Souped-Up Debt Vehicle Pushes the Envelope
(Bloomberg Opinion) -- Average investors have found a turbocharged way to bet on the growing leverage in corporate America: business development companies. The question is how the wager will do when the economy hits the brakes.
That nervousness was clear on Wednesday, when shares of some of the best-performing BDCs, which are publicly traded vehicles that invest in highly indebted companies, fell slightly on the news that the Federal Reserve was unlikely to raise interest rates further this year. The Fed’s move signaled that the central bank might be worried about the economy’s future growth.
Even with that dip, BDCs have been a sleek vehicle for investors to profit from growth in corporate debt. The Wells Fargo BDC Total Return Index is up 14.3 percent this year, nearly double the 7.2 percent return of the iShares iBoxx High-Yield Corporate Bond ETF. Leveraged loans, too, are up just 4.3 percent in 2019. All but one of the 42 BDCs tracked by the Wells Fargo index are up this year. And that includes Hercules Capital Inc., the BDC whose shares dropped 5 percent last week after the resignation of its founder and CEO, Manuel Henriquez, who was among those charged in the college admissions scandal.
While BDCs are public companies, they are essentially investment funds. They take the money they raise from shareholders and buy loans, typically corporate ones, and often use debt to fund leveraged buyouts or other transactions. So this may seem like an odd time for the shares of BDCs to be soaring. Corporate debt has essentially doubled since the financial crisis. Buyout leverage ratios are higher than they have been in a while. And more and more people are warning that a growing number of companies could have trouble paying back their loans. Bloomberg Opinion said recently that structured lending vehicles, like collateralized loan obligations, are creating a debt bomb. The New York Times followed up with a similar column this week.
What’s more, what is likely in part juicing BDC returns is the promise of even more debt. A year ago, in mid-March 2018, Congress passed the Small Business Credit Availability Act, which, among other things, allows BDCs to increase their borrowing to $2 of debt for every $1 raised from shareholders, up from a 1-to-1 ratio. Nicholas Marshi, the editor of BDC Reporter, said that of the 45 BDCs that he tracks, 38 have or are adopting higher leverage ratios. BDCs invest in floating rate debt. And until Wednesday, the go-slower Fed had seemed to reassure investors that rising interest rates wouldn’t sink indebted companies, as long as the economy holds up. Investors seem to think the combination of stable interest rates and looser borrowing rules will lead to more profits for the BDCs.
Marshi isn’t so sure. BDCs have to borrow themselves to take advantage of those higher leverage limits. Marshi figures the cost of that credit for BDCs investors, after interest and management fees, could be at least 8.5 percent. Yet at the end of last year, the average yield on the loan portfolio of Goldman Sachs BDC Inc., for example, was just 10.1 percent. That’s not a lot of room for profit, especially when these are high-risk loans that aren’t always repaid.
But the bigger problem could be excess supply. Marshi estimates that the increased leverage limits will lead BDCs’ assets under management, which have already nearly doubled in the past five years to nearly $100 billion, to increase an additional 27 percent. That’s an additional $27 billion looking for someplace to go in a market where everyone from private equity firms to average investors are chasing yields. BDC Harvest Capital Credit Corp. recently told investors it wasn’t able to lend capital as quickly as it expected.
The average BDC in Wells Fargo’s index trades at a price-to-book ratio, the preferred metric for the loan firms, of just more than 0.9. That’s about where BDC valuations peaked last year, and close to their 10-year average. Ryan Lynch, an analyst at finance-sector-focused investment bank Keefe Bruyette & Woods, has buy recommendations on just eight of the 25 BDCs he covers. “There’s a ton of capital coming into the space,” he said.
More capital with nowhere to go means lower borrowing costs. That means not only do more deals get done, but potentially riskier ones, when more people are urging caution. Washington has oiled this debt machine. Investors may not end up in the winner’s circle.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Stephen Gandel is a Bloomberg Opinion columnist covering banking and equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.
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