ADVERTISEMENT

Why Private Equity’s Biggest Names Are Getting Into a Small-Loan Backwater

Why Private Equity’s Biggest Names Are Getting Into a Small-Loan Backwater

(Bloomberg) -- In finance, boring and safe often go together. There could hardly be a more boring category name than business development companies (BDCs), or a more boring role than their original business model: turning money from mom-and-pop investors into loans to small and family-owned Main Street businesses. So how did private equity stars like KKR, Apollo, Blackstone and Carlyle Group fit in, or loans of $800 million? The transformation was part of a broader set of changes that led to the rise of so-called private credit, a domain that approached $1 trillion before the coronavirus upended markets. Along the way, BDCs saw yields and leverage increase -- even as lending standards slipped. Now BDCs have more excitement than many investors can handle.

1. What is a BDC?

Business development companies are a type of closed-end investment firm. Their roots go back to the Small Business Investment Incentive Act, passed by Congress in 1980 to give a boost to middle-market businesses -- in today’s terms, typically those with $100 million or less in annual earnings. The shares of a BDC can change hands like a stock. They’re also designed to give retail investors access to credit markets they are otherwise unable to bet on. In return for supporting small American businesses, the firms enjoy certain benefits, including significant tax advantages if they dole out at least 90% of their income as dividends to shareholders.

2. Who do they serve?

BDCs were originally designed to provide capital to borrowers considered too small or risky by banks or traditional lenders. But the sizes of some checks, and recipients, ballooned. Ares Capital Corp., a behemoth BDC with $15 billion in assets, in late 2018 participated in a $792 million loan for the refinancing of Pathway Vet Alliance, a private equity-backed operator of veterinary hospitals. The deal was still among one of the largest holdings in its portfolio, as of Dec. 31.

3. Why did this happen?

After the financial crisis, U.S. banks facing new regulatory requirements concentrated on the safest kinds of investment. That left an opening for what’s variously known as private credit, direct lending or shadow banking -- money coming from investors outside of the banking system. With interest rates low, private lenders gravitated toward some higher risk, higher yield parts of the field. Private lending overall ballooned to an $812 billion market. BDCs, meanwhile, grew to a $113 billion space in 2019 from $19 billion in 2009, according to Advantage Data.

Why Private Equity’s Biggest Names Are Getting Into a Small-Loan Backwater

4. What’s been the appeal?

Dividends. BDCs pay out loan proceeds in the form of dividends that in good times tend to be both stable and relatively high. In recent flush periods, the stocks on the Wells Fargo Business Development Company index paid an average dividend yield of more than 9%, about double that of a typical junk-bond fund. BDCs are usually able to hand out the hefty dividends because they invest in riskier parts of companies’ capital structures, like their subordinated debt -- and don’t pay tax on profits. For borrowers, BDCs provide financing for growth initiatives, acquisitions or buyouts that they might not otherwise be able to access.

5. What did the risks come from?

Several factors. Bad bets on loans can send a BDC’s stock plummeting. That tends to have more of an impact on shareholders than the BDC managers, whose fees are tied to the number of assets they hold rather than the firm’s performance. The structure creates an incentive for managers to grow as large as possible without prioritizing the quality of loans they are making. And in 2018, Congress gave BDCs the green light to boost their debt-to-equity ratios to 2:1, from 1:1, that is, to use twice as much borrowed money.

6. How are they dealing with the pandemic’s turmoil?

BDCs could end up being among the debt market’s biggest losers in the current uncertainty. “The BDC sector is among those most affected by this credit shock,” analysts at Moody’s Investors Service wrote in an April report, downgrading their outlook for the sector to negative from stable. Moody’s sees BDC loan portfolios declining in values due to the vulnerability of many smaller and mid-sized businesses who borrow from BDCs to the pandemic’s disruption, which could weaken the companies’ liquidity positions and lead to covenant breaches on their own debt. Despite the negatives, the current market turbulence may shift terms in lenders’ favor, according to Fitch Ratings. Better-rated BDCs also have few immediate debt maturities, putting them in a stronger position.

7. Are BDCs getting any relief in the crisis?

The Federal Reserve has rolled out programs -- the Main Street New Loan Facility and Main Street Expanded Loan Facility among them -- that may benefit BDC borrowers. But analysts say some companies won’t qualify due to their high leverage levels. The Securities and Exchange Commission has also given BDCs temporary regulatory relief on asset coverage rules that essentially cap debt-to-equity ratios, allowing them to use the value of their portfolios as of Dec. 31 when doing the calculations.

The Reference Shelf:

©2020 Bloomberg L.P.