Bank participation in middle market direct lending has dropped precipitously over the last two decades. This trend has primarily been driven by massive consolidation within the banking industry, in addition to a general shift to stricter regulatory requirements imposed on banks. The number of FDIC-insured banks in the U.S. has fallen from over 9,100 in 2003 to approximately 4,700 in 2023, while total assets have increased from $9.1 trillion to $23.7 trillion, respectively. Further, regulations such as the Dodd-Frank Act following the Global Financial Crisis (GFC) increased the minimum amount banks were required to hold in liquid assets, leaving banks less inclined to underwrite smaller, less-liquid credit. Moreover, banks in the U.S. have tightened their lending standards over the past year in response to the regional bank crisis. Over 50% of respondents to the Federal Reserve’s Opinion Survey on Bank Lending Practices reported a tightening of lending standards to large and middle market firms in the second quarter of 2023, up from 45% in the first quarter of 2023.

As traditional banks have receded from the middle market, private credit managers have continued to fill the demand gap and gain market share. Companies are increasingly seeking financing from private credit managers due to their ability to provide speed of execution, flexibility, and certainty of closing, which traditional banks often cannot match, particularly in challenging market conditions.

For investors, direct lending continues to offer enhanced income potential, diversification benefits, and exposure to private companies, features that are not available in the public credit markets. Non-traded business development companies (BDCs) are one way for investors to access direct lending exposure.

What Are They?
A non-traded BDC is a closed-end fund that provides financing primarily to U.S.-based companies who are not large enough to secure funding from (or otherwise do not have access to) banks or other traditional lenders. Non-traded BDCs are not traded on an open exchange and are available to investors that meet certain suitability requirements, which may vary by state.

Why Were They Created?
BDCs were created as a result of the Small Business Investment Act of 1980, and initially were designed to help small and middle-market companies gain access to capital. Increasingly, large companies are borrowing from private lenders due to their ability to offer speed, flexibility, and certainty of execution that traditional banks often cannot, particularly in challenging market conditions.

BDCs must invest at least 70% of their total assets in qualifying assets, which are generally defined as private U.S. companies or public U.S. companies with a market capitalization of less than $250 million. They elect to be subject to regulation under certain provisions of the Investment Company Act of 1940, and generally operate as a Regulated Investment Company (RIC) for U.S. tax purposes, which requires 90% or more of its annual net income and capital gains to be distributed to shareholders.

How Do They Work?
While non-traded BDCs can have some equity exposure, the majority are focused on debt through direct lending to middle market companies, which represents approximately 200,000 U.S. businesses with annual revenues between $10 million and $1 billion. The primary investment objective is to generate income; and that income is created through debt payments from loans that can span senior secured debt, subordinated debt, or unsecured debt. The capital and managerial assistance provided to the underlying companies by BDCs aids their advancement and future development. Many of the underlying companies may also be supported by a private equity sponsor (sponsor-backed), supplying additional capital and operational oversight.

Key Benefits
Non-traded BDCs offer investors unique private credit investment opportunities, with investment minimums as low as $2,500, and must distribute 90% of their annual taxable income to investors, providing income potential for investors. They are typically offered with interest payments at a spread above a floating reference rate and a floor on minimum rate, reducing interest-rate risk for investors and providing protection in an inflationary environment.

Non-traded BDCs also offer investors periodic liquidity, typically through quarterly share repurchases (up to 5% of the NAV of the fund), transparency through periodic reporting to the SEC (e.g., Form 10-K, 10-Q, and 8-K), and simplified tax reporting with a Form 1099 instead of a Schedule K-1.

Key Considerations
Investors should keep in mind that all fund managers are the same. The experience, skill level, size of team, assets under management, and track records of managers are all key factors to consider when investing in a fund. Non-traded BDCs may at times invest in the debt of developing and/or financially distressed companies and are subject to credit and default risk, making it even more critical to have a thorough diligence process in place to evaluate managers and their ability to operate in challenging environments. And while non-traded BDCs generally offer quarterly share repurchases, the number of shares eligible for repurchase may be limited, and share repurchases may be suspended at the board’s discretion.

Non-traded BDCs give investors the ability to invest in the credit of private companies, while offering periodic liquidity. With the potential for higher yields, lower volatility, and diversification, non-traded BDCs may be an attractive alternative to public fixed income.

Kunal Shah is managing director and head of private asset research and model portfolios at iCapital. Owen Boyle is vice president of private markets product specialist at iCapital.