Leverage Boost for BDCs Adds to Trump Era Goody Jar

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(Bloomberg Gadfly) -- The Wall Street giveaways continue in the Trump era. The question is when the weight of all those gifts will threaten the stability of the financial system.

A late addition in the spending bill that Congress passed, and President Donald Trump signed on Friday, is a provision that will allow publicly traded lending vehicles, officially called business development companies, or BDCs -- but unofficially known as shadow banks -- to double their leverage. The provision was originally part of the bipartisan Dodd-Frank rollback the Senate passed earlier this month. But the measure was dropped because Republicans feared it would turn off Democrats, who didn't want the bill to look like a giveaway to the big banks. The BDC provision would have given the bill that flair. One of the largest BDCs was sponsored by and shares a name with Goldman Sachs Group Inc. 

That wasn't enough to keep it out of the spending bill, though. Supporters of the provision argue that BDCs are important lenders to small businesses and that the leverage limit increase is small, to $2 for every dollar in equity, up from the current 1-to-1 limit. That's far less than banks, which can be levered 9-to-1 and were levered as much as 30-to-1 in the run-up to the financial crisis.

But Nicholas Marshi, who is the chief investment officer of Southland Capital Management and has written about BDCs for years, says the small-business argument is a farce. Most BDC loans go to leveraged buyouts or to pay dividends, not to new businesses or to fund business expansions. What's more, many BDCs have exploited exemptions to the rules that make them far more leveraged than the existing 1-to-1 limit.

Consider the Goldman Sachs BDC Inc. Four years ago, Goldman's BDC formed a 50-50 joint venture with the Regents of the University of California. Goldman's investment in the JV counts toward its leverage cap, but not the debt of the JV, which itself has a target leverage ratio of 2-to-1. It has already lent about $300 million more than Goldman and the California Regents have invested in the fund.

A number of BDCs have government-sponsored small-business lending funds. Those funds are also exempt from BDC leverage caps. Collateralized debt obligations have also been a popular investment of BDCs. They tend to have leverage ratios north of 8-to-1. All told, according to an analysis published on the investment website Seeking Alpha two years ago, a number of large BDCs had an effective average leverage ratio of 2.8, and one as high as 5.6. That's still much lower than banks, but BDCs typically lend to the riskier, highly leveraged companies that banks typically pass on, which is part of the reason lawmakers who originally wrote the BDC regulations decided to limit their leverage to 1-to-1. 

A number of other aspects of BDCs are reminiscent of some of the financial instruments that got the banking system in trouble during the financial crisis. The debt of BDCs, because of their low stated leverage ratios, typically receive a much higher credit rating than the companies that BDCs loan to or invest in. It's similar to how CDOs were able to issue debt that was rated more highly than the subprime mortgage bonds they packaged. One of the biggest JVs formed by a BDC is with a division of insurance giant American International Group, which had to be rescued after the financial crisis because it was a counterparty to some of that era's most notorious deals. And BDCs seem to be a fertile ground for self-dealing and conflicts of interest. Prospect Capital, for instance, a $2.4 billion BDC, which has a raised concerns before, has 12 percent of its fund invested in a private REIT that is run by the management of Prospect Capital.

While investment in BDCs has grown over the past few years, it's still small, at just $60 billion in assets. Subprime mortgage bonds totaled $1.3 trillion in late 2007. Still, BDCs are helping to fuel the growth of lending markets like leveraged-loan CLOs that are much bigger and raising concerns. And the new leverage rules will allow existing BDCs to get much bigger and could open the door to even more of them. What's more, if lawmakers and regulators think it's time to apply less scrutiny to potentially troubling corners of the financial system, investors need to be more worried about what will come next. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Stephen Gandel is a Bloomberg Gadfly columnist covering 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.

©2018 Bloomberg L.P.

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