BDCs were created in the 1980s by Congress to encourage capital investments in privately owned companies. They are alternative asset managers that invest in small to mid-sized private firms with EBITDA in the range of $50mil-$500mil.
BDCs were incorporated as regular investment companies and are non-taxable entities as long as they pass through most of their income to shareholders in the form of dividends. Further, in order to avoid these companies from taking on excessive risk, Congress imposed a leverage limit of Debt/Equity of 1x. However, for precaution, the average BDC is levered 0.65x to protect against mark to market fluctuations. It is critical for them to be in good financial standing as they frequent the capital markets to fund new investments and growth.
Large institutional banks have been forced to steer away from middle market lending and this has opened up a void for the BDCs to fill.
The BDC universe, while growing, is still small, with less than 50 total publicly traded companies in existence and a total market cap of less than $45Bn. Due to the size of the space, institutional participation is limited therefore BDCs are largely a retail product.
The BDC investments vary across the risk spectrum, from 1st lien sr. secured debt, to unsecured subordinated debt. Understanding the seniority of the credit, the underlying portfolios and the type of originations are critical. Differentiating those BDCs that truly underwrite and service loans from those that simply provide capital to syndicated structures is important to understanding which BDCs really add value.
Given that BDCs lend to small business, they are economically sensitive and therefore do not offer the same diversification benefit as traditional fixed income securities.
The BDC yields are currently trading wide relative to history. Further, the BDC spreads are currently trading in line with single C debt, while their underlying credit performance has been in the B to CCC range. In a yield starved market, BDCs appear to offer good value.