Non-Bank Lenders
BDCs are closed-end investment management companies that invest in businesses through various equity investments and debt securities--predominantly the latter, which can range from senior secured loans to non-investment-grade vehicles. "Basically, all they are is lenders," says Troy Ward, a BDC analyst at Stifel Nicolaus. "Their assets are all of these different loans they make to all of these different companies."
By law, BDCs must invest at least 70% of their assets in eligible portfolio companies. BDCs generally spread their bets across diversified portfolios with dozens of companies in different industries, although some have a strong focus on particular sectors.
Horizon Technologies, for example, makes secured loans to development-stage companies backed by venture capital and private equity firms in the technology, life science, health care information and services, and clean-tech industries. NGP Capital Resources Company invests in debt securities--and sometimes takes equity positions--in private small- to mid-size energy companies. Medallion Financial Corp. invests in companies that finance taxicab medallions, among other things (its ticker symbol is TAXI).
Some BDCs have relationships with financial heavyweights. One example is KKR Financial Holdings, which is managed by a unit of the private equity firm Kohlberg Kravis Roberts & Co. Another is BlackRock Kelso Capital Corp., an affiliate of global investment management firm BlackRock Inc.
By law, BDCs are limited to 1-to-1 debt-to-equity leverage (8-to-1 is typical at banks). But that didn't shield them during the recession, when share prices at BDCs went down the tubes. Problems occurred when some of the businesses in BDC investment portfolios couldn't service their debts, which negatively impacted the financials at many BDCs.
At the same time, BDCs had a hard time getting capital to invest in businesses because they were hurt like everyone else when the lending markets froze. In addition, they couldn't issue more shares in the secondary market because they're prohibited from selling shares if the stock price of these closed-end vehicles trades below their net asset value.
This all highlights the cyclicality of publicly traded BDCs. Some people consider BDCs to be alternative investments, but that's debatable--at least when it comes to traded BDCs--because their share prices tend to be correlated to swings in the economy. Whereas mortgage REITs are impacted by what interest rates do, BDCs are credit plays predicated on the underlying strength of the companies they make loans to.
"How well they do is based on how good the credit quality of the portfolio of loans does," Ward says. "If everyone pays back, BDCs do well. BDCs are cyclical to the business cycle. If we go into a deep recession, they will suffer."
And that's reflected in recent years by the share price performance of BDC stocks vis-à-vis the S&P 500. According to Stifel Nicolaus, total returns on BDC stocks outperformed the S&P 500 in 2005-06 when times were good; underperformed in 2007-08 during the recession; and outperformed in 2009-10 during the slow rebound. In 2011, BDC stocks tracked by the firm had a total loss of 7.4% versus flat returns on the S&P 500, a dip caused by recession fears during last year's summer swoon.
Sustainability
BDC stocks have rebounded this year, and many had posted returns that matched or exceeded the S&P 500 through early March. And robust stock prices at many BDCs have opened the door for additional funding through secondary offerings, enabling them to invest in more businesses to add to their portfolios. Issuing additional stock can be dilutive to shareholders, but because BDCs don't have retained earnings due to their pass-through tax status, they sometimes issue equity to grow.