By Shiloh Bates JANUARY 2021 - Flat Rock Global
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INVESTING IN BUSINESS
JANUARY 2021
DEVELOPMENT COMPANIES
By
Shiloh Bates
I NTRODUCTION
In 2012 I joined the the Business Development Corp of America (BDCA) as a Senior
Analyst. Structured as a private Business Development Company (BDC), our team grew
BDCA to be one of the largest BDCs with $2.5BN of total assets. A few years later my
firm launched the first mutual fund dedicated to investing in publicly traded BDCs. Since
that time, I’ve worked for firms that both manage BDCs and invest in BDCs managed by
others.
My goal in writing this piece is to convey some of what I’ve learned and to help others
make intelligent investments in this space. While many industry analysts I’ve worked with
at investment firms tend to fall in love with the industries they follow, I take a more critical
perspective. Indeed, for many BDCs the primary beneficiary is the management team that
runs the BDC, rather than its shareholders. However, I’ve always been able to find select
BDCs that offer what I believe are attractive risk/reward characteristcs. At the end of this
piece I’ll go over my approach to selecting the BDCs we at Flat Rock Global invest in.
As shown below, the BDC industry is growing rapidly and becoming a more relevant part
of the economy.
Source: Advantage Data & Houlihan Lokey Fall 2020 Direct Lending Update(1) Reflects the fair value for BDC portfolios tracked by Advantage Data.
A BDC is a public company whose assets are predominantly non-investment grade middle
market corporate loans. BDCs take advantage of U.S. banks pulling back from traditional
corporate lending. Structured as a pass-through entity, a BDC is required to pay out 90%
of its operating profits each year. As a result, BDCs pay high dividend yields, ~10% as of
January 2021, and are particularly attractive to investors seeking income. The best place
to own a BDC is in a tax-advantaged account. Otherwise the BDC’s distributions will be
taxed at an investor’s marginal tax rate.
Investing in BDCs
P a g e 1 | 46
A BDC usually has an external manager; this entity earns a fee for its primary role of
underwriting and managing the investments made by the BDC. In a publicly traded BDC,
like Ares Capital Corp. (ticker ARCC), shares are traded daily on the NASDAQ. Each
quarter, the BDC files public financials (10-Qs & 10-Ks) that include details of all the
investments owned by the BDC. Below is a snippet of ARCC’s Schedule of Investments
(SOI).
ARES CAPITAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED SCHEDULE OF INVESTMENTS
As of September 30, 2020
(dollar amounts in millions)
(unaudited)
Acquisitio
Company Business Description Investment Interest Rate Amortized Cost Fair Value
n Date
Health Care Services
42 North Dental, LLC (fka First lien senior secured revolving loan
Dental services provider 7.25% (Libor + 6.25%/Q) 5/26/2017 $ 5 $ 4.7
Gentle Communications, LLC) ($5.0 par due 5/2022)
Absolute Dental Group LLC and First lien senior secured loan ($7.5 par 11.00% PIK (Libor +
Dental services provider 9/30/2020 7.5 7.5
Absolute Dental Equity, LLC due 9/2022) 10.00%/Q)
First lien senior secured loan ($16.0 par 11.00% PIK (Libor +
9/30/2020 16 16
due 9/2022) 10.00%/Q)
Class A pref units (14,750,000 units) 9/30/2020 4.7 4.7
Common units (7,200,000 units) 9/30/2020 — —
28.2 28.2
Acessa Health Inc. (fka HALT
Medical supply provider Common stock (569,823 shares) 6/22/2017 0.1 —
Medical, Inc.)
ADCS Billings Intermediate First lien senior secured revolving loan
Dermatology practice 6.75% (Libor + 5.75%/Q) 5/18/2016 5 4.8
Holdings, LLC ($5.0 par due 5/2022)
ADG, LLC and RC IV GEDC First lien senior secured revolving loan 6.25% (Libor + 2.50%
Dental services provider 9/28/2016 13.9 12.1
Investor LLC ($13.9 par due 9/2022) Cash, 2.75% PIK/M)
Second lien senior secured loan ($100.5
9/28/2016 89 72.4
par due 3/2024)
Membership units (3,000,000 units) 9/28/2016 3 —
105.9 84.5
Source: Ares Public Filing
The loans that the BDC makes are usually to private companies, which only disclose their
financials to their lenders. For example, financials for 42 North Dental, LLC. in the snippet
above were reviewed by Ares but are not available to someone investing in the Ares Capital
Corp BDC. The information in the snippet above is usually all the information provided
about the investment. The SOI provides lots of important information for the BDC
investor: company name, the industry, the type of security, interest rate, acquisition date,
the cost and fair market value.
A BDC’s quarterly financials provide a calculation of the BDC’s Net Asset Value (NAV)
per share. This is the value that a share would theoretically be worth if the BDC were
liquidated. The NAV will be a key valuation metric throughout this piece. Industry
practitioners usually describe a BDC’s “share price as a percent of NAV”, though it should
be recognized that the NAV will always be stale, as BDC financials are not produced in
realtime. Thus, the correct terminology should be, “share price as a percent of the most
recently reported NAV.” The reported NAV is usually at least sixty days old.
Investing in BDCs
P a g e 2 | 46
A BDC is similar to a closed-end fund, with a share price that can differ materially from
the most recently reported NAV. A BDC needs to be closed-end, because its assets are
illiquid; it wouldn’t be possible to liquidate a BDC’s investments to meet shareholder
redemptions in the same way that a mutual fund could.
Because of the illiquidity of the BDC’s underlying loans, the BDC is able to charge a higher
interest rate for the loan to capture an “illiquidity premium.” But the public BDC shares
are very liquid - that is the beauty of the structure.
As we will discuss, BDCs are income-generating investment vehicles. By their structure,
BDCs do not pay income taxes at the corporate level, so long as they meet certain
requirements. As income generating vehicles, BDC managers aim to attract yield-seeking
investors through consistent (and perhaps growing) dividend payments. Ideally, these
dividend payments are funded by net investment income generated by the portfolio. Net
investment income takes the interest earned on the loans and subtracts the operating
expenses of the BDC. The BDC’s ability to pay the dividend with net investment income
is measured using a common metric in the space: the dividend coverage ratio. This ratio is
calculated by dividing the quarter’s net investment income by the declared dividend.
As of this writing, there were ~50 publicly traded BDCs and another 20 private BDCs that
may list shares on an exchange in the future. Many of the largest BDCs are managed by
well-known alternative asset managers like KKR, Apollo, Carlyle, etc. Others are managed
by smaller firms with a niche-focus.
What makes for a good BDC? It’s quite simple: pay a consistent dividend while
maintaining a steady NAV. A consistent dividend and steady NAV is driven by creating a
pool of high quality loans; making loans is the easy part, making high quality loans that
get repaid is the tough part. BDCs are mostly buying loans at a slight discount to par value
(98-99 cents on the dollar). If the loan performs well, the BDC will receive its contractual
interest plus a small gain when the loan is repaid at par. However, if the loan does not
perform, the downside is substantial, and depends on numerous factors including how
much the business is impaired and how senior/secured the loan is.
Investing in BDCs
P a g e 3 | 46
Below are the twelve largest BDCs ranked by total assets as of January 15th, 2021. What
stands out is the difference in valuations in the price-to-NAV ratio. Hercules Capital
(ticker: HTGC) trades at 1.45x NAV and FS KKR Capital Corp II (ticker: FSKR) at 0.68x
NAV. Today most BDCs trade at a discount to NAV because of the lingering effects of
COVID-19 pandemic on their loan portfolios.
Total LTM
Last Share Price / Market Cap Net Debt /
Issuer Name Ticker Div Yield Assets($ in Return on
Price ($) NAV ($ in mm) Equity
mm) Equity
Ares Capital ARCC 17.15 104.2% 9.3% $ 14,950 $ 7,248 4.3% 93.3%
Ow l Rock Capital Corp ORCC 13.19 90.4% 9.4% $ 10,234 $ 5,120 6.0% 45.5%
FS KKR Capital Corp II FSKR 16.88 68.4% 13.1% $ 7,750 $ 2,866 -16.0% 73.0%
FS KKR Capital Corp FSK 17.34 70.8% 13.9% $ 7,126 $ 2,143 -16.3% 105.2%
Prospect Capital PSEC 5.95 71.0% 12.1% $ 5,438 $ 2,268 4.1% 68.5%
Golub Capital GBDC 14.47 101.0% 8.0% $ 4,444 $ 2,419 2.4% 83.2%
New Mountain Finance NMFC 11.78 96.2% 10.2% $ 3,032 $ 1,141 1.2% 145.9%
Main Street Capital MAIN 32.36 150.2% 7.6% $ 2,657 $ 2,142 -2.3% 69.0%
Apollo Investment Corp AINV 12.07 78.1% 10.3% $ 2,653 $ 787 -9.8% 171.6%
Bain Capital Specialty Finance BCSF 12.72 77.9% 10.7% $ 2,621 $ 818 -1.0% 151.0%
Hercules Capital Inc HTGC 14.92 145.4% 8.6% $ 2,504 $ 1,710 10.7% 108.9%
TPG Special Lending TSLX 20.90 123.5% 7.9% $ 2,137 $ 1,409 14.4% 96.5%
Source: Bloomberg, LLC
Investing in BDCs
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BUSINESS D EVELOPMENT COMPANY I NVESTING
The first question to answer before investing in BDCs as an asset class is, “are BDCs
cheap?” As BDCs are income generating investments, the most comparable asset classes
are high yield bonds, broadly syndicated leveraged loans, oil and gas Master Limited
Parterships (MLPs) and Mortgage REITs. Shown below are the yields of these investments
since 2015. Currently, the yield of BDCs is only surpassed by the MLPs, which are
suffering from low oil and natural gas prices, among other factors.
Source: Bloomberg, LLC
Investing in BDCs
P a g e 5 | 46
Below are the same securities showing annual return and standard deviation for the last
five years.
Annual Return
Index Constituent 12/31/2015 to Standard Deviation
12/31/2020
S&P BDC Index 6.30% 25.64%
Alerian MLP Index -5.98% 34.99%
VanEck Mortgage REIT ETF 5.54% 33.04%
S&P LSTA Leveraged Loan Index 5.23% 3.72%
Bloomberg Barclays High Yield Index 8.58% 5.64%
Source: Bloomberg, LLC
The S&P BDC Index has a decent return, but the standard deviation would give many
investors pause. The high yield index returns have benefitted from substantial interest rate
cutting by the Federal Reserve Bank, though it’s not clear how favorable the returns can
be going forward. The S&P LSTA Leveraged Loan Index also stands out as having decent
returns with low volatility; we will discuss this index in detail later.
There are a few ways in which investing in BDCs is very different from other asset classes:
Retail Investors
1. The BDC space is dominated by retail investors, which allows a smart investor to
outperform a passive BDC index. There are three reasons why institutions aren’t as active
in the space:
An institution willing to write a large check could invest in middle market loans originated
by the BDC manager in a separate vehicle, and potentially negotiate a reduction in
management fees in the process. This is known as a Seperately Managed Account.
BDCs are not in many of the the largest equity indices. This is due to what is called Acquired
Fund Fees and Expenses (AFFE). If a mutual fund owns a BDC, the operating expenses of
that BDC will be included in the operating expense of the mutual fund. Of course, the mutual
fund’s manager isn’t receiving any of the expenses paid to the BDC manager. Because all
mutual fund managers are sensitive about their stated expense rates, the ‘consolidation’ of
a BDC’s operating expenses is punitive.
A mutual fund, regulated under the 1940 Act, can only own a maximim of 3% of a BDC’s
shares.
Investing in BDCs
P a g e 6 | 46
Having small equity floats makes it difficult for large investment firms to acquire enough
stock in the secondary market to make the investment worth their effort.
Because of the above factors, large sophisticated investors, who could have a postive effect
on BDC corporate governance aren’t prevalent. In fact, where there has been shareholder
activism in the space, the activists have largely been unsuccessful and lost significant
money in the process.
The Failure of a Successful Value Metric
2. Value is often a trap in the BDC space. For many investors looking at BDCs for the first
time, the inclination is to focus on the ones trading at the largest discount to NAV. Today,
in an environment where many investors are actively searching for yield, BDCs managed
by some of the largest, well-known money managers trade at ~25% discounts to NAV.
Why aren’t these screaming buys? After all, the BDC manager is telling you through the
NAV exactly what it thinks a share should be worth. And who would know better than the
BDC’s manager?
The problem is that the discounted BDCs have loans that have underperformed in the past.
They may have invested in industries that are troubled today like oil & gas or retail, or it
may be that individual loans and securities are underperforming.
The most favorable way to look at a discounted BDC would be to assume that troubled
loans are marked correctly by the BDC’s manager and that information is already
incorporated into the NAV. But, often this seems to not be the case. For example, let’s say
a loan that was originated at a price of 99 has shown up in a BDC’s new financials at a
price of 90. The effect is to lower the NAV. But, what should we expect of future marks
for the loan? Perhaps the loan’s performance will rebound and it will go back to near par.
But, the loan value could also go lower. When the BDC manager lowered its price of the
loan by 9 points, the manager is saying, “this loan is a lot riskier than when I first made it.”
The loan now has upside of around 9 points but the downside is 90 points. This is the return
asymmetry of making loans. It’s also the reason that many BDCs struggle to keep a
consistent NAV.
Most investors look at a BDC’s stated ~10% dividend yield and get pretty excited.
However, investors should really care about their total return, which would include changes
in the NAV and share price.
One of the largest BDCs that trades at a significant discount to NAV is Prospect Capital
(ticker: PSEC). Thus far, there has been no reversion to trading close to NAV. In fact, the
trend for the discount has been increasing.
Investing in BDCs
P a g e 7 | 46
Source: Bloomberg LLC
Unfortunately for Prospect Capital’s BDC investors, the discount to NAV has been
accompanied by dividend cuts, as the BDC’s investments don’t generate the income they
used to.
Source: Bloomberg LLC
There are a few BDCs that trade above NAV. These BDCs have earned their share price
through stable dividends and NAV over years. When a BDC trades above NAV, it is able
to issue new equity accretively, which increases the NAV. Hercules is an example of a
Investing in BDCs
P a g e 8 | 46
BDC that has taken advantage of its premium valuation to grow its equity base. Hercules
has an impressive annual loss rate of only 0.04% since inception.
Source: Bloomberg, LP
Misalignment of Interests
3. The interests of the BDC investor and the BDC’s manager are often divergent. The BDC
manager is usually external, getting paid a management fee and incentive fee to operate the
BDC. The BDC manager often has little of its own capital invested in the BDC. The BDC
manager’s incentive is to grow the BDC, which enables it to collect more fees. And if the
performance of the BDC is poor, the BDC manager doesn’t own much of the stock anyway.
BDCs often highlight their growth in assets in their investor presentations, but the BDC
investors rarely see the benefits of growth.
In my opinion BDC fees are too high on average, which has resulted in poor industry
returns over the last few years. A BDC manager is paid ~1.7% annually plus an incentive
fee of ~20% to make secured corporate loans at rates of 8-10%. The BDC’s underlying
investments just don’t produce enough income for the BDC to pay these kind of fees.
The BDC’s manager ends up very profitable, however. Many BDCs are managed by public
companies like Ares Management, KKR, & Apollo Management. Though not a subject of
this report, investing in the stocks of these asset managers is probably a better investment
than owning the equity in the BDCs they manage. Of course, the BDC managers shown
below also have other lines of business like private equity and distressed investing.
Investing in BDCs
P a g e 9 | 46Annual Return
Stock
Last Five Years
Ares Capital Corp. (BDC) 13.94%
Ares Management Corp. (BDC Manager) 36.41%
FS KKR Capital Corp. (BDC) -3.36%
KKR & CO. (BDC Manager) 24.56%
Apollo Investment Corp. (BDC) 4.59%
Apollo Global Management (BDC Manager) 34.55%
Source: Bloomberg, LP
BUSINESS D EVELOPMENT COMPANY S TRUCTURE
The easiest way to think of a BDC is a simplified bank, where the assets are middle market
loans and the financing is provided by equity and debt raised by various parties.
Middle Market U.S. Loans Long Term Financing
Revolving Credit Facilities Revolving Credit Facilities
First Lien Loans Term Loans
Second Lien Loans Secured Notes
Unitranche Loans Unsecured Notes
Equity Interests Equity
Congress created BDCs as part of the Small Business Investment Incentive Act of 1980,
which was an amendment to the Investment Company Act of 1940, to provide small and
medium sized businesses with improved access to capital markets. Given their status as
Investing in BDCs
P a g e 10 | 46Regulated Investment Companies (RICs), BDCs are not required to pay corporate income
taxes if they meet certain criteria with regard to portfolio diversification, shareholder
distributions, types of assets and annual reporting.
The diversification test requires that at least 50% of the BDC’s underlying loan assets are
comprised of individual loans representing less than 5% of the BDC’s total assets at fair
market value. The shareholder distribution minimum is 90% of the BDC’s taxable income.
Therefore, BDCs retain minimal earnings and must constantly raise external debt and
equity to grow. At least 70% of a BDC’s assets must be held in private U.S. companies or
public U.S. companies with market capitalizations of less than $250 million. Additionally,
to count toward the 70% bucket, qualifying assets may not be investments in other
investment companies.
Other BDC requirements include maintaining an asset coverage ratio of at least 150% in
order to borrow or declare dividends. That is to say that for every $1 of equity capital
invested in a BDC, it can borrow $2 of debt to make additional investments, which can
potentially enhance returns to equity investors. However, higher levels of debt means
higher levels of risk to equity investors. Therefore, most BDCs operate well below the 2:1
limit.
A BDC’S I NVESTMENTS
Core Focus – Middle Market Loans
A middle market loan issuer found in a BDC is often owned by the founder, management
team, or a middle market private equity firm. Middle market companies borrow to support
leveraged buyouts, growth initiatives, mergers and acquisitions, change of ownership
transactions, and/or recapitalizations.
When a private equity firm acquires a business, they contribute a portion of the purchase
price - around 40% - in equity. The remainder of the purchase price is financed by issuing
loans. Private equity firms are buying companies they believe will grow revenue and profits
over time, which will increase the value of their equity investment. The use of leverage
amplifies the returns they expect to make. Of course, the leverage will work against them
if the returns are negative.
Middle market loans are generally provided by a single lender or small club of lenders
including BDCs, middle market CLOs, hedge funds and interval funds.
A typical middle market loan has a 5–7-year maturity, but many borrowers aim to prepay
after two or three years, especially if they have consistently grown revenue and cash flow
and can secure cheaper financing. These loans are generally secured by all the assets of the
Investing in BDCs
P a g e 11 | 46borrower, including property, plant, equipment, accounts receivable, inventory, cash, etc.
While secured by the assets of the company, the loan is expected to be repaid through cash
flows produced by the business.
Middle market loans tend to have strong lender protections, or covenants, built into their
credit agreements to safeguard the lender’s investment. Loans will have financial
covenants that require a borrower to have a minimum level of annual cash flow in
comparison to the amount of money borrowed. This is called financial leverage. Another
common financial covenant is a test that compares the company’s annual cash flow to the
amount of annual interest expense. This is called interest coverage. A violation of a
financial covenant is considered a default under the loan’s legal documentation, even
though the company may not have missed an interest or principal payment when the
covenant default happens.
Lenders also restrict a borrower’s ability to sell certain assets, make acquisitions, pay
dividends to shareholders, or issue additional debt. Due to these strong lender protections,
the historical loss rate of middle market loans is low.
Origination of middle market loans is typically facilitated by relationships between lenders,
financial sponsors, and middle market investment banks. It is not uncommon to see a
middle market private equity firm have a preferred lender or group of lenders with whom
they frequently partner with on transactions.
The most common debt structures issued by middle market borrowers are revolving credit
facilities (revolvers), term loans and junior debt facilities. Many borrowers will issue
multiple forms of debt to create the optimal capital structure. A BDC can invest in all the
different tranches of debt, as well as the equity of a company. The way in which BDCs
allocate capital to the various positions of a company’s capital structure is a key
differentiator among them.
Revolvers are usually senior to, or equally senior with, a first lien term loan. They are also
floating rate and priced as a spread over Libor. From a BDC’s perspective, lending in the
form of a revolver adds a layer of operational complexity since the borrower can draw and
repay the loan as needed. Therefore, the BDC must always have enough cash or assets that
can be quickly and easily converted to cash reserves for whenever the borrower decides to
draw on the facility.
Term loans are usually floating rate loans priced as a spread over Libor. These loans are
typically senior secured in the company’s capital structure and give the lender a first lien
or second lien on all its assets. Spreads vary based on the perceived risk of the borrower
and current market environment. Currently, typical spreads over Libor range from
approximately 4 -8%.
Investing in BDCs
P a g e 12 | 46Often a Libor floor is put in place, which is typically 1.00%. Libor floors provide protection
for lenders when Libor is very low, as the base rate becomes the floor. Today, with Libor
at 0.22%, many loans are using the floor as the reference rate, which increases the returns
to the lenders.
Term loans amortize, or repay, lenders around 1-5% per annum with a bullet payment due
at maturity.
Junior debt, often referred to as mezzanine debt or subordinated debt, is subordinate to
revolvers and senior secured term loans in the capital structure, but senior to equity. Junior
debt can be priced as a spread over Libor or as a fixed interest rate. Junior debt typically
does not amortize throughout the term of the loan. Given the inherent level of risk that
comes with the subordinate position in a borrower’s capital structure, junior debt requires
a higher interest rate than senior secured loans. Typical junior debt interest rates are around
9-12%.
To further compensate lenders, middle market loans are typically issued at a discount of 1-
2% of par value. This means that for a $1,000,000 par loan issued at a price of 98 cents on
the dollar, the lender will fund $980,000 while being owed the full $1,000,000.
Middle market borrowers are generally viewed as those that generate $5 million to $75
million of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
annually, though this range can vary across asset managers. EBITDA is a proxy for a
company’s annual cash flow. Given the lack of an active secondary market for middle
market loans, lenders demand an illiquidity premium when pricing these loans since it is
unlikely that they can trade out of the loan prior to its maturity.
The amount of debt as a multiple of EBITDA (leverage ratio) that middle market borrowers
operate with is highly variable. It depends on the borrower’s industry, profitability, stability
of earnings and annual capital expenditures, among other factors. A leverage ratio in the
range of 3-5x is common for middle market borrowers, with the lower end of that range
more common among smaller, or “lower”, middle market borrowers with less than $20
million of annual EBITDA.
Investing in BDCs
P a g e 13 | 46Source: Barings Insights: Four Mistakes Investors Make in Private Credit (And How to Avoid Them)
Broadly Syndicated Loans (BSL)
It is also somewhat common to find a BSL in a BDC. Generally, these loans are made to
companies larger than middle market borrowers. Examples of BSL borrowers include Dell
Computer, Charter Communications and Sprint. These loans are issued when private equity
firms hire investment banks to arrange debt financings for the companies they buy. JP
Morgan, Citigroup and BAML, for example, earn an underwriting fee to place a loan with
a variety of investors including BDCs.
The loans are referred to as “broadly syndicated” because each loan will have numerous
participating lenders/investors. Sometimes the arranging bank will keep some of the loan
on its balance sheet and other times the loan becomes fully owned by third parties.
In contrast to the typical middle market loan, there has been a steady increase in the
issuance of covenant-lite BSL in the US; today around 80% of BSL lack financial
covenants. The trend reflects a more borrower-friendly loan market, where many lenders
are looking to deploy significant amounts of capital.
While lenders prefer having financial covenants on the loans, a pool that is largely
covenant-lite may have fewer defaults over its life. That is because only a missed interest
or principal payment can cause a default. There are examples of companies that have
experienced sharp decreases in their annual cash flow that would have defaulted if they
had covenants in place. Because they did not, the company managed to survive and recover.
Ironically, if the business would have had covenants, its lenders would likely have taken
over the company and sold it to the highest bidder, resulting in a substantial loss. A lack of
financial covenants on the loans can push a borrower’s problems into the future.
Investment banks buy and sell BSL in the secondary market. The investment banks try to
make a spread of around 50bps if the loan is frequently traded. Some loans are over $1BN
Investing in BDCs
P a g e 14 | 46in size and trade frequently in the secondary market. Other loans are $250M in size and
trade less often. The smaller loans generally have marginally higher interest rates to
compensate investors for the lack of liquidity.
While BSL is not the priority investment for BDCs, this market is important for the BDC
investor because middle market loans should command a yield premium over BSL due to
the middle market loan’s illiquidity. Additionally, there is lots of data on the performance
of BSL, and this is often used as a close proxy for the performance of middle market loans.
In addition to lower yields and a lack of financial covenants, BSL differ from middle
market loans in multiple ways. Given that their issuers are large, established corporations
with long track records of financial performance, BSL issuers can typically operate with
higher leverage and loan to value ratios compared to their middle market counterparts.
These elevated debt levels are also the result of a more efficient supply-demand dynamic
in the BSL market and the substantial amount of capital raised in recent years by CLOs,
hedge funds, and loan mutual funds. Further, BSL typically have dozens of investors
working independently of one another and receiving allocations from investment banks.
This contrasts with middle market loans, which often only have 1 to 3 lenders working
together to underwrite the borrower, often without any investment bank involvement.
One key benefit of middle market loans over BSL is that when a borrower becomes
troubled, the middle market loan’s restructuring process is going to have only a few
participants. A BSL loan restructuring may have multiple classes of investors seeking the
best outcome for their claim; to sort through the mess is time consuming and expensive.
Other Assets Found in BDCs – Loan Joint Ventures
In addition to investing in individual corporate loans, BDCs sometimes invest in joint
venture loan funds. The BDC may invest in a joint venture with the same overall investment
strategy as the BDC, but usually the joint venture is geared more towards secured loans.
Through joint ventures, BDCs provide equity capital and employ bank debt to invest in
pools of middle market loans or BSL. However, in the joint venture structure, the debt is
considered off-balance sheet and is not accounted for in the calculation of the BDC’s asset
coverage ratio. Below is an example of a recently formed loan joint venture.
Investing in BDCs
P a g e 15 | 46Source: TCG BDC Press Release
Investing in BDCs
P a g e 16 | 46Portfolio Composition
BDC portfolios are comprised primarily of First Lien Loans. In recent years, this trend
has increased, with first lien loans now accounting for 68% of BDC portfolios.
Source: Advantage Data & Houlihan Lokey Fall 2020 Direct Lending Update. Represents the aggregate composition of all BDC portfolios tracked
by Advantage Data. May not add to 100% due to rounding.
The chart below shows the increasing current yields available as a lender moves between
different types of loans in a BDC. As you move from left to right, the loans become riskier,
and the required return goes up.
Second Lien Subordinated
Debt
Lower Middle Market
Non-Sponsor Borrowers
Directly Originated Middle
Market Loans
Broadly Syndicated Loans
Risk-free Rate (T-bills)
(1) Excludes potential deductions for differential credit losses and fees. Source: Cliffwater, LLC Report on US Direct Lending
Investing in BDCs
P a g e 17 | 46CREDIT ANALYSIS OF THE BDC’S INVESTMENTS
Firms that invest in middle market loans have an investment team that extensively
researches the loans before they are purchased. The financial analysts that do this work
often have previous commercial or investment banking experience; many have earned an
MBA or Chartered Financial Analyst® designation. While credit analysis is outside of the
scope of this paper, the basics are outlined below.
A starting analysis is usually a comparison of the value of the loan to the value of the entire
business. This metric is called the loan to value. The trick is that most of the businesses do
not have a publicly traded stock, so the financial analyst needs to think about the current
purchase price and comparable historical transactions. An investor in middle market loans
will want a low loan to value, so that if the business value deteriorates, they will still be
able to get repaid. Conversely, the private equity firm that owns the business prefers a high
loan to value as that requires less equity to finance the business. Historically, an initial loan
to value in the middle market is around 60%. When the loan to value is higher, the investor
in the middle market loan will require a premium spread over Libor as extra compensation
for the risk he is taking. Besides loan to value, an investor in loans needs to consider the
company’s leverage multiple. A company’s EBITDA is used as a proxy for annual cash
generation. EBITDA is then compared to the amount of debt outstanding, usually net of
any cash on the balance sheet. A higher leverage multiple implies more risk for the lender
and less equity cushion in the business. A typical middle market loan has 4.5x its EBITDA
in first lien leverage and an additional 1.0x EBITDA of junior debt that might be a second-
lien or unsecured loan. As shown below, there is usually significant initial equity cushion
for a middle market loan.
Investing in BDCs
P a g e 18 | 46An investor in middle market loans might be comfortable with a higher leverage multiple
for a business that is growing steadily and showing increased profitability, while a lower
leverage multiple would be appropriate for a cyclical company or one with less favorable
business prospects. Size is also an important factor for a middle market lender, with larger
companies viewed as being more stable and less risky.
The interest rate will also be a factor - more leverage usually means a higher required
spread over Libor to compensate the lender for the increased risk. Most new-issue middle
market loans today have initial first lien leverage of 3-6x EBITDA, a wide range driven by
the factors discussed above.
The private equity firm that acquires a business may be targeting returns of 20% or higher.
But there is significant risk to achieving those returns. The owner of a middle market loan
may be targeting an ~8% return but taking much less risk. Even if the business has multiple
quarters of poor earnings, usually the middle market loan will eventually be repaid at par.
However, if underperformance is severe a default may arise.
The actual loss on the loan is determined by the recovery rate in the event of a default.
Some loans have defaulted and recovered 100% of their par balance, resulting in no loss of
principal for the lender. Other loans have experienced dismal recoveries, like some made
to oil and gas companies when commodity prices fell dramatically in 2015/2016.
Investing in BDCs
P a g e 19 | 46LOSSES ON BDC LOANS
For the loan investor, the best thing that can happen is for the loan to make all its contractual
interest and principal payments. If the business grows as its private equity firm’s owner
might expect, the loan investor does not participate in the upside. The loan investor takes
the risk that the business’ prospects decline significantly, and contractual interest and
principal payments are not met. When this happens, the business files for bankruptcy and
the loans are likely impaired. The chart below shows the annual loss rates experienced by
a group of BDCs.
ANNUAL ANNUAL ANNUAL
BDC BDC BDC
LOSS RATE LOSS RATE LOSS RATE
AINV -2.1% OXSQ -2.4% MRCC -1.6%
ARCC 1.3% FCRD -3.7% NMFC 0.3%
BBDC -1.3% FSK -3.2% PFLT -0.3%
BCSF -2.0% FSKR -3.9% PNNT -2.0%
BKCC -3.7% GBDC 0.8% PSEC -0.8%
CGBD -1.8% GLAD -2.7% SLRC -0.4%
CPTA -5.6% GSBD -2.6% SUNS -0.4%
OCSI -2.7% HRZN -1.7% TCPC -1.4%
OCSL -3.1% HTGC -0.3% TPVG -1.2%
ORCC 0.2% MAIN 2.2% TSLX 0.7%
MCC -7.0% WHF 1.0%
Source: Company reports and Wells Fargo Securities, LLC as of September 30, 2020
The BDC’s with lower realized loss rates are also the BDCs that trade at a higher percent
of NAV. (See page 4)
During Q1 2020, at the height of market reaction to COVID-19’s potential impact, the fair
market value of BDC portfolios was written down by almost 7%. With modest recoveries
of ~1% in each of the following two quarters, BDCs still have room to run before they
achieve pre-COVID-19 levels in terms of portfolio NAV. Note the difference between loss
rates and write-downs. Assets that have been written down can still recover their interest
and principal payments in full.
Investing in BDCs
P a g e 20 | 46Source: Company reports and Wells Fargo Securities, LLC as of September 30, 2020
Another way to think about risk in the BDC’s loan portfolio is to look at the index for BSL
loans compiled by JP Morgan. As we discussed above, these generally are not the loans in
an actual BDC, but they do provide a relevant comparable of larger sized secured loans.
The default rate for BSL peaked at less than 8% during the Great Financial Crisis. COVID-
19 has defaults trending higher through year-end, but the market’s expectation isn’t for
increasing defaults from here. For example, JP Morgan projects for 2021 a BSL default
rate to decline to 3.5%, in line with the 3.0-3.5% long-term average.
Investing in BDCs
P a g e 21 | 46JP Morgan Leveraged Loan Default Rate For Broadly Syndicated Loans
Source: JP Morgan Securities Default Monitor, December 2020
Of course, a BDC investor isn’t just concerned with default rate. We also need to know the
recovery rate in the event of default. Combining the average annual default rate for BSL
loans with the recovery rate in the event of default results in a loss rate of ~1.0%, which
compares favorably to first lien middle market loan yields of ~6.0%.
HISTORICAL RECOVERY ANALYSIS
Sources: 1st lien loans & senior unsecured bonds represent the period 1987-2020; Second lien recovery rate is from JP Morgan Default Monitor
for period 2008-2020.
Investing in BDCs
P a g e 22 | 46VALUATION OF A BDC’S ILLIQUID INVESTMENTS
The assets of a BDC, typically first and second lien corporate loans, are most often
considered Level 3, meaning there is no trading activity to point to that provides a
valuation. Typically, an independent valuation firm, such as IHS Markit Partners or Cherry
Bekaert, makes an independent assessment of the value of each investment on a quarterly
basis. These assessments are based on unobservable inputs which significantly impact an
asset’s fair market value. These inputs include yields of the asset and expected yields for
similar investments and risk profiles, as well as indicative quotes from brokers and dealers
on comparable investments. Other metrics considered are the amount of leverage used by
the company and expected recovery of the company’s assets given a default. The
independent valuation firm will also model out the expected discounted cash flows
(“DCF”) of an asset. Typically, valuation firms use the effective yields of CCC (or
“speculative grade”) bond indices as the discount rate in their DCF models. The third-party
valuation firms use these techniques, along with some consideration of indicative prices
based on bids from market participants, to value loans in the portfolios of BDCs.
Employees of a BDC’s manager review the valuations from the third-party valuation firm
for factual correctness and ensure the most up-to-date information is reflected. Once a
valuation is agreed upon, a BDC’s Board of Directors reviews the valuations and
determines the fair value of each investment in good faith.
This process is extremely important for investing in BDCs. The fair value of the BDC’s
assets, less any liabilities on its balance sheet, gives us the Net Asset Value of the BDC.
Investing in BDCs
P a g e 23 | 46INTERNALLY VS. EXTERNALLY MANAGED BDCS
BDCs can be either internally or externally managed. An internally managed BDC hires
an internal staff to make and manage investments in middle market businesses. As
employees of the BDC, the staff is compensated by the BDC manager based on a
compensation structure that is disclosed to the BDC’s investors. Hercules Capital (ticker:
HTGC) and Main Street Capital (ticker: MAIN) are examples of internally managed BDCs.
Internally managed BDCs tend to have lower operating expenses than externally managed
BDCs. Additionally, given management’s compensation is often tied to NAV growth rather
than assets under management growth, management’s interests are better aligned with
shareholders compared to those of external managers.
With just a few exceptions, BDCs operating today are predominantly externally managed.
Externally managed BDCs outsource management of the company’s assets to a third party.
These managers are typically compensated with a hybrid fee structure that includes a base
management fee of 1.5-2.0% of the BDC’s gross assets, as well as performance-based
incentive fees. This fee structure can create a conflict of interest as it incentivizes a BDC’s
management team to prioritize AUM growth over shareholder value. However, externally
managed BDCs are often sponsored by leading global asset management platforms with
significant investment, operational, and capital markets resources. For example, Apollo
Investment Corp. (ticker: AINV) is an externally managed BDC operated by Apollo Global
Management, one of the largest global alternative investment managers with $433 billion
in assets under management. In this case, the external management structure makes sense
because the manager of the BDC is benefitting from the platform resources of the manager.
Source: AINV Investor Presentation, September 30, 2020
Investing in BDCs
P a g e 24 | 46BDC advisory fees are quite high, and partially explain the industry’s mediocre returns
over the last five years. For many BDCs that lack a “total return lookback” the incentive
fee is based only on the income produced by the loans. If the loans are declining in value,
there is no corresponding reduction to the incentive fee.
Total Return
Hurdle
Issuer Name Ticker Management Fee Incentive Fee Catch-Up Incentive
Amount
Lookback
Ares Capital ARCC 1.50% 20.00% 7.00% 8.75% No
Owl Rock Capital Corp ORCC 1.50% 17.50% 6.00% 7.28% No
FSKKR Capital Corp II FSKR 1.50% 20.00% 7.00% 8.75% No
FSKKR Capital Corp FSK 1.50% 20.00% 7.00% 8.75% Yes
Prospect Capital PSEC 2.00% 20.00% 7.00% 8.75% No
Golub Capital GBDC 1.38% 20.00% 8.00% 10.00% Yes
New Mountain Finance Corp. NMFC 1.75% 20.00% 8.00% 10.00% No
Apollo Investment Corp AINV 1.50% 20.00% 7.00% 8.75% Yes
Bain Capital Specialty Finance BCSF 1.50% 17.50% 6.00% 7.27% Yes
Sixth Street Specialty Lending, Inc. TSLX 1.50% 17.50% 6.00% 7.28% No
Source: BDC Public Filings
Investing in BDCs
P a g e 25 | 46PRIVATE BDCS
In launching a BDC, sponsors typically have two options: a publicly traded BDC or a non-
traded (private) BDC. Publicly traded BDCs are available to retail investors through
listings on public exchanges such as the NASDAQ. Private BDCs raise funds through
private placements and issue capital calls as funds are needed for new investments.
According to Eversheds Sutherland, of the $90 billion of assets allocated to BDCs, a small
subset of $7 billion is allocated to private BDCs. However, there has been a recent trend
toward private BDC launches, with the category making up 80% of all BDC formations in
the past three years, according to Murray Devine & Company. Below are some examples
of private BDCs.
BDC AUM Manager
Business Development Corporation of America $2.2B Benefit Street Partners
Owl Rock Capital Corporation II $1.9B Owl Rock Capital Advisors
HMS Income Fund $949M Main Street Capital Corporation
Goldman Sachs Private Middle Market Credit II $836M Goldman Sachs Asset Management, L.P.
Sierra Income Corporation $595M Medley Management
Audax Credit BDC Inc. $368M Audax Management Company
Guggenheim Credit Income Fund $349M Guggenheim Partners
TriplePoint Private Venture Credit, Inc. $138M TriplePoint Advisers, LLC
AG Twin Brook BDC $69M AG Twin Brook Manager, LLC
Source: Company Public Filings
For a private BDC, there is no concept of trading below NAV. This gives managers of
private BDCs the ability to raise capital without the technical concern of where the vehicle
is trading on the public market. It also allows managers to pay out and forecast growth of
dividends without considerations of reactionary stock price movement. In addition, the
fundraising structure of utilizing capital commitments helps managers avoid performance
drag through uncommitted cash balances. Managers of private BDCs can better forecast
capital inflows and match timing of asset expansion with opportunities appropriate for the
BDC’s investment strategy.
Typical private BDCs are sold exclusively to accredited investors through private
placement offerings. Private BDCs comply with the same regulations set forth for
traditional BDCs, such as reporting required by the Exchange Act of 1934 and compliance
with the Investment Company Act of 1940. BDC investors include high net worth
individuals, family offices, and institutional investors.
The obvious downside to the private BDC is that the investor does not have daily liquidity.
Typical liquidity events for private BDCs include an IPO, a merger (often with a public
BDC), or a spin-off. Liquidity events require board (and often shareholder) approval.
Investing in BDCs
P a g e 26 | 46One example of a private BDC pricing its initial public offering is Bain Capital Specialty
Finance Inc. (ticker: BCSF). BCSF, which began operations in 2016, listed 7.5 million
shares on the New York Stock Exchange on November 15, 2018. The BDC used
substantially all the proceeds from the offering to pay down its outstanding debt.
When Bain Capital Credit, the manager, listed BCSF’s shares, the BDC’s equity began
trading below NAV. This was a tough outcome for the investors that purchased shares at
NAV. At the time of the listing in 2018, Bain Capital Credit did not have another public
BDC. Without a long track record or a similar offering on the public market, the security
lacked the shareholder confidence needed to trade at the value of the underlying assets, in
my opinion.
Source: Bloomberg, LP
Private BDCs make the most sense when the manager already manages a BDC that trades
above NAV. That way, the investor can have some confidence that when the liquidity event
happens, it will be beneficial for the private BDC’s shareholders. Additionally, some
managers will offer substantial fee rebates to entice investors into their private BDCs. The
snippet below is from Golub Capital’s press release announcing Golub Capital BDC’s
(ticker: GBDC) merger with Golub Capital Investment Corp (GCIC), a private BDC
externally managed by Golub Capital. The merger was completed on September 16, 2019.
Prior to the merger, GCIC’s most recent 10-Q filing showed a NAV of $15.00 per share.
GBDC, which has historically traded at a premium to NAV, was the sole surviving entity.
GCIC shareholders received 0.865 shares of GBDC per share owned of GCIC as part of
the transaction. On September 16, 2019, shares of GBDC closed at $18.33 per share.
Therefore, the private BDC shareholders benefitted from the enhanced liquidity of a
publicly traded BDC and a 5.7% price premium to NAV.
Investing in BDCs
P a g e 27 | 46Source: Golub Capital, Public Press Release
LEVERAGE IN BDCS
BDCs issue debt from commercial and investment banks to increase their capacity to make
investments and potentially enhance their returns to equity investors. However, higher
levels of leverage imply higher levels of risk for the BDC. While utilizing leverage can
enhance a BDC’s returns, it can also magnify losses if the manager does not invest
prudently. Therefore, the amount of leverage a BDC will utilize varies based on the
manager’s targeted returns and confidence in its ability to effectively originate and make
new loans. Solar Capital (ticker: SLRC), for example, had a net debt to equity ratio of 0.56x
as of September 30, 2020, while Goldman Sachs BDC (ticker: GSBD) had a net debt to
equity ratio of 1.29x for the same period. This is not to say one manager is better than the
other, but rather that they are just different strategic approaches. The figure below displays
the potential upside from leverage.
Investing in BDCs
P a g e 28 | 46Company A Company B Company C
Equity $100.00 $100.00 $100.00
Debt $0.00 $100.00 $200.00
Total Assets $100.00 $200.00 $300.00
Debt as % of Total Assets 0.00% 50.00% 66.67%
Avg. Yield on Investments 8% 8% 8%
Investment Income $8.00 $16.00 $24.00
Avg. Debt Interest Rate 3% 3% 3%
Interest Expense $0.00 ($3.00) ($6.00)
Net Investment Income $8.00 $13.00 $18.00
Net Return 8% 13% 18%
While this is a simplified example that does not account for operating expenses or potential
credit losses, it highlights the amplification of returns produced by different levels of debt
with the same equity base across three companies. Ultimately, if a BDC manager can
efficiently deploy capital at interest rates that exceed its cost of debt and operating expenses
without experiencing material credit losses, the use of leverage will be accretive to the
BDC’s net investment income.
The actual cost of debt will also vary between BDCs based on their performance track
record and the size of their underlying loan asset portfolios. Larger pools of high-quality
loans from managers with strong historical performance will be able to issue higher levels
of debt at lower interest rates. The increased capital available enables the manager to make
larger investments across the capital structure, and the low cost of debt prevents the need
to stretch for yield on riskier borrowers.
Issuance like the one from Ares Capital Corporation we consider to be very favorable for
its shareholders.
Source: Company Public Press Release
Investing in BDCs
P a g e 29 | 46BDCs issue various forms of debt to support their operations. Typically, BDCs issue debt
through banks or syndicates, which are groups of financial services companies that pool
their resources together to share exposure to an investment. The forms of debt one may
find on a BDC’s balance sheet include revolving credit facilities (revolvers), term loans,
secured notes and unsecured notes.
Revolvers allow BDCs to draw and repay capital as needed. The BDC typically pays a
floating rate based on Libor on the drawn amount. It also pays a small rate for the undrawn
amount on the facility. The benefit of a revolver is that it allows a BDC to paydown the
facility when the debt is not needed, which reduces the BDC’s interest expense and
increases available liquidity to draw on the facility again in the future.
A BDC may also issue term loans to meet its funding needs. Like a revolver, term loans
are floating rate loans priced as a spread over Libor. However, terms loans are fully drawn
by the BDC at issuance and do not provide the same flexibility of drawing and repaying as
needed like a revolver. Once a portion of a term loan is repaid it is considered retired from
the facility.
Revolvers and term loans will usually be secured by the investments of the BDC, with first
lien assets receiving a ~70% advance rate and investments with more downside risk a lower
advance rate.
Unsecured notes are another common source of financing for BDCs. Notes are different
than term loans in two main ways. First, notes are not drawn upon, and are present on the
BDC’s balance sheet from issue to maturity. Second, notes charge a fixed interest rate
whereas loans charge a floating rate above LIBOR. Unsecured notes will generally have a
higher interest rate than secured notes, that are backed by collateral.
Investing in BDCs
P a g e 30 | 46Below is a breakout of the various debt facilities utilized by New Mountain Finance Corp
(NMFC). For large BDCs, it is a best practice to have multiple different lenders and
facilities to provide the BDC favorable financing costs and maximum flexibility.
FACILITY
AS OF 9/30/2020, $ IN MILLIONS AMOUNT OUTSTANDING INTEREST RATE MATURITY
SIZE
Broadly syndicated 1st lien loans
Wells Fargo Credit Facility (Wells Fargo / Raymond James /
L + 2.00%
State Street / CIT Bank / Cadence / Old Second / SMTB / $459 $745 October 2023
All other: L + 2.50%
Fifth Third)
(No LIBOR floor)
Deutsche Bank Credit Facility (Deutsche Bank / KeyBank / L + 2.85%
$242 $280 December 2023
Customers Bank / Hitachi / Citizens Bank) (No LIBOR floor)
NMFC Credit Facility (Goldman Sachs / Morgan Stanley / L + 2.50%
$151 $189 June 2022
Stifel / MUFG) (No LIBOR floor)
2018 Convertible Notes $201 $201 5.75% August 2023
SBA I Guaranteed Debentures $150 $150 3.26% weighted average rate March 2025 or later
SBA II Guaranteed Debentures $150 $150 2.14% weighted average rate Sept. 2028 or later
Series 2016 Unsecured Notes $90 $90 5.31% May 2021
Series 2017A Unsecured Notes $55 $55 4.76% July 2022
Series 2018A Unsecured Notes $90 $90 4.87% January 2023
Series 2018B Unsecured Notes $50 $50 5.36% June 2023
Series 2019A Unsecured Notes $117 $117 5.49% April 2024
5.75% Unsecured Notes $52 $52 5.75% October 2023
Unsecured Management Company Revolver - $50 7.00% December 2022
Total $1,806 $2,218
Source: New Mountain Finance Corporation September 30, 2020 10-Q
During the COVID-19 pandemic downturn, we were very focused on BDCs’ ability to
maintain compliance with any covenants in its borrowing facilities. We also looked
unfavorably on BDCs with near-term maturities on financing lines. One of our favorite
BDC picks was able to access financing during the height of the COVID-19 market stress.
Source: Company Public Press Release
Investing in BDCs
P a g e 31 | 46Asset Coverage Test
Under Section 61(a) of the Investment Company Act of 1940 (the 1940 Act), BDCs were
historically restricted to an asset coverage ratio of no less than 200%. Simply put, a BDC
with $1,000 in equity may borrow $1,000 of debt (for a total of $2,000 in assets). However,
in March of 2018, Congress passed the Small Business Credit Availability Act, which
amends Section 61(a) of the 1940 Act. Contingent on board or shareholder approval, the
amendment allows a BDC an asset coverage ratio of 150%, effectively doubling its
capacity to issue debt. For example, a BDC with $1,000 of equity may now have up to
$2,000 of debt. This change allows BDCs to acquire lower spread loans and still cover the
dividend with net investment income.
The careful consideration managers place on the asset coverage ratio can be seen in times
of stress. For example, amidst the COVID-19 pandemic in April 2020, the SEC granted
BDCs exemptive relief in the form of greater flexibility to issue senior securities and enter
follow-on co-investment funding solutions, subject to certain conditions. Within the
exemptive relief order is a provision for BDCs to use portfolio company valuations as of
December 31, 2019. Given the stress in the loan markets at the time, December 31, 2019
valuations were likely higher than those on March 31, 2020. In most cases, this provided
BDCs with improved asset coverage ratios and allowed managers to draw additional debt
to support portfolio companies.
However, for most BDCs any stress on the liability side of the balance sheet was abated by
the end of 2020.
Investing in BDCs
P a g e 32 | 46BDC DUE DILIGENCE
Investing in BDCs requires extensive due diligence.
Portfolio Composition
One factor to consider is the BDC’s asset class exposure. Generally, BDCs with higher
concentrations of first lien senior secured loans will be more insulated from credit risk than
those with higher concentrations of junior debt and equity investments. The image below
shows the breakdown of Owl Rock Capital Corp’s (ORCC) asset class exposure as of
September 30, 2020. We view its exposure to 96% senior secured loans, of which 79% is
first lien senior secured, as favorable relative to many other BDCs with larger exposures to
junior debt and equity.
Asset Type % of Assets at FMV
First Lien Senior Secured 79%
Second Lien Senior Secured 17%
Equity Investments 2%
Investment Funds and Vehicles 1%
Unsecured Debt 1%
Source: Owl Rock Capital Corp, September 30, 2020 10-Q
The first lien focus was especially important to us given the higher default risk caused by
the COVID-19 pandemic.
The BDC due diligence process should include an analysis of the portfolio diversification
based on investment size and industry exposure. Typically, investors should look for highly
diversified portfolios in which no single borrower represents a significant percentage of
the overall portfolio fair market value. Additionally, BDC investors should look for
portfolios with higher exposure to less cyclical industries such as technology enabled
services and healthcare.
Investing in BDCs
P a g e 33 | 46The figure below shows the diversification characteristics of Crescent Capital BDC’s
(ticker: CCAP) portfolio, which is well-diversified by industry and average individual
borrower size as a percentage of the portfolio’s overall fair market value.
Source: Crescent Capital BDC, September 30, 2020 10-Q
Balance Sheet Strength
The key to a strong BDC balance sheet is access to diverse financing sources with a low
weighted average cost of debt, which we discussed above.
It is also critical to assess a BDC’s liquidity position. A BDC’s liquidity primarily consists
of cash on its balance sheet along with debt available on its credit facilities. BDCs must
maintain a healthy level of available liquidity for a variety of situations. First, BDCs need
liquidity to fund distributions to investors, usually on a quarterly basis. Second, BDCs
need liquidity to fund investments. BDCs often make investment commitments in the form
of revolvers and delayed draw term loans (DDTLs) for which the borrower can draw on
portions of the facility as needed, but they are not required to be drawn at issuance.
Therefore, a BDC should maintain enough liquidity to cover unfunded commitments.
Unfunded commitments are detailed in a BDC’s quarterly financial statements, an example
of which is shown below.
Investing in BDCs
P a g e 34 | 46Note 10. Commitments and Contingencies (continued)
Unfunded commitments to provide funds to portfolio companies are not recorded in the
Company’s consolidated statements of assets and liabilities.Since these commitments may
expire without being drawn upon, the total commitment amount does not necessarily
represent future cash requirements. The Company has sufficient liquidity to fund these
commitments. As of September 30, 2020, the Company’s unfunded commitments consisted
of the following:
Commitment
Category / Company Amount
Senior Secured Loans—First Lien
5 Arch Income Fund 2 LLC $ 3.4
A10 Capital LLC 14
All Systems Holding LLC 7.2
Ardonagh Group Ltd 1
Aspect Software Inc 0.7
RSC Insurance Brokerage Inc 3.1
RSC Insurance Brokerage Inc 7.1
RSC Insurance Brokerage Inc 4
Sungard Availability Services Capital Inc 0.3
Sweet Harvest Foods Management Co 0.8
Truck-Lite Co LLC 9.2
Truck-Lite Co LLC 16.1
Asset Based Finance
Home Partners JV, Structured Mezzanine 11.8
Opendoor Labs Inc, 2L Term Loan 47.1
Total $ 310.8
Unfunded Other Asset Based Finances/Other commitments $ 211.7
Source: FSKR September 30, 2020 10-Q. Image excludes certain holdings.
Investing in BDCs
P a g e 35 | 46You can also read
