30 Sep BDCya, Wouldn’t Wanna Be Ya (Q3-14)

Some investors never weary of quietly ridiculing the timid caution of managers who refuse to make inglorious bets when markets are underpricing risk. Sitting in cash is anathema to institutional investors so many credit managers are forced to put money to work in assets with increasingly greater risk in hopes of achieving promised return potential. Higher leverage multiples, no covenants, and abbreviated due diligence epitomize today’s aggressive lending environment. Credit doves will argue that this trend is mitigated by lower than historical borrowing costs, which give borrowers more cushion to service debt; but we disagree based on the types of lenders making loans today. We’ve repeatedly cautioned that the imbalances building up in the private credit markets today will most certainly result in high loan defaults in the future. Many credit managers will have limited ability and experience to deal with problem loans either due to investment policy or inexperience. Some specialized lending structures, such as business development companies (“BDCs”) and collateral loan obligations (“CLOs”), are prohibited from holding defaulted loans and will have a veritable dilemma dealing with distressed debt: accept losses or more likely “pray and delay” in hopes the loans will improve over time. These specialized structures and many other private credit managers are levered too and although that helps exaggerate returns when loans are good it also magnifies losses when loans go bad.

BDCs were created by the US Congress in 1986 as a means to encourage the flow of capital to private, middle-market businesses in the US. It was not until the private equity industry’s demand for leverage accelerated at the turn of the last century that BDCs really took off. BDCs are unique investment companies in that they primarily focus on lending to private companies but provide investors with the liquidity of a publicly-traded stock. The retrenchment in traditional lending that accompanied the financial crisis, and the aftershock of increased bank regulation, catapulted alternative private lending activity in the US and grew the market capitalization of listed BDCs at a compounded annualized rate of 39% from the end of 2009 through 2013. The number of listed BDCs has increased by 78% in the last five years and today has about $65 Billion in assets. The backdrop of ultra-accommodative monetary policy and yield-starved investors has made BDCs extremely popular.

Excessive loan growth by a lender should never be interpreted by investors as good news on its own. In a highly competitive credit market like today, with benevolent default conditions, risk can be easily mispriced. As Figure 1 illustrates, the growth in aggregate portfolios of BDCs and an influx of private credit competition has weighed on yields. At the same time, leverage multiples have been increasing thereby causing credit quality to suffer at the expense of asset growth.

BDCs argue that they have a better cost structure and higher yields versus specialty finance companies, despite similar credit risks. Expenses as a percentage of average assets is 3.9% for BDCs compared to 6.2% for specialty finance companies (like CIT). But BDCs are typically externally managed and should therefore benefit from the operating leverage in the existing credit platform of the manager. Investors in BDCs, which give their managers permanent investable capital, should not be paying fees based on assets; instead, managers should be compensated against earnings or distribution growth.

BDCs are also more tax-advantaged than specialty finance companies and distribute at least 90% of their income to investors in order to avoid corporate income tax. Higher yields of BDCs are due to a combination of leverage (1-to-1 debt-to-equity) and their niche focus on transactions in the lower, middle-market where specialty finance companies, that are 10X larger, are not inclined to compete. Smaller, middle-market companies have less information transparency so require much greater analysis and monitoring to properly underwrite and manage risks. The rapid growth in industry assets suggests that not all BDCs will have maintained credit discipline. We expect the number of defaulted loans, non-accruals, and portfolio reserves to be higher within BDCs versus other specialty lenders. In their most recent earnings releases, some of the largest BDCs reported higher non-accruals on existing loan portfolios and lower average yields on new loans. Since BDCs are leveraged, typically with floating rate debt, the impending rise in interest rates will further diminish the appeal of BDCs.

We believe that we are in the early stages of capital formation in the alternative lending markets. Conventional lenders are facing increasing scrutiny, as recently underscored by the leveraged lending guidelines promulgated by the three US federal regulatory bodies for banks. Those guidelines will limit leverage and severely impact a borrower’s ability to repay a loan. Banks are getting pushed out of the lending market and this is steadily contributing to BDCs, CLOs, private debt funds, and other alternative lenders to gain share. Consolidation will eventually overcome the obstacles of underperforming portfolios and drive capital to the most successful lenders. In the meantime, investors should focus on alternative lenders with consistent track records and experienced management teams that place credit discipline and capital preservation ahead of asset growth.

Excerpted from Third Eye Capital Management Inc.’s Q3 2014 Investor Letter.