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Finding yield with BDCs
BDCs provide attractive yields and easy liquidity. Watch as two experts discuss why Business Development Companies are a hot investment.
Grier Eliasek - President and Chief Operating Officer of Prospect Capital Corporation
Bob Marcotte - President of Gladstone Capital Corporation
Duration:
00:50:47
Transcript:
Courtney: BDCs or Business Development Companies are for public investors’ access to private companies, which typically aren’t accessible. With attractive dividend yields and easy liquidity, this growing vehicle is one to watch. Grier Eliasek, President and COO, Prospect Capital Corporation, Bob Marcotte, President, Gladstone Capital Corporation. Welcome to Asset TV’s BDC Masterclass. Gentlemen, welcome.
Grier: [00:00:40] Thank you, Courtney.
Bob: [00:00:41] Thank you very much, Courtney.
Courtney: [00:00:42] We know BDCs or Business Development Companies, but Grier, tell us, what is a BDC?
Grier: [00:00:47] Sure. A Business Development Company is an investment company that’s organized under the 1940 Act as well as other parts of the Securities and Exchange Commission Code. And what it is, it’s a structure that allows for a pass through of income to investors in the form of a relatively high and attractive dividend. BDCs are required to distribute at least 90% of their income to investors. So it’s a very high payout ratio. And BDCs also are required to have a certain percentage of their investments in so called qualifying investments which are predominantly US private companies; at least 70% of the investments need to be in US private companies.
Courtney: [00:01:37] And, Bob, give us your perspective on this.
Bob: [00:01:39] BDCs are a form and a framework for diversified private investing. And they have a natural market in serving smallish companies that don’t have access to the capital markets on a regular basis. Their portfolios are built up with smaller companies for the most part. And they pay through their earnings to their shareholders.
Courtney: [00:02:01] And, Grier, you mentioned that it’s a pass through, can you tell us more about what that means?
Grier: [00:02:06] Well, what that means is as long as those distribution requirements are met, and there’s also certain diversity requirements which are beneficial to investors, as well as a leverage restriction, BDCs are limited, and no more than one to one debt to equity. So as long as those tests are met and the distribution payout is hit then BDCs enjoy no corporate taxation. Now, for investors, that income might be some portion of qualifying dividends, some portion non-qualifying, generally a greater percentage is in the non-qualifying aspect. So to an extent you can hold BDCs in some type of a tax deferred or tax efficient format, that’s generally the most optimal way to do so.
Courtney: [00:02:55] Okay. And, Bob, can you give us a little bit of a perspective on how are they different from, you know, a mezzanine fund, private equity, you know, they’re kind of compared a lot to those vehicles, and sometimes I think they work with them, but how are they different?
Bob: [00:03:07] Well, just as a comparison, think about a BDC much like a REIT, okay, and it’s a passed through vehicle, is investing in certain qualified assets as a REIT does. The difference is it’s loans. Most BDCs are investing in loans because those loans generate current return which is ultimately passed through the shareholders. As an investor in loans, they are compared to leveraged loan funds, they’re compared to high yield bond funds, in many respects they are similar. The assets are all loans. The question really becomes a matter of the structure of leverage and the type of investments they construct in their portfolio. High yield bonds are generally larger companies and they’re generally publicly traded securities. By definition the BDCs do not invest in publicly traded securities for the most part.
Courtney: [00:03:59] Okay. So they’re investing in private companies, Grier, tell us about this.
Grier: [00:04:02] Well sure, and I would add to that, when you look at mezzanine funds compared to BDCs, the vast bulk of Business Development Companies are publicly traded. So you can buy a public stock, you can sell that stock right away if you so desire. So there’s real liquidity there, such liquidity goes up as you get to larger capitalization BDCs generally. Mezzanine funds are private partnerships, so they’re illiquid. So you invest in a mezzanine fund and it’s a multiyear, relatively irreversible decision that you have to be comfortable with before you get your capital back. Mezzanine funds don’t have as high a payout requirement. And they don’t tend to run with leverage like a Business Development Company, in part because leverage or mezzanine funds can create tax issues, in part because obtaining leverage for junior debt, which is what mezzanine debt is, is relatively more difficult. BDCs tend to focus more their investing on senior debt that tends to be more leveragable as well.
Courtney: [00:05:09] Bob, can you tell me how do you work with private equity at times, or do you work with the other banks and lending institutions, tell us about this universe and how it all works together?
Bob: [00:05:19] Each BDC is somewhat different in how they originate assets and the character of the underlying assets. Leverage finance is a common denominator and that tends to be some form of private equity investment transactions going on and the BDCs will provide capital as part of that transaction. Typically it would be a couple of terms of leverage, maybe a little bit more than a commercial bank would provide and it provides a higher level of return ultimately to the private equity sponsor. BDCs also invest in non-sponsored transactions. They’ll invest in syndicated loans in some cases and also structured credit which is more like CLOs or other forms of leverage finance as well as in some cases, limited amounts of equity. One of the key components in looking at BDCs is what do they put in their fund that generates the current return that ultimately is passed through the shareholders, the key differentiator for many funds.
Courtney: [00:06:16] And are, Grier, providers of mezzanine debt having trouble competing with BDCs for deals?
Grier: [00:06:22] I would say yes, over the last 10/15 years there’s been a long term trend which mezzanine funds have lost market share to BDCs. And the reason for that is multi fault, first, mezzanine funds can’t obtain leverage, so that makes them less competitive than BDCs that can. Secondly, there’s been a mixed shift in the marketplace for middle market companies and their owners are private equity firms, so wanting to borrow in a one stop fashion, which means traditionally borrowing had been done in a bifurcated fashion. So a private company owned by a private equity firm, would borrow money, it would get the senior debt from a bank, including a revolving feature and would get junior debt from a mezzanine fund, bifurcated. Today that still exists but it’s much more common for a one stop player like a BDC to come in to do all the senior debt and all of the junior debt in a combined fashion. Sometimes it’s also called unit tranche investing. And the reason the borrower prefers that many times is it’s simpler, documentation is simpler. You’re only dealing with one counterparty as opposed to many. These are dynamic situations in which companies oftentimes need more capital to do an acquisition, to do some other type of goal on the way. And the fewer parties you have to go to, to get that approval then the easier it is.
Courtney: [00:07:55] So unit tranche financing is very attractive if you are a middle market company looking for financing. And, Bob, tell us about that, what’s the matchmaking process between the middle market company and the BDC?
Bob: [00:08:07] It’s much like a lot of the other leverage finance arenas, typically it involves an investment bank or with a company of any size or it involves a relationship that exists between the BDC and a private equity sponsor, maybe acquiring the company or looking to recapitalize the company. Typically they’re going to look for folks that understand the business, they are looking to grow that asset to accrete equity returns to that private equity sponsor and they want someone that understands and supports the business in a fundamental way on a long term basis.
Courtney: [00:08:40] That’s really interesting. And, Grier, do you ever take an opportunistic equity stake in the companies that you work with?
Grier: [00:08:46] We do, so part of our business … a significant part of our business, the biggest part of our business involves lending money in a non-controlled fashion to borrowers. But we also have a significant part of our business focused on acquiring and controlling interesting companies, so called one stop buyouts. And in this case we’ll supply generally all the term debt to a company and we’ll also supply the majority of the equity. And the management team will be an equity co-investor with us, so they’re substantially aligned and want to see the company is successful. And this is a bit of a differentiated approach, the vast bulk of BDCs don’t do this. You need to have staffing and the requisite skill set, people that know how to run companies, sit on boards, manage companies, to be the owner is generally significant uptake in work required, compared to merely being a lender to that business.
And there are a lot of benefits to the one stop approach as an owner, because we get a current cash yield out of the investment and then we get upside from the investment. And that need for yield as part of our total return package really limits the multiple that we can pay for a business. So it adds to capital discipline of the front end, [unclear 00:10:08] to pay for these businesses. And we’ve done quite well in that segment, we’ve had deals like Gas Solutions for example an energy midstream and processing company that we owned, we bought for about three and a half times cash flow years ago, we clipped 30-40% yields along the way as the higher percent owner of the business. And then we sold it and made six times our money, energy, manufacturing is an industrial business; there was an [unclear 00:10:35] cash on cash return. Right now, one that we’re particularly excited about is a business called Harbortouch which is a company that supplies touch screens that goes into local merchants, restaurants and also does the credit card processing for that business. So we’re excited about the future exit opportunity for that as well. So you own the equity ups, and it’s nice to own equity because if you’ve got a pure debt book, a credit book, you’ve one direction to go, down, through defaults. So having some equity ups to mitigate is a nice thing.
Courtney: [00:11:08] So this sounds a little bit like a private equity or a VC the way you’re getting involved with an equity stake, but it’s different obviously. And then when you think about the exit, do you have an exit, the way they would there in BDCs?
Grier: [00:11:23] Well, the good thing about managing a Business Development Company as a permanent capital business is, we don’t have these artificial time constraints that say you have to exit after x number of years, five years say, that you would in a private limited life fund. So we can be very patient. We can hold onto investments forever if it makes sense to do so. Some of our financial services buyouts for example, where we have tax efficiencies. We own them as partnerships, there’s no taxes downstairs, at the portfolio company level there’s no taxes upstairs. It’ll not be hard to find buyers that have similar tax benefits that we have and maybe we’ll hold on to those for a long, long time. In other cases, cyclicals where say in energy which are doing quite well and we thought, now is the right time to exit. We have the flexibility to decide whether or not to sell or to hold.
Courtney: [00:12:11] Bob, this, you know, permanent capital’s a term that I think is fairly unique to BDCs, it’s not one your hear about for instance certainly in private equity or VC; tell us how that applies in your business?
Bob: [00:12:22] Well, I think Grier covered it well. I think the idea of having a permanent capital base that allows you to take the gains or reinvest those proceeds as income back, is just a much more efficient vehicle in terms of growing the business, in terms of providing stability in the asset base and ultimately a consistent dividend to the shareholders. In our case that permanent capital base allows us to support business over a very long lifecycle. The private equity sponsors that we finance want to understand that we can stick with their business as they grow and build on that business and we can do that with our capital base. And then the permanent capital aspect is I think important for investors to keep in mind right now where you have a significant number of BDCs trading at a discount to net asset value and folks saying, “Ooh, is that going to put pressure on BDCs?” Well, not really, as long as you have stable long term funding which folks do as responsible stewards of capital. You have a significant ability to reinvest loan repayments and prepayments and other exits out of the book.
For example, in the case of our business we had about 3.2 billion of gross originations in 2014. And we funded that about a billion 7 through repayments and exits. So even if there’s no new capital coming in from equity and debt issuance, assuming you’ve hit your target leverage ratio, there’s a lot of capital coming back out of the existing book, that we can just sit there and recycle and be very patient about and wait for market values to recover. Chasing, you know, going through a fund raising process like a mezzanine fund every four to five years is a very distracting process, raises questions about where you are, raises questions about exits that you need to be able to show returns to, and that’s a very disruptive process to the business. So the fact that we have that permanent capital is very important.
Courtney: [00:14:17] So this is such a luxury that you can be opportunistic in your business where, you know, a lot of other comparable, maybe sort of comparable business are constrained by, you know, exits. And you’re not. You can be very selective about what you want to do.
Bob: [00:14:31] In this environment, one other thing that I’ll also add is the regulatory environment, which I’m sure we’ll touch on. Regulations are affecting the players in the leverage finance business. And while BDCs are a significant player, they are not in the same game and have the same restrictions as the bank regulations that are applicable today. And what is tending to happen is there’s a shift in the leverage finance marketplace. And quite frankly, when you talk to a private equity sponsor, the idea that you have some flexibility, that you can work with them in amortization, having a much more patient capital base, because that’s where our funding comes from, allows them to have a clearer path to grow their business. When you’re not taking the money out, the moment that you lend it to them, with amortization the first year, as might be required under certain banking regulations, you’re able to reinvest their proceeds and that not only builds a stronger and bigger company but it provides a capital appreciation for the underlying private equity sponsor, huge value add that the BDCs can bring to the leverage marketplace.
Courtney: [00:15:32] And we’ve certainly touched on it, right now you enjoy a one to one leverage ratio. But I think we touched on it, congress is thinking about or considering moving that up to a two to one. Grier, can you tell us about where that sits right now?
Grier: [00:15:46] Sure. And this has been a lot of good work extended by people in the industry to get to the point we are today. Most people you talk to right now would say, “A little over 50/50 odds of success of passage by the end of 2015.” The Bill is anticipated to enter the House in the next few weeks. Work is about to commence in the senate side, there’s already sponsors and co-sponsors being put into place. And the Bill’s vision right now could obviously be tweaked. But a lot of folks have weighed in at this point in time. So what we have right now, folks are reasonably optimistic as what the final Bill’s going to look like. And that is for the debt equity leverage limit to go from one to one to two to one as you said before. There’s likely to be some type of waiting period before that leverage would kick in to allow shareholders and bondholders and rating agencies time to adjust. In addition to that there’s other aspects of the Bill, certain types of preferred equity as held by institutional investors would not count towards indebtedness, which is not the case right now, preferreds actually count as debt on BDC balance sheets. So that would open up more flexibility. And there are certain restrictions that BDCs have on the percentage of their assets or just doing deals at all, with certain types of financial services, companies, including banks, broker dealers, registered investment advisors and the like. And there’ll be a lot more flexibility opened up there which is beneficial to us, and while we want to see that as part of the legislation because we have a financial services buyout business as part of our one stop buyout business.
Courtney: [00:17:43] And, Bob, do you think this would require bipartisan support to pass?
Bob: [00:17:47] Undoubtedly, I mean I think the current market environment is a little … leverage finance, rate changes, current economic environment certainly today is a little different than two or three years ago. It is going to take a balanced approach. Personally I think the markets provide a lot of capital through the BDCs to the marketplace. The BDC sector has grown by almost fivefold over the course of the last couple of years. There is a lot of capital today. I think the leverage is a benefit but it’s not certainly today the real constraint to the growth of the business, it has grown naturally pretty significantly in the last three to four years.
Grier: [00:18:25] And it’s important to point out, less folks think actually a lot more risk is about to enter the industry. Banks are levered about ten to one by comparison, BDCs one to one. We’re talking about walking up from one to one to two to one. And the reason folks want to go to two to one is because BDCs if anything over the years I’ve observed, reduced the risk of their assets, doing less equity, less subordinated debt and more senior secured debt firstly in one stop unit tranche debt as relates to your question earlier. And that type of higher quality assets are more leveragable and arguably can restrain going to a higher leverage ratio, which is still again relatively modest compared to banks.
Courtney: [00:19:11] So the higher leverage ratio would sort of naturally push allocations more to the senior side of the capital structure, which would result in, you know, less risk?
Grier: [00:19:24] Well, that’s the argument some have made. Others have said that’s a push. But certainly folks should carefully weigh the ramifications and think there may be some de-risking going on the asset side to counterweigh a little bit more leverage on the right hand side. The reality is that when you look at Business Development Companies from a business and financial risk standpoint, unlike the banking sector where I believe 1,000 banks approximately have failed in the last decade. It’s an enormous number. Zero – zero BDCs have failed. Zero BDCs to my knowledge have ever had a payment default on any type of loan, bond or other meaningful obligation. So that’s a very strong and stable track record that the industry has to show off.
Courtney: [00:20:15] And will there be any compression of margins if there was more of a focus towards a senior secured debt versus mezzanine or you know, some of the more subordinated debt?
Grier: [00:20:26] I think some of that could happen. And there’s going to be a value sharing. I think a significant part of the value is going to BDC shareholders through the form of higher return on equity. I do see the potential as more capital is earmarked for, firstly in paper, and if you can lever more and get a higher ROE, maybe coupons on firstly in debt, to compress a bit, to a limit. But the realities right now, there are private senior loan funds that can lever beyond one to one and are competitive forces in the market, not mezzanine funds you asked about before but more private senior loan funds. They’re not registered vehicles so they don’t have the one to one cap restriction. So that’s already there as a competitive force which probably means a lot of that is already in the market and you’re unlikely to see massive yield compression. And in fact on the yield compression point, yields have compressed already in 2013 and 2014 as more capital entered the market. But we have seen stabilization there and we’re actually seeing yields start to go back up again, especially because so many BDCs are below book and are unable to issue equity. In the December quarter for example, our weighted average yield on investments went up from 11.9 to 12.3%. So it actually increased.
Courtney: [00:21:53] Yeah. I think yield is a really important topic to touch on. I mean when you look at BDCs versus MLPs or REITs or then compare it to a 10 year treasury, Bob, take it from here, but explain sort of where they lie.
Bob: [00:22:05] Well, the current average yield on the BDC shares is roughly 10%. And when you factor in the security and the relative leverage of those portfolios you have to compare it against the high yield funds for example, which currently average about 6% yield more or less. So there’s about a 400 basis point differential. And frankly, you’ve got a more secure instrument, you’ve got security, you’ve got better creditor protections. You’re just in a much stronger position in the capital structure of those companies. You can compare it to loan funds which are very similar, again bigger companies, but the yield range in there might be 4½-5%, maybe 5½%. So you’re looking at roughly twice the yield for what in many cases is a comparable or even better preferred structure which I think is largely as a result of the efforts in the origination capabilities as well as the leverage that’s baked into the BDC structure.
Grier: [00:23:05] You know, our company went public 11 years ago. And so we’re in a second decade of managing this business through various cycles. And I can’t think of a time like today where you could buy BDCs at such high yields and discounts to book value. And we’re in an upswing economy. In 2008 and 2009, you saw discounts emerge with BDCs, with other financials, with the stock market in general, everything was selling off. But you also had significant credit issues and the overall economy having significant issues. Today, while the economy’s not perfect, it’s growing, it’s a benign default environment, our non-accrual rate by now is .03%, for other BDCs I know it’s low as well. And so credit, it really shouldn’t be the big concern. What people are concerned about is interest rates going up. And then you have BDCs that have almost entirely floating right assets. So BDCs, [unclear 00:24:11] been left behind when the fundamentals say, “This is a very interesting asset class.” And you look at our stock, it’s yielding at about 11½%, 11½% dividend yield, compare that…
Courtney: [00:24:25] It’s huge.
Grier: [00:24:26] It’s like a 1,000 basis points higher than equivalent five year treasuries. And you can buy it at a 15% discount to book and enjoy a potential upside. But that’s a pretty nice yield being paid just to sit there and wait. And it’s probably, you know, twice the yield, well you can get more than twice the yield you can get for MLPs and REITs, which have their own business risks attached to them and are fundamental equity as well. MLPs have the whole commodity driven risk which is concerning people right now, real estate has concerns about cap rates and what happens when interest rates start going up. And with the BDC book is fundamentally debt, it’s really credit risk, if credit looks healthy, arguably there should be … it is trading at least around [unclear 00:25:16] and not at a discount like you see today. So value investors, pay attention.
Courtney: [00:25:21] Yeah.
Bob: [00:25:22] Well, I think there’s a magnification of that issue when you … the comparison to the high yield funds, those are typically fixed rate instruments. So as rates go up they’re obviously not going to perform as well as Grier has pointed out, the fact that most of the BDCs are on floating rates, so it’s going to go up. I think the other thing that need to be mindful when you look at the risk profile is the leverage in the portfolio, the underlying leverage in the BDC portfolio is typically significantly below that of a high yield bond fund, leverage in a bond fund could be upwards of 5½-6%, as a multiple of underlying cash flow, most BDCs are probably in, what did you say, 4-4½ range? So there’s an inherent, almost 25-30% differential in the equity base and the value of the additional cushion in the leverage ratios of that fund. So when you think about uncertainties, think about uncertainties like dollar changing or interest rates or things like that, the BDC has a measure of additional credit protection insulation in the structure of its instruments. And it’s focused on a very small business. In many cases it has better controls. We’ve been around since 2001, and we’ve been through a few cycles, managing through a small business is a challenge. But if you have the right team and you have the right controls, that’s a process that a sophisticated and well run management company can handle. And that’s really what a BDC’s about, managing through the cycles. And I would encourage folks to think about the assets in those entities and the way they’ve been run.
Grier: [00:26:52] That’s a great point about comparing BDCs to bond funds. BDCs, yeah, 4-4½ turns of leverage is about right. Our book it’s about 4.1 turns of leverage at our [unclear 00:27:05]. We’re sitting at 75% secured debt for our assets. So you’re talking about a much higher recovery rate, [unclear 00:27:14] recovered at 80 cents in the dollar for example, very high recovery rate. Bonds levered two to three turns higher, 20% recovery rate typically on bonds. Bonds are fixed instruments. BDCs are floating rates. High yield bonds have a huge energy exposure and are about 17% oil and gas, BDCs are in the mid single digit by comparison. So on pretty much every measurement, BDCs look like a superior … you get paid more and the risk is much less than with bonds.
Courtney: [00:27:52] Yeah. It’s pretty impressive. And I just want to drive home the floating rate point. I think maybe when people are thinking rates are going up, what’s going to happen. That’s your inherent shock absorber, right, Bob?
Bob: [00:28:03] Yes, I think people are concerned, really kind of two things, one, what happens in the short term when rates go up? There are obviously some floors and there are some great protections that are built into BDCs. But that’s generally a very small part of their exposure because the leverage is somewhat limited and because their debt typically is either hedged or it’s not all floating right. So there may be some concern about what happens when the near term rates go up, but it’s relatively small given the leverage position. Beyond that, I think the only real question is are there going to be stresses on the underlying companies in the portfolio as that rate burden increases. And quite frankly I think everyone’s expecting some move up in rates and that will be generally beneficial, but not to the point where it’s going to affect the underlying credits, in structuring the deals and the flexibility of our capital structure, in many cases we’re managing to fix charge coverages and the ability to manage their debt, which is very different than would be in a public market scenario where a much larger company with a higher level of leverage.
Courtney: [00:29:04] Right.
Grier: [00:29:06] An increase in rates is depicted out there as the boogeyman to be fearful of.
Courtney: [00:29:10] Yeah.
Grier: [00:29:11] As so much of the time, and it’s just not the case with BDCs, at a minimum BDCs won’t suffer from rates going up. And more likely are to benefit on the margin by being paid more on assets both for new loans being put out as well as loans in the existing book. And BDC balance sheets have almost entirely fixed rate debt for a lot of BDCs, for ourselves we’re over 90% floating rate assets and over 90% fixed rate liabilities. You would have to be crazy not to fix your liabilities at such low interest rates of where we’ve been in the last few years.
Courtney: [00:29:47] Right.
Grier: [00:29:47] Especially if you have callable paper, as we do, a lot of our debt we issue with weekly program notes, so it’s actually retail driven paper that after a brief non-call period we can retire that debt and refinance it at a lower rate. But the institutional debt is fixed for life. But even with that, long term sticky funding looks attractive, rates going up net, net are a good thing for BDCs.
Courtney: [00:30:15] Okay, good. What do you think here, Bob, a good thing?
Bob: [00:30:17] Absolutely a good thing, I think the rates … the rate increase is well under control for the BDCs. And the underlying companies I think are in pretty good shape given the dynamics of the current marketplace. The small corporate earnings growth rates, small cap opportunity is still pretty rich in today’s marketplace.
Courtney: [00:30:41] And I want to pivot a little bit, I think we touched on a few of them, but what secular trends are you seeing right now that are going to impact BDCs?
Grier: [00:30:50] Sure. Well, one of those trends, just looking at overall the economy what’s going on is what’s happening to the consumer. So we see 2015 as very much the year of the consumer, after consumer struggled for so many years, you’re probably seeing improvement in employment, wage growth starting to kick in and that’s going to accelerate we think. And then you get this energy gasoline dividend to boot in peoples’ wallets. So we’re seeing on anything touching consumers in our book is benefitting tremendously. And we’re consciously earmarking more capital into consumer oriented deals, including deals in the financial services segment, for example, online lending. We’ve built up about a 300 million dollar portfolio and it’s growing at 30-50 million dollars per month, focused on consumer online lending. And we expect for that to continue to grow. Real estate we talked about before, part of our business includes real estate with a heavy emphasis on multifamily residential. So we own dozens of apartments spread across the country. And that benefits from improving consumer credit, through increasing occupancy and rising rents and low bad debt expenses on the apartment side. So that’s a big secular trend to be mindful of.
Courtney: [00:32:21] And, Bob, what about you, what are you seeing in terms of secular trends?
Bob: [00:32:24] I think we tend to focus on smaller companies, so the broad sector sometimes impact them, sometimes they don’t. Many of our companies are either going in sectors and reinventing sectors when we think about new entrepreneurial companies. The sectors where we’ve seen things affecting our smaller companies tends to be software oriented, business services, technology and efficiencies, recurring cash flow businesses are really what we focus on. Because the predictability of revenue and the stability of that competitive position is very important to us, smaller businesses obviously need a stickier and a much stronger credit profile in order to be able to sustain any issues of interest rate change or economic uncertainties.
Courtney: [00:33:13] So you’re pretty sector agnostic?
Bob: [00:33:15] We are sector agnostic. We are predominantly focused on places where there’s growth. Growth is really beneficial in several ways. First off, our capital is more attractive when business is growing. Secondly, that growth serves to deleverage businesses naturally as they continue to expand and grow. And lastly, that growth profile in order for us to value the underlying enterprise. And if we get to a point where we need to manage and work with a company in terms of working through a rough patch, that enterprise value is critical in providing options for us to manage those small companies to the right place and the right exit if that’s necessary.
Courtney: [00:33:54] Grier, do you want to say something?
Grier: [00:33:56] Yeah. And also on the secular front, energy is where there’s been this massive upheaval in the last year with crude oil dropping by roughly 50% in the second half of 2014. We have a very low oil and gas exposure in our portfolio, well under 5%. So this is more of an opportunity for us than a threat. And we think this month, March, maybe isn’t the perfect time to get into energy, that things are actually going to get worse before they get better. There’s continued oversupply. But as the year progresses throughout 2015, if you have capital and you understand the energy sector and we do, we have an office in Houston, we have a lot of people with deep expertise in this sector, then some very attractive deals are going to open up on that landscape. So look out for that as a sector based opportunity as well.
Courtney: [00:34:58] So you’re sitting on the fence just waiting for the right opportunity, but there is opportunity that’s on the horizon with energy, just waiting for the right…
Grier: [00:35:05] There is, our teams are looking at a lot of deals right now. There’s kind of a mismatch between buyers and sellers, those seeking capital, those having capital. And I think as things play out there’s going to be deepening distress, because what happened in energy was there was an overshoot and you have hedges there in place, and drilling continues. So the price drops which is a signal for drilling to stop. But it actually continues because people have hedges in place. And that goes through for several more months and then it drops off, off the cliff. And I think you’re going to see prices go significantly downward from here.
Courtney: [00:35:44] But when you mention gas too, there’s another interesting point, it ties back to consumers, they’re saving at the pumps, are you seeing that tie back into your consumer driven businesses?
Grier: [00:35:53] We are, and our biggest consumer driven business are our bricks and mortar branch based businesses, first our Credit Central, Nationwide which is an auto finance business we own. And we’re seeing delinquencies in charge offs decline, in fact, plummet month after month. And it’s a very attractive time from the consumer standpoint. And then I talked about real estate and online lending. And it’s such an attractive opportunity that we’re actually looking at spinning out some of these businesses as standalone public companies to offer investors the ability to play in these situations on a pure play basis as opposed to combined with the rest of our BDCs. So we’ve earmarked, pertaining to this theme, a real estate business, our online lending business and then separately our CLO business.
Courtney: [00:36:45] And I want to switch, we have this new feature, we have viewer questions, we love hearing from our viewers at Asset TV. We actually have Lydia Sheckels, she is the CIO of Westcott Financial Advisory, they are just named the number one financial advisor in Pennsylvania by Barrens three weeks ago, so congratulations to them. And, Lydia, when you’re ready, go ahead.
Lydia Sheckels: [00:37:05] Hello, Courtney. Thank you for having me today. My question is, how do you monitor the underlying credit quality of the loans held by the BDCs?
Courtney: [00:37:17] Bob, how do you…
Bob: [00:37:18] Yeah. A very good question, you know, obviously BDC is regulated by the FCC are going to put out their quarterly financials which includes all the details of their underlying portfolio, including their fair market value at a mark to market basis on a quarterly. I think folks, you know, that shows the detail of what’s going on inside that book of business. In addition it obviously is going to slice and dice the portfolio, including the type of instruments that are involved, the maturity of the instruments involved, the interest rate on the instruments involved, all of those are components of that risk profile. The only thing you’re probably not going to see is the underlying leverage but I think in the context of some of the business disclosures and discussions around what their strategies are and the type of deals that they’re booking, I think you’ll generally find commentary, not statistics from most of the operators and the BDC managers on the leverage in their portfolio is. The last thing that I would say is it’s about consistency and stability of their earnings coverage of their dividend and their ability to continue down on a go forward basis. Does the portfolio yield in return match the underlying distributions from the shareholders that they have committed to?
Courtney: [00:38:37] Okay, interesting. Grier, what’s your take on this?
Grier: [00:38:38] Well, it takes a lot of time to manage and supervise a portfolio. It’s a very active process, especially for us because about 25% of our book is companies we control. So our monitoring includes sitting on boards, working closely with management teams, setting budgets, developing strategies, looking for [unclear 00:39:00] acquisitions, so there’s that element. On the pure lending non-controlled side, many times we’ve bought observation rights, so we still want to know what’s going on in terms of information packages. We do monthly portfolio monitoring reports internally. And then there’s the additional discipline and system of the third party valuation process. We brought best practice to the industry, we went public, to have all of our companies fair valued every quarter, every security since inception, completely independently. And that process injects further discipline as well because they’re going in, questioning, asking a lot of questions about companies and really keeping our deal teams on their toes.
Courtney: [00:39:00] Okay. And I want to pivot a little bit. How large is the BDC market right now? It sounds like it’s really growing, Bob, what’s your take on where it is right now and where it’s headed?
Bob: [00:39:54] Last count I think it’s 60 plus BDCs on a publicly traded basis and assets somewhere north of 60 billion dollars I believe. To keep it in perspective, it sounds large, but when you consider the markets they serve, the high yield market, the leverage to loan market, we’re talking trillions of dollars in the leverage alone marketplace today. So the BDC market, while it’s grown significantly over the last several years, is still relatively small in the broad scope of the leverage finance business, certainly my earlier comments about, you know, what’s going and where the shifting is happening, some shares come from … of that growth has come from the mezzanine funds and some share has come from the commercial banks that are having certain restrictions about what they do and how they invest in funds. So there is a very, I guess, favorable outlook for the non-bank financials as we look out over the next couple of years, when you look at just this relatively small size of the BDCs and the much larger markets in which we play.
Grier: [00:40:56] When we went public in 2004, the combined market capitalization of the BDC industry was about 5 billion. Today it’s approximately 30 billion. And there’s been named proliferation in terms of the number of BDCs to Bob’s point. But there’s actually been dollar consolidation in which the larger BDCs actually have a greater share today than they did before. And we’re one of the two largest in the industry and account for a significant part of that capitalization with more than 3 billion dollar capitalization. Most of the BDCs manage a couple of hundred million of capital, they’re able to do smaller deals or kind of club participation deals and it becomes harder to lead larger transactions. And what we’ve seen in the marketplace is for larger deals, say 50 to 300 million in size, there are actually not that many competitors for deals of that size because you need a larger balance sheet in order to play. That’s a sweet spot for us, smaller deals, a lot of people can deploy capital, 50 to 300 million, a lot fewer, above 300 million you start competing with the syndicated markets, the syndicated loan market, syndicated bond market, you’re competing with Wall Street basically. But that 50 to 300 million provides a pretty large sweet spot.
Courtney: [00:42:20] And I want to just circle back, if credit spreads in the middle market were to widen, what is the impact going to be on BDCs, Bob?
Bob: [00:42:28] Widening spreads will obviously be a creative opportunity. You know, there’s been obviously some measure of pressure given the demand for yield and the corporate loan market has been pushed down and the bank yields have been pushed down. And some of that spills over to the sponsors and their expectations of what they might see for some of their smaller companies. So the reverse would obviously happen as expectations of yields go up, it’ll spill through the marketplace. For the most part the BDCs have not been as affected as the large ticket marketplace because it’s harder to deploy money, the risk profile is slightly different. And there’s been a little bit more discipline in approaching to the middle market than there has been in the larger, broader leverage finance business space.
Grier: [00:43:16] Spreads are widening out, they’ve widened over the last few weeks and months in the middle market. And BDCs are benefitting. I talked before about how our rate of average yield went up the last quarter. They’ve also widened in the broadly syndicated market which is fine. You know, sometimes you talk to BDC managers and you feel like their folks are saying it’s middle market versus broadly syndicated, good versus evil. And that’s not our take on it at all. It’s, you know, what are the best risk adjusted opportunities. We’re the largest investors in CLO equity on the planet. We have a billion two of equity which is against an underlying 16 billion of assets. And that’s all broadly syndicated loans as the underlying. So we care deeply what’s going on in the broadly syndicated space, just like middle market elsewhere in our business. And you’ve seen spreads widen demonstrably over the last several months on the broadly syndicated side, not just with energy names, that would be logical, but many non-energy names. That’s good news for us because CLOs are all about long term option value, the longer the option value, the more you can buy assets at a discount the more money you make along the way and on the back end. So we’re seeing these benefits now in real time, and again going back to the spinoffs, that’s why … one of the reasons why we’re spinning off our CLO business, to give people the opportunity to benefit from that in a pure play fashion as investors.
Courtney: [00:44:43] So this is purely accretive it sounds like.
Bob: [00:44:46] It is, I think we’re outlining the flow of funds in the marketplace, to the broadly syndicated marketplace late last year went off, whether it was a risk profile or an interest rate profile and it really caused things to back up a little bit. And the result is still playing through our position in the marketplace, yields are up and I expect that to be a trend in the near term.
Courtney: [00:45:09] Now, if somebody’s thinking, I want to invest in a BDC and let’s say they’re a retail investor or they’re an institution, I’d like to lay out both cases, maybe one of you could take each, Bob, if you’re an institution, why would you want to invest in a BDC?
Bob: [00:45:23] Any fixed income investor should be looking for relative risk reward. And I think in this marketplace, the fact that there are big broad money market funds or high yield bond funds, that have large established platforms does not necessarily make them the biggest and best risk reward opportunity. In fact it almost goes the opposite, the demand for … demand for product has naturally driven down both yields and in some cases made financing frameworks more flexible and frankly, looser. And the result is less covenants, less controls and less protections to the underlying investor who ultimately holds a stake in that. So on a BDC context, when you think about flow of funds and the sheer scale of the marketplace, the BDCs are relatively focused, a relatively secure and a relatively high yielding environment. And when you look at those strategies and the focus and compare liquidity, ultimately our stocks are generally as liquid as redeeming a bond fund. And the result is, why would you not consider a BDC as part of a broader portfolio? I think the question is, how do you want to look at the broader BDC environment given that there are so many of them out there? You probably want a portfolio approach because there are differences amongst BDCs, both in terms of the strategy, the size and the type of investments they make.
Courtney: [00:46:54] Well, that’s really interesting. So, Grier, from the retail perspective, you’re a retail investor or you’re an adviser advising retail investors, why would you want to invest in a BDC?
Grier: [00:47:02] Well, retail investors, and sometimes this is over-generalized, retail versus institution. But retail investors tend to be a little more yield centric, institutions a little bit more where you are relative to net asset value centric. And from a retail standpoint again, you’ve got BDCs available at a double digit coupon, you’re talking about a 1,000 basis points give or take over equivalent treasuries. You’ve got the floating rate benefit as well to protect earnings. You’ve got, in many cases some BDCs have already adjusted their dividends as we did in 2014 based on yield compression that had been occurring throughout 2013 and 2014. So that’s a positive because if a BDC has already adjusted its dividend then that provides a lessened risk, that might be happening sometime in the near future. All these are beneficial to a retail investor. But I think the price to book can’t be ignored as well. BDCs have historically traded at a slight premium to net asset value. Today they’re available at double digit discounts. BDCs are trading at a deeper discount to net asset value, the enclosed in funds, which is remarkable when you consider the much higher returns that are available to BDCs relative to most, floating rate, leverage loan, bond … leverage loan funds or bond funds on the closed in side. So I think there’s a lot of positive attributes to both the retail investor as well as the institutional investor right now, in a way that candidly we haven’t seen before in an upswing environment.
Courtney: [00:48:50] Interesting. And we have learned so much about BDCs today. But I just want to get really quick your final takeaways, so, Bob, what are yours?
Bob: [00:48:59] BDC environment is positive for us, I think the non-bank financial has a lot of good strong fundamentals, and a solid manager focused on the consistency and stability of a dividend is a place where you want to invest. Everyone needs some measure of hedge and fixed income in their underlying portfolios, the BDC should be a part of that fixed income allocation.
Courtney: [00:49:24] Grier.
Grier: [00:49:25] And my final take is if someone likes BDCs, I think we’ve talked a lot of good reasons today as to why it makes sense to own them. If someone doesn’t like BDCs, pay attention to our spinoffs, because we’re looking at spinning off some of our businesses into non-BDC formats, our real estate business would spin into a REIT format. Our CLO business would spin into a closed in fund format which has certain advantages. And our online lending business would spin into a corporate non-registered format. So if you don’t like the wrapper there’s other wrappers available too.
Courtney: [00:50:00] Okay. Well, if I could have a final takeaway which I usually don’t, yielding 1,000 basis points over treasuries, I think is one. So, gentlemen, thank you so much, we’ve learned a lot about BDCs and I appreciate you being here. And we want to continue this conversation about BDCs, check us out on social media, Twitter, LinkedIn, Instagram or our blog, and let us know what you think about what you learned today. And if you’re interested in learning more about Masterclass or want to provide a viewer question like Lydia just did, reach out to me at Courtney.woodworth@asset.tv. Thanks again for watching and I look forward to hearing from you soon. From our studios in New York, I’m Courtney Woodworth.
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MASTERCLASS: BDCs - March 2015
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