or thinly traded companies. BDCs have existed since the 1980s, but have only lately experienced a surge in popularity. In fact, several sponsors have recently launched or have announced plans to launch BDCs. As a result, more broker dealers are considering approving BDC investments for their alternative investment platforms.
In doing so, broker dealers should be sure they’re properly analyzing BDCs; not all BDCs are created equal. By taking a close look at the following three types of risk commonly associated with BDCs, broker dealers can determine which BDC makes sense for their platform.
1. Portfolio risk
It’s important to note that a BDC acts as a “wrapper” for its underlying assets. Because of this, broker dealers should understand what types of companies the BDC is loaning to or investing in, what level of the capital structure the BDC focuses on, and if the BDC receives any special terms from portfolio companies. Note: Subtle differences in loan underwriting can lead to drastically different risk/return profiles.
Naturally, portfolio risk directly influences suitability. For example, a BDC that invests primarily in a diversified portfolio or in relatively liquid senior secured-lien loans will have a different risk profile than a BDC that invests more heavily in second-lien loans and subordinated debt . And if a BDC is focused on originating loans, broker dealers should understand the terms the BDC is getting. (Successful loan origination often depends on the skills and network of the BDC’s advisor and subadvisor.)
Broker dealers should also be aware of the market trend of covenant-light lending to below-investment-grade companies, which can lead to greater risk during a downturn.
2. Interest rate and financing risk
Although BDCs are modestly leveraged with at least $2 in assets for every $1 in debt, they still may face a maturity mismatch. Often they are financed with short-term loans, but are investing in longer-term, illiquid securities.
Interest rate changes can pose a risk to BDCs depending on their borrowing structure. Ideally in a rising interest rate environment, a BDC will own a significant amount of floating-rate debt, yet will be financed with fixed-rate debt allowing the BDC to gain as interest rates rise. However, if a BDC depends on a short-term credit line, it could end up being pulled. Broker dealers should also note that some portfolio companies might be unable to pay increased interest costs, preventing the BDC from any interest-rate driven gains.
Most important, broker dealers should know whether or not a BDC is prepared for a change in interest rates, so they can see how it will fit with a client’s broader portfolio of fixed income securities.
Investors purchase BDCs for their yields; however, their source of distributions is not often transparent. Not surprisingly, a drop in distribution leads to unhappy clients. And unsustainable distributions can sometimes lead to permanent principal loss.
In its early stages, a BDC may fund distributions from the capital raise or advisor support agreements, but this is not sustainable. BDC advisors may also temporarily defer fees to make the distribution appear covered, but they usually are repaid later. Ideally, broker dealers should see distributions fully covered by net interest income (i.e., the spread between the interested collected and interest paid), although the occasional trading gain may also help.
Tailor your due diligence process
While it’s important to consider these three types of risk, it’s even more important for broker dealers to employ the appropriate due diligence process—one that addresses the unique nature of BDCs. This could include everything from conducting thorough interviews with a BDC’s portfolio-management team to tracking sources of distributions by piecing together footnotes from several 10-Qs. Taking these steps is key to choosing a BDC that will not only complement a broker dealer’s platform but will also deliver the yields their investors demand.
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