Business Development Companies (BDC) provides debt financing to small as well as mid-capitalization companies. They are required to invest at least 70% of their total assets in private or thinly traded public companies. BDC’s are usually also Regulated Investment Companies (RIC) and thus exempted from paying corporate taxes on any income they distribute to their stockholders as dividends. To qualify as an RIC, they are required to distribute at least 90% (98% to avoid a 4% excise tax). There are also certain other miscellaneous restrictions.
BDC’s stimulate public capital to private businesses in an efficient manner. They are structured like a closed end mutual fund, the variation being instead of investing in public companies, the fund invests in private enterprises. As with closed end mutual funds, the Net Asset Value (NAV) is an important measure of valuation for these companies.
The risk profiles of BDCs are generally high due to their exposure to riskier sub-ordinate and mezzanine debt, and to small-cap private enterprises. Asset valuation is guesswork, as the portfolio companies are not generally traded. These risks are somewhat mitigated by the fact that regulations limit their leverage to 1:1. In a recession, BDC’s generally under perform because of their exposure to sub-ordinate debt.
However BDC’s provide valuable service for small private businesses. The conventional financing options for such enterprises are either to issue equity or to avail of a bank loan. Issuing equity has the downside that the owner’s are essentially “selling out” parts of their company in exchange for the revenue to get the business moving. Getting a bank loan has the downside that they usually need collateral. BDCs provide a good middle ground - they usually require no collateral but instead charge a higher interest rate upfront with some protection in the form of warrants on the equity in the company. The risk is mutual – if the invested in company goes down, the BDC investments usually get wiped out.
Our Experience Investing in BDCs:
Our first investment in companies that fund other companies was in CMGI Inc (CMGI) right in the middle of the Internet bubble early in 1999. At that time, we were more into short-term trading and by the end of 2001 had lost about 20% of our original investment in CMGI. No denying that CMGI was a high-flier, and with a valuation of 200 times revenue at the height of the bubble, the expectation was that many of its portfolio companies were on the cusp of achieving greatness through an IPO. It soon became evident that many of those companies were buying revenue from other similar companies and thus in effect profitability was never achievable. Needless to say, any one who invested in CMGI Inc. (CMGI) on a long-term basis lost in excess of 90% by 2002 and the performance since then has also been dismal.
Even though burnt by this experience with CMGI, we appreciated certain aspects of investing in such companies. Chief among them is the thrill of being able to invest in private enterprises without the additional baggage a venture capitalist has to handle. An investment in any public company, essentially translates to betting on management expertise in the field the company is in. With BDC’s, the gamble is on management being good venture capitalists!
The high yield aspect of BDC’s appealed to us in the mid-2005 timeframe. We invested in both American Capital Limited (ACAS) and Allied Capital Corporation (ALD) around then, enjoyed dividends in the 10% range, and traded out of them with alacrity with returns of about 20% each by late 2006. Luck reversed upon entering a position in MCG Capital Corporation (MCGC) in late 2007 and at posting time we lost about 90% of our original investment on paper. Our calculation was that an investment in MCG Capital Corporation (MCGC) carried fewer risks than a corresponding investment in American Capital Limited (ACAS) or Allied Capital Corporation (ALD) as it seemed MCG Capital Corporation (MCGC)’s portfolio was especially conservative, given its weighting in communications (local telephone companies) and media. But, as it turned out, those companies did not meet profit expectations and the company had to write-down some of those investments.
American Capital Limited (ACAS), Allied Capital Corporation (ALD), MCG Capital Corporation (MCGC), and Prospect Capital Corporation (PSEC) Comparison:
For comparison purposes, we selected companies we have experience trading in and another BDC, which remained relatively unscathed during this shakeout. Interestingly, even American Capital Limited (ACAS) and Allied Capital Corporation (ALD) would have given negative returns in the same timeframe although not quite as intense as our investment in MCG Capital Corporation (MCGC). We used a number of key measures to gauge the risks involved to arrive at the general valuation as well as the relative valuations for an effective comparison.
Below is a look at the portfolio mix, taken from their latest 10-Q filings:
|Secured Sub-debt or Unitranche||24.60%||66.5%||39.3%||32.0%|
|Equity (Preferred, Common, Warrants, etc.)||43.48%||26.0%||27.7%||12.8%|
From a BDC’s perspective, risk is highest with Equity and the lowest for Senior debt. Below is an explanation of the terms used above:
- Senior debt (Bank Loan) – least risky, has collateral, but interest rates are correspondingly lower.
- Mezannine/Sub-Ordinated Debt – more risky with interest rates in the range of 10-14%. No collateral is required per se, but is usually secured through warrants on the equity in the company. With warrants, a put-option is usually executed where there is an agreement for the company to buy back the warrants at a pre-arranged price based on the valuation of the company. In priority of payment, this type of debt falls right in the middle – before equity but after senior debt. It can act as an equity cushion that supports the senior bank debt.
- Equity – most risky. The BDC gets part-ownership in the company and so the prospects are directly tied to the portfolio company’s performance.
The following table indicates the portfolio diversification achieved by the companies:
|Commercial Services – 11.3%||Business Services - 35%||Media - 20.8%||Oilfield Fabrication – 23.7%|
|Real Estate - 10.1%||Consumer Products - 25%||Communications - 28.5%||Gas Gathering and Processing – 11.9%|
|House Hold Durables – 8.8%||Industrial Products - 8%||Information Services - 3.8%||Manufacturing – 9.6%|
|Internet & Catalog Retail 5.1%||CLO/CDO - 8%||Technology - 2.9%||Money Market - 6.0%|
|Rest – 64.9%||Rest - 24%||Rest - 44.0%||Rest – 48.8%|
The companies are fairly diversified with PSEC being the only company concentrated heavily in one area – Energy. Even that may get revised to align with the company’s recent switch in the name from Prospect Energy to Prospect Capital. While diversification across industry sectors insulates the company from a downturn in specific industries, the flip side is that management will not be specialized on the industry sectors they invest in rendering their input debatable.
Below is a look at debt by maturity date:
|Maturity||ACAS – Amounts & Percentage of Total Debt||ALD – Amounts & Percentage of Total Debt||MCGC Amounts & Percentage of Total Debt||PSEC – Amounts & Percentage of Total Debt|
|Less than 1 year||302M, 6.8%||277.1M, 13.4%||168.9M, 22.17%||None|
|1-3 years||195M, 4.4%||967.3M, 46.9%||175.8M, 23.07%||90.67M, 100%|
|4-5 years||548M, 12.25%||340.8M, 16.5%||4.3M, 0.56%||None|
|After 5 years||75M, 1.7%||476.1M, 23.1%||412.9M, 54.19%||None|
|Asset Securitization||2.21B, 49.5%||None||None||None|
Prospect Capital Corporation (PSEC) looks least risky by this measure, given the low debt level. American Capital Limited (ACAS) also has relatively contained risk profile, given the low levels of short-term debt due in the near future.
Below is a comparison of some key financial metric:
|Earnings per Share||2.90||1.51||0.86||1.87|
|Debt to Equity||0.80||0.718||0.889||0.212|
|Levered Free Cash Flow||406.5M||50.41M||54.12M||(32.12M)|
|Dividend||869.4M, 4.20/share.||463M, 2.60/share.||56M, 0.74/share**.||48M, 1.60/share.|
- *Data for trailing twelve months (ttm).
- **Dividend suspended as of 8/2008.
While the dividend payments as a percentage of Levered Free Cash Flow seems inverted for all companies, MCGC was the most affected as their management did not anticipate the credit-crunch and had to come up with cash for debt repayments. This resulted in the suspension of dividends for MCGC as of 8/2008.
Investment in a BDC is a good proxy to investing in small private companies. The sizeable yield compensates well for some of the risks associated with investing in a basket of small private enterprises and their debt. Executive management expertise in the venture capital arena along with a focus on investments in their area of expertise should both be considered when deciding on a BDC to bet your money on. It must also be understood that the investment will under perform the overall market in an extended downturn in the economy. Even with these embedded risks, allocating a small amount of the small-cap portion of ones diversified portfolio into a carefully selected BDC Company should provide good overall returns over the long-term.
1. MCGC Capital (MCGC) Analysis - 05/08.
2. Excessive Executive Compensation - Analysis - 07/08.