Saturday, November 24, 2012

Be Cautious of BDCs

Everyone should read Jason Zweig's The Intelligent Investor column in the Wall Street Journal, he provides rational and concise investment commentary, this week's article (Should You Bottle Up Your Money in 'Baby Bonds'?) reminded me of my distaste for business development companies, or BDCs, as investment vehicles and how yield chasing investors may not fully understand the risk they're incurring in pursuit of yield.

Most BDCs invest in small and middle market commercial loans, and in some cases equity, to businesses that have trouble raising cash from traditional banks or other lenders.  Similar to REITs, BDCs must pay out 90% of their taxable income to investors and have become popular with retail investors seeking income.

Since BDCs invest in small and up and coming businesses, many people describe BDCs as "private equity" funds for the individual investor.  And like private equity funds, the management company selecting the securities in the portfolio charges an average fee of 2% annually on the assets and then 20% of capital gains above a certain return threshold.  In order to pay out an average yield of 9-11% after expenses, managers have to take additional risks and leverage in order to achieve it, no free lunches.  As an example of how fees eat into potential investor returns, one of the most prominent BDCs, Apollo Investment Corporation has paid the manager an incredible 28% of the revenues in the first 9 months of 2012.  In this low interest rate and yield chasing environment, how are BDCs able to pay the high dividend on top of the high management expenses?

One way is leverage, business development companies have a legal limit to their leverage, they're only allowed to be 2:1 assets to equity.  Leverage was an issue during the credit crisis as many BDCs were hit especially hard, following the recovery many BDCs lowered their leverage significantly, however its been creeping up in the past several quarters signaling that managers are having to increase risk in order to meet investor dividend expectations.  The "Baby Bonds" described in Jason Zweig's article is an example of how some BDCs are getting more creative in their financing and pushing more levers.

Sample list of BDCs as of 11/24
The other way to pay the yield is increasing credit risk.  Due to their similar dividend yield, BDCs get a lot of comparisons to mortgage REITs.  However, a BDC's assets are far riskier than that of the typical mREIT.  An mREIT is essentially a spread game, purchasing long term government guaranteed agency mortgage bonds (zero credit risk) and financing those purchases with the issuance of lower interest rate short term debt (thank you to the Fed's ZIRP), with investors collecting the difference.  BDCs invest in small businesses that are below investment grade and can't get financing through more conventional means, these are highly speculative loans made to shaky companies at credit card like interest rates.  Valuing these securities is also tricky as there's not an active secondary market, for accounting purposes these loans are often considered Level 3 meaning there are unobservable inputs for the asset or liability in the public markets, these assets aren't "marked to market".  Level 3 assets allow management a lot of room in determining the carrying value of an asset, and increasing the risk of fraud (see David Einhorn's book "Fooling Some of the People All of the Time").

Lastly and more for amusement purposes, the chase for yield and the proliferation of new ever more thinly sliced ETFs has brought a 2x leveraged BDC ETN, BDCL, the ETRACS 2x Leveraged Long Wells Fargo Business Develop Company Index distributed by UBS (since it's an ETN, you'd be exposed additionally to the credit risk of UBS).  The advertised leveraged yield is 18.71%, the 2x leverage is on top of the already leveraged underlying BDCs, and the annual ETN tracking fee is an additional 0.85% on top of the high fees of the underlying BDCs, creating an incredible amount of risk and leverage to pay out the sky high yield.

Investors should simply stay away from BDCs, and especially the BDCL.

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