Over the past 24 months, the idea that “there is no alternative” for retail investors in today’s market has attracted a growing chorus of advocates. The sentiment — conveniently packaged with the catchy and somewhat disarming “T.I.N.A” acronym — has been particularly pitched among income investors, who over the past two years have gravitated away from fixed income and piled into bond proxy stocks. As part of this fervent hunt for yield, money managers and RIAs have rediscovered the BDC market, but while the segment has provided one of the few attractive destinations for income investors, some are finding that all yield is not created equally.
BDCs, or business development companies, were created as part of the Small Business Investment Incentive Act of 1980 and regulated under the Investment Company Act of 1940. The sector, up until the credit crisis in 2007, was considered more of a niche industry, but has since grown exponentially along with the rise of other non-bank lenders. The underlying appeal for retail investors is that BDCs, in order to maintain preferential tax treatment, must distribute a minimum of 90% of their income to shareholders. Today, there are 53 publicly traded business development companies, 44 of which are focused on debt. As I highlighted at the CEFA Advisor Summit in June, what’s so unique about this space is that it’s virtually the only way for financial advisors or retail investors to gain exposure to small- and mid-market corporate loans, which has been one of the more attractive areas for yield and, at the same time, represents one of the most clear-cut ways to benefit from the growth of the U.S. economy.
As of June 30, more than three out of every four BDCs were showing a dividend yield that exceeded 8%, according to the second-quarter CEFU Report, with nearly half (or 47.2%) of the entire BDC universe producing dividend yields of over 10 percent. But while investors may be drawn to the yield, those that stay, do so because they’ve discovered that value in the sector can be better assessed by digging deeper to understand the sources of income, the manager capabilities and the alignment of interests.
The No.1 priority for BDC investors should be finding the names that produce stable and consistent investment returns for investors. And for BDCs, consistency can be boiled down to whether or not they can cover their current level of dividend with income. As of the end of July, only one half of the BDCs in the market fit this description, according to a Raymond James analyst report, “BDC Industry Investment Banking Weekly Newsletter.” As a result, among those who aren’t generating sufficient net investment income, or NII, to cover their quarterly dividend, there has been an uptick in the number of those who have cut their dividend payouts.
The second priority for BDC investors is the credit quality of the underlying assets. Investors and advisors should be looking under the hood to understand the nature of the assets held by BDCs. For BDCs with less than $1 billion market cap, for example, the amount of first-lien, senior-secured debt as a percentage of total origination came in at a mean of 47% in the first quarter of this year. This stat reflects that many of the BDC managers are forced to deliver on their promise for yield through investment primarily in riskier second-lien junior debt or mezzanine debt with a fixed rate.
Beyond looking at the NII and the underlying credit quality, there are some more qualitative factors at play that are directly related to a BDC’s ability to source more attractive loans (those backing higher yielding and higher quality assets). Investors and advisors should know whether a fund is externally or internally managed and if it’s the former, understand the fee structure and the nature of incentive fees. Moreover, particularly for externally managed funds, advisors need to have transparency into the managers’ client relationships, and how these managers address potential conflicts of interest in their allocation of investment opportunities.
Importantly, for internally managed BDCs, investors will want to fully grasp the strength of the platform and how the managers source opportunities. Do they have the infrastructure to support consistent dealflow? Do they have a presence across the US, and do they maintain strategic relationships with regional banks? A robust platform can generate as many as 1,500 opportunities a year, of which the fund managers might select 30 to 50 of the best credits with the most appealing yields. Investors should also have a sense of whether dealflow is largely driven by private equity owned borrowers, a factor that can suppress the weighted average yield, while elevating the amount of company-level leverage for portfolios that are overweight in sponsor-backed transactions. Diversity by industry type is also critical, as those with significant investments in the energy space have discovered over the past 12 months.
Impending Interest Rate Increases
Given the potential for impending interest rate increases, which could occur later this year, we also expect to see those managers with a higher percentage of floating-rate debt to benefit from a rising interest rate environment, once LIBOR rates surpass LIBOR floors associated with most floating rate loan investments. This is all the more reason for investors and advisors to dig deep when it comes to analyzing the asset mix.
As investors continue to chase yield, particularly if interest rates take a measured path higher, they won’t want to lose sight of quality as a consideration. We actually anticipate that despite the growing strength of the U.S. economy, the BDC market will only become further bifurcated as those funds trading at discounts to their net asset values will face even an even higher bar when seeking to raise new funds. The better-performing BDCs – those with direct origination platforms and “credit-first” underwriting standards – should continue to attract new investors with steady earnings and consistent dividend levels, covered by NII.
Income investors in particular are generally seeking assets with strong risk-adjusted returns, and capital preservation is often a key consideration. So when a BDC is generating a dividend yield approaching 13% to 15%, it’s more often than not the result of share price degradation. On the contrary, when dividend yields sit between 8% and 10% for BDCs whose NII dividend coverage well exceeds a one-to-one ratio, the market is either rewarding a track record of growth or revealing expectations for a future bump. It brings to mind Warren Buffett’s famous adage that “Price is what you pay; value is what you get.”
Aaron Peck is Chief Investment Officer and Chief Financial Officer of Monroe Capital Corporation (Nasdaq: MRCC), a BDC providing senior, unitranche, junior secured and subordinated debt financing and minority equity investments primarily to lower middle market companies in the U.S. and Canada. Monroe Capital Corp. is affiliated with Monroe Capital, LLC, a premier lender to the middle market.