In the evolution of the leveraged finance markets, we see continued tailwinds for a growing set of non-bank lenders known as business development companies (BDCs). Three developments have diminished banks’ appetites for leveraged credit exposure: 1) consolidation in the banking sector, 2) higher regulatory capital requirements and 3) tighter leveraged lending. These factors, along with the wind-down of corporate lending arms, have created an opportunity for BDCs and other direct lenders. We believe this trend could continue beyond the current market cycle.
During the past several years, financially strong BDCs have worked hard to achieve investment grade ratings (Baa3/BBB-). This has helped them to issue unsecured debt and diversify their funding profiles. This trend has also provided an interesting investment space and opportunities for fixed income investors willing to research this growing sector.
BDCs are finance companies that lend to the middle-market segment and typically provide first-lien senior secured loans to borrowers for growth, mergers and acquisitions, or leveraged buyouts. Often, these borrowers are privately held companies owned by families or private equity sponsors that may be too small to efficiently tap public capital markets. (See graphic below: BDCs Defined.)
The IMF Global Financial Stability Report, dated April 2020, estimated the overall private/non-syndicated credit market to be $700+ billion. We calculated that BDC-financed assets account for roughly $120+ billion of this growing market.
Within the BBB-rated universe of corporate credits, BDC bonds trade at relatively wide spreads—even relative to other finance companies. While a selective approach is required, we believe bonds issued by BDCs with well-diversified portfolios, low leverage, strong equity cushions and healthy liquidity are worth considering. For those selected BDCs, we could see their spread differentials relative to other low-BBB finance names (e.g., aircraft lessors or real estate investment trusts (REITs)) continue to compress over time as BDCs receive more attention. For asset managers with appropriate research resources, these companies could offer attractive opportunities.
Investment grade BDCs typically can benefit from substantially lower funding costs than that of below-investment grade entities. Therefore, we expect selected higher-quality BDCs to work to maintain their high-grade ratings through market cycles. While some BDCs did face asset quality and liquidity pressures during the COVID-19 crisis, we believe the subsector’s overall performance demonstrated the resilience of the business model.
BDCs are closed-end investment companies regulated by the SEC created under provisions of the Investment Company Act of 1940. The intent was to promote access to capital by small- and medium-sized US firms. Many BDCs focus on making loans to private-equity-backed firms for buyouts, growth capital or M&A.i
BDCs can be public or privately held. Often, a BDC will initially raise private capital from high net worth investors or institutions prior to its initial public offering. Similar to a REIT, BDCs are required to pay out most of their earnings.ii
BDCs report their financial statements on a fair-value basis and must value their investments quarterly. BDCs will recognize unrealized and realized gains and losses through the income statement. Given that BDC loans and investments are not usually traded actively in the market, BDCs will typically engage third-party valuation firms such as Duff & Phelps to review portfolio values quarterly. Valuation of BDC investments can be particularly challenging given their lower liquidity. However, there is some transparency into the loan level. BDCs include a schedule of all investments in their 10-Qs/10-Ks and additional disclosures on the largest portfolio exposures.
BDCs are an important component of the leveraged finance markets servicing middle-market companies. We see a number of secular trends that should support their growth.
BDCs have been a growing segment of the fixed income market, increasingly tapping public debt markets to help diversify their funding profile. At the end of April 2021, BDCs represented approximately 22% of the Bloomberg Barclays Investment Grade Finance Company Index with 10 issuers. This has grown from roughly 8% of the index and only three issuers just five years ago. As the sector continues to grow, we expect BDCs to see increasing representation in the unsecured markets. We believe the BDC sector could potentially follow a similar growth path to REITs. At one time a lesser-known niche within the unsecured markets, REITs have become a well-followed sector within the markets.
Our internal research, including reviews of public filings, shows that most BDCs have debt-to-equity leverage of around one times or less (many target 0.9 to 1.25x). We believe the low leverage within BDC structures can provide a cushion to absorb portfolio losses before impacting unsecured bondholders. BDCs have the ability to issue equity and have done so in the past to de-lever, which can help align with bondholders’ interests. Also, BDC loan portfolios are typically highly diversified and granular with average positions of 1.0% or less of a portfolio, which can help manage credit risk. With no targeted benchmark to adhere to, BDCs also have flexibility in industry selection. Many try to avoid areas such as cyclicals and energy, for example, in favor of sectors including healthcare, software and business services.
BDC investments often include riskier loans made to smaller companies that may have higher leverage. That said, we believe the substantial equity commitment made by the owners/sponsors of these smaller entities gives them a vested interest in providing ongoing support. Additionally, a BDC’s status as lead lender and incumbent in their loans often can help them to drive workouts and maximize recoveries in distressed situations.
While we believe there are many positives to BDCs, there are risks and certain industry developments that we continue to watch closely. As with any finance company, asset quality remains a key credit consideration. In contrast to large borrowers financed through the syndicated market, most middle-market loans, which have a different risk profile, are typically with established relationships, feature higher pricing and have strong covenants. However, we are mindful that the relatively low barriers to entry in the BDC space have increased competition within middle-market lending. This has the potential to weaken underwriting terms, conditions and pricing.
Although BDCs have diversified their funding sources to include more unsecured debt, most BDCs fund their operations with secured bank facilities and some also fund in the collateralized loan obligation markets, which have priority over senior unsecured bondholders in a distressed situation. BDCs with greater funding diversity and lower amounts of secured debt generally have greater flexibility in more challenging capital markets (as we saw last year).
Finally, with greater competition for first-lien loans, we believe there could be incentives for BDCs to invest further down the capital structure into riskier levels of debt such as second-lien or other more complex investments. This could create additional risks in BDC investment portfolios.
We view the BDC sector as a creditworthy subsector that will likely continue to grow in importance. It warrants a selective investment approach. While we look for issuers with strong underwriting track records through cycles, the COVID-19 crisis was a good test for the BDC structure, which demonstrated greater resilience than some might have expected. Based on our research within the category, relatively wide spreads could offer opportunities. This might be particularly relevant for investors that understand the market landscape and typically focus on more established players with long track records, sizeable scale, and affiliations with larger sponsors and/or investment managers.
i Source: https://bdcreporter.com/bdc-primer/
ii BDCs have a statutory leverage limit of debt-to-equity equal to one. In 2018, the Small Business Credit Availability Act raised the leverage limit to 2.0x debt-to-equity. However, BDCs must opt in for this change. (Source: CBO.gov.)
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