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The Ins and Outs of BDCs

Business development companies (BDCs) are primarily small caps, but their dividends are anything but small. The industry offers investors double-digit dividend yields earned primarily by lending to and investing in companies that are too small for Wall Street. High yields come with high risks, however, and there is little public information about the investments that BDCs hold on their balance sheets.

In this edition of Industry Focus: Financials, join The Motley Fool's Gaby Lapera and contributor Jordan Wathen as they discuss the ins and outs of BDCs, the rise of activism in the sector, and why investors may be better off avoiding this industry than investing in it.

A full transcript follows the video.

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This podcast was recorded on Sept. 19, 2016.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You are listening to the Financials edition, taped on Monday, Sept. 19, 2016, but you are listening to this on Oct. 17, because I'm in Hong Kong, probably, or potentially China. Who knows? Either way, we're pre-taping. It's pre-taping palooza. My name is Gaby Lapera, and joining me on Skype is Jordan Wathen, The Motley Fool's top business development company analyst. Hey, Jordan! How's it going?

Jordan Wathen: Pretty good. How are you?

Lapera: I'm doing excellent. Today, we're going to talk about business development companies, or BDCs. This is because a month or so ago, we did a show on business development companies earnings, and I got a barrage of emails saying that people had no idea what BDCs are, both the acronym and the actual business. Just be super clear, just in case, I don't want to forget like I did last time, BDC stands for business development company. That's what we're talking about today. We've done a few shows on BDCs before, but I figured it was time for a refresher, since I got so many emails from people saying that they had no idea what they were, why they should care about them, or why we're doing an earnings show on them. So, I guess, get excited for that. I want to warn listeners up front, BDCs are complicated. We're going to do our best to present this topic in a simple way, but by the very nature of the companies, it is a difficult task to do that. They are also very risky businesses, which we'll get into more throughout the show. But why don't we go ahead and dive in.

BDCs, business development companies, they're a little bit -- they're a lot a bit, actually -- like a cross between banks, REITs, and private equity funds. 

Wathen: Right. When you think about a business development company, it's really just a publicly traded portfolio of debt and equity investments in small private companies. So, companies that are too small for Wall Street, for example, that can't issue bonds, that are just too small, that you wouldn't list on public stock market, might seek out private financing from a business development company. There are about 50 or so publicly traded business development companies out there. Most are fairly small, most have market caps of less than $1 billion. So, we're really talking about companies that are small- and micro-cap companies, by definition.

Lapera: Yeah. And, micro-cap companies, for listeners who are just learning, typically are a lot riskier than other types of companies, because they are a lot more exposed to general fluctuations in the market. They have less capital to be able to ride out a down period.

Wathen: Right. That's especially true for business development companies, because BDCs are generally in the business of making loans to buy businesses, so these loans are riskier than your average loan. These loans are commonly referred to as leverage loans. A BDC's typical customer would be a private equity firm, and the private equity firm might find a business they want to buy, but the whole business of private equity is built around the idea that they're going to put up as little of their own money to buy a company. So, if they identify a company that they think is worth $100 million, they might only put up $40 million of their own capital up, and then borrow the other $60 million from a BDC to buy the company.

Lapera: Listeners might be asking themselves right now, "That's what I thought banks did. They write loans. Why aren't these companies going to a bank?"

Wathen: Right. People have this view of banks as being in the risk business, that basically, they're lending money and taking risks and making a profit in doing so. But really, especially since the great financial crisis, banks aren't in the business of taking risk anymore. Banks want to minimize risk as best they can. A typical bank loan is really something that's designed for companies that don't need the money. Banks want to loan against collateral, they want hard assets that they can sell if the loan goes bad. You can really think about this basically as, banks are lending money at 4% or 5% interest rates. They really can't afford to take much risk there, because there really isn't much upside to protect against all the loan losses that will eventually come.

Lapera: Right. BDCs, by contrast, frequently have loans that yield 9% to 10%, which is a lot higher.

Wathen: Right. A bank might loan against a company's inventory. Let's say a retail store has $10 million of inventory. A bank might write a $3 million loan against that. Their thinking is basically, "If you can't pay us, we can at least liquidate this inventory for $3 million." Business development companies, on the other hand, aren't lending against hard assets. They're typically lending against earnings, or the business' cash flows that are expected over time.

Lapera: Right. I think we mentioned in a previous show that BDCs end up invested in really weird businesses as a result. I think you said a favorite was bowling alleys, they're hugely popular. 

Wathen: Right, bowling companies, mattress companies have been tossed and turned between private equity firms like crazy, too. But, in general, BDCs are lending against companies that don't have a lot in the way of hard assets, they're more service-oriented businesses. Some companies that have been really popular in the BDC space have been software-as-a-service companies, companies that generate recurring revenue from a service, but don't necessarily have hard assets like real estate or inventory.

Lapera: Yeah. The reason that BDCs even exist is because, back in the '80s, regulators were starting to get worried, because banks did use to make these kinds of loans. They were deemed a little bit too risky for banks, so Congress created this structure that allowed BDCs to be born into the world of finance. That's how we ended up with them today. I don't know if you remember, but earlier, I said that BDCs were a little bit like private equity funds and banks, which we've covered. But, they're also like REITs in that they are required to pay out 90% of their taxable profit for the year in dividends.

Wathen: BDCs can avoid corporate taxation, so, avoid paying taxes on the profits they generate, by distributing 90% of their taxable income to shareholders each year. Obviously, a BDC would prefer to avoid as many taxes as it can. It obviously wants to meet that criteria. At a 35% tax rate, if you can avoid that, it's very good for shareholders.

Lapera: Definitely. So, like we said, BDCs are really interesting hybrid companies that function a little bit like REITs in that their dividend yield is super high, a little bit like banks in that they give out loans, and a little bit like private equity funds in the types of businesses that they invest in. Unlike all those three -- well, I don't know, private equity is pretty risky -- very, very risky. And unlike private equity, you can actually buy stock in BDCs, which is why we talk about them on the show so much. Or, really, only when you're on, Jordan, I think you're the only person who talks about BDCs with me.

Wathen: Yeah, probably the only guy out there.

Lapera: So, we talked a little bit about how banks and BDCs are different. We kind of know why someone would want to invest in a bank. Why would you want to invest in a BDC?

Wathen: The whole idea of investing in a BDC is capturing the extremely high dividend yields that they pay. You kind of alluded to this. The industry as a whole, the median BDC right now pays a dividend deal of about 10%, which, as far as I know, is probably among the top of any industry out there. Equity REITs probably pay 5 or 6%, mortgage REITs might pay 10 or 11%, but BDCs are definitely up there in the yield department.

Lapera: I think the average yield in the S&P 500 is something like 1.5%.

Wathen: Right, it's close to 2%. You're talking about an industry that pays out five times, six times, seven times what the average stock in the S&P 500 does.

Lapera: Which is alluring if you want easy cash. Other reasons you might want to invest in a BDC -- you have a high tolerance for risk, and you don't mind all your money disappearing.

Wathen: Right, exactly. If you think about what a BDC does, they're basically providing loans that the Federal Reserve has said, "These are way too risky for banks." After the financial crisis, the Federal Reserve came out and said, "Look, even though this really wasn't the reason why the financial crisis happened," the real problem with the financial crisis was that banks just got drunk on mortgage loans, but, banks also used to lend to these buyouts, and the Federal Reserve said, "Hey, we're putting out a hard limit on these loans. You can no longer make leveraged loans at six times the company's earnings. That's the limit we're going to put on it." BDCs popped up to supply the demand for loans that are that risky, that are at multiples of a business's annual earnings.

Lapera: Yeah. I know there are a few BDCs that are generally considered safer than others. Do you have any opinions on that?

Wathen: Yeah. One that makes less risky investments would be something like Golub Capital BDC (NASDAQ: GBDC). They basically focus on first-lien loans. So they have a first claim to the assets. And there's usually another debt, and always another equity investor, behind them. Just as a matter of business, Golub Capital BDC doesn't make equity investments. They typically avoid them, just because they like to avoid a conflict of interest with people who might bring them deals to invest in, so they don't invest in equity. For the most part, I would consider them a very low-risk BDC relative to some others out there, which hold higher equity stakes.

Lapera: Fair enough. As you can tell, neither Jordan nor I think that BDCs are a great idea. You do you, though, that's totally up to you. We're not telling you what to do with your money. But now we're going to talk to you a little bit about why, maybe, you wouldn't want to invest in BDCs. I'm going to lead off with my No. 1 reason which is: You're investing in a company that's investing in another company that you don't actually know that much about.

Wathen: This is a great place to start. As a matter of practicality, understanding what a BDC owns is very hard to do. They invest in more than 100, in most cases, private companies, which you know nothing about other than the name that they list in their annual and quarterly filings. So, you can do a little bit of Googling, but you won't find financial statements, for example, of the companies that they invest in.

Lapera: Right, because they're tiny, privately held companies. I'm stuck on car washes today, but they're like, Lily and Al's Car Wash. They're not investing in big corporations.

Wathen: Main Street Capital (NYSE: MAIN) is a good example. They trade at a huge multiple to book value, I think it's 1.5 times book value, something like that. But, they have invested in companies as small as 10-store restaurant chains, and a small jewelry store in Idaho, for example. These are businesses that... I live in South Carolina, it would be very hard for me to go do due diligence on a jewelry store in Idaho.

Lapera: Yeah, that's totally fair. Also, the way that BDCs get their valuation is really interesting. They have this thing called net asset value, which is basically the value of what they hold in loans. The problem is, they're Tier 3 assets. That means the BDC gives their best guess as to how good the loan is. It's not based on hard accounting, really, it's based on how they feel about the loan.

Wathen: Right. Let's use a mutual fund as an example. A mutual fund might own shares of Google. To get the value of a Google share, the mutual fund just has to look at the stock market and say, "Google is trading for $X, this is what our shares of Google are worth." Well, when it comes to private debt and private equity, these are level 3 assets. So, the BDC basically has to do the fundamental work and say, "This loan is money good, so we'll mark it at par, we'll mark it at 100% of loan value." And I've seen several cases where a BDC will mark a loan at 100% and say "Everything is performing splendidly," while another BDC will mark the loan at 70% of par, which indicates that the loan is going to come under distress at some point.

Lapera: Yeah, that's hard. This information is on the BDC's 10-Qs, right? They're required to list all the companies that they have loans out for, and how they think those companies are doing. It's kind of hard to actually know, as a Joe Schmoe investor sitting in your office trying to figure this out, what's actually going on inside the BDC. Another thing that is hard to figure out what's going on inside of the BDC is conflicts of interest, which, I know you were excited to talk about, Jordan.

Wathen: Yeah. If there's one thing that categorizes BDCs as an industry, it's that there are huge conflicts of interest between management teams and shareholders. The unfortunate reality is that most management teams are compensated based on the size of their asset pool. So, BDCs and BDC managers want nothing more than to grow the pile of assets they're managing, and they will do almost anything possible to do it. What should matter, and what I'd hope matters over time, is that these fee arrangements change, and eventually managers will start focusing more on returns on assets rather than the size of their assets. But, to date, the focus has primarily been on size of assets, and when management teams are compensated on how much they manage rather than how well they manage it, the incentives just aren't in line. It's really unfortunate.

Lapera: Yeah. Thing brings me to another risk. (laughs) I don't know if you've noticed yet, but the risks side is a lot bigger than the not-risk side. Another risk of BDCs is that they are prime targets for activist investors. Which means, you don't really know what's going to happen to the company when another group of investors buys it out and can change the entire future of the company.

Wathen: There was an interesting deal recently, actually. There's a BDC by the name of Fifth Street Finance (NASDAQ: FSC). It became the subject of an activist investor who really ticked off the manager, and the manager said, "We want you gone so we're going to buy out your stake and we're going to pay a premium to do it." It was a terrible deal, and it was really kind of sad, because what happened was everyone had hope that this activist investor was going to force the changes needed to bring the valuation of this BDC up. But, in reality, they just said, "Eh, never mind, we'll cash out at a gain." Management stayed in, and nothing happened. It was a really bad deal.

Lapera: Yeah. That's one of the things you risk. Activist investors could be going in out of the goodness of their hearts, and they really want to change it -- or they could just be like, "Eh, we'll take our payday and run," leaving the BDC even worse off than when they found it.

Wathen: I think that's a fair characterization of what happened at Fifth Street Finance. We'll just leave it at that.

Lapera: There are potential ways that you can feel this out, like if the company is internally managed or externally managed. But, that's no real guarantee. And if you're curious about what those terms mean, I can email you links to them later on, but we are rapidly approaching the end of our show. By rapidly approaching, I mean that we're here, we're at the end of our show. (laughs) Just a quick summary, BDCs have a very interesting structure, like banks, REITs, and private equity had a baby. There are potential upsides, which is high dividend yield and high growth. But with those potential upside comes high risk. That is something that is totally up to you, but is definitely not for me. Is it for you, Austin Morgan? Austin Morgan is shaking his head.

Austin Morgan: It is not.

Lapera: Austin Morgan says no. There you go, we have our ruling from our producer. Jordan, do you have any last thoughts?

Wathen: No, not really. I would just say, tread very carefully. If you do get interested in this industry, don't get suckered in by yield. It's very easy to draw a straight line into the future and say, "Everything will be the same, I'll always get this 13% dividend." But when any company pays out 90% of its earnings, it's always subject to the potential risk of a dividend cut. So, be careful out there.

Lapera: Those are some wise words. Listeners, if you're interested in learning more about BDCs, Jordan and I have actually done a couple other episodes about them. If you would like links to those episodes, email me. If you need links to internally versus externally managed BDCs, email me. You can contact us at industryfocus@fool.com, or by tweeting us @MFIndustryFocus. As usual, people on the program may have interests in the stocks they talk about, in The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thanks to Austin Morgan, and thank you for giving us your opinion on BDCs. And thank you to you all for joining us. Everyone, have a great week!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A and C shares). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.