BDCs as a Liquid Alternative to Public Debt

BDCs as a Liquid Alternative to Public DebtBusiness development companies (BDCs) were created by an act of Congress in 1980, in response to “stagflationary” pressures that had eroded the supply of investment funds available for small and mid-size companies in the 1970s. Like real estate investment trusts (REITs) and master limited partnerships (MLPs), BDCs are regulated by the Securities and Exchange Commission (SEC) and are required to distribute the vast majority of profits to shareholders. In return, BDCs pay little or no income tax themselves – they pass the tax burden to individual investors, who typically have lower marginal tax rates than corporations. The mandatory distribution of tax-free profits makes BDCs – like REITs and MLPs – attractive substitutes for yield-oriented investors amid the low-interest rate environment.

We expect the BDC market to grow, both from investor demand for yield, the growth of non-bank middle market financing, and the general trend toward securitization of private assets.
~ Cliffwater, January 2015

REITs enjoyed an explosion of popularity in the wake of the dot-com bust, then crashed along with the housing market in the 2008 financial crisis. Since then, they have rallied back to deliver a 380% total return since their bottom in early March 2009 (based on the Vanguard REIT Index Fund (NYSEARCA:VNQ) from 3/1/2009 to 2/10/15). Meanwhile, MLPs became another go-to investment for alternative yield-seekers amid the shale and fracking boom, but have seen a sell off with the recent decline in oil prices. BDCs have never made it into bubble territory, and are still a long way off, but they too have seen a selloff since the summer of 2014 as investors shifted to higher quality income assets such as Treasury Notes, REITs and dividend paying stocks as oil prices rose and generated concerns about loans from BDCs to oil related companies.

Down But Not Out

As seen in the following chart, both MLPs, represent by the Alerian MLP ETF (NYSEARCA:AMLP) and BDCs, represented by UBS E-TRACS Wells Fargo Business Development Company ETN (NYSEARCA:BDCS), are both selling at close to 10% off their highs from last year, while REITs are down about 5% from their highs in January of this year.

Comparison of BDC MLP and REIT ETFs

BDC Market Capitalization Small and Growing

According to data cited by Cliffwater in a new whitepaper, the entire BDC universe was capitalized at just $32 billion as of November 2014 – compared to $880 billion for REITs and $500 billion for MLPs. And far from being particularly “risky” or speculative investments, BDCs recently received a shout-out from James Grant, author of the uber-conservative Grant’s Interest Rate Observer.

BDCs are like “venture debt” private equity firms, except they’re open to all investors, whereas private equity is accessible to accredited investors only. Most are publicly traded, but like REITs, some are not. Some of the most popular publicly traded BDCs include:

  • Apollo Investment Corp (AINV)
  • Ares Capital (ARCC)
  • Fifth Street Finance (FSC)
  • Golub Capital (GBDC)
  • Triangle Capital Corporation (TCAP)

BDCs also have a much smaller market capitalization than high-yield bonds, which stood at $1.6 trillion as of November 2014 and continues to grow. BDC asset claims are senior to bond claims, as well, so you might expect BDCs to yield less than high-yield bonds – but that’s not the case. According to the backtested, historical performance of Cliffwater’s recently launched BDC Index, BDCs generated an average yield of 10.23% over the five years ending in December 2014, while high-yield bonds averaged yields of just 6.9%.

Historically Higher Spreads from BDCs

BDCs trade at a historically higher spread to the 10-year Treasury yields versus high-yield bonds, REITs and MLPs. Cliffwater points out in the whitepaper that the BDC/Treasury spread is historically 7.01%, while high-yield bonds have historically traded at 4.70% over 10-year Treasuries. REITs and MLPs come in even lower at 1.24% and 3.08%, respectively. With the decline in Treasury yields over the past year, BDCs are currently trading at a spread of 8.06%, a full 1.05% higher than the historical average. This higher than average yield gap makes BDCs a relatively attractive.

For more information, download a pdf copy of the Cliffwater whitepaper or visit Cliffwater’s website on BDCs and their new BDC Index.