I have been researching the expenses associated with the 25 BDCs that I follow to see which ones can deliver more return to shareholders. BDCs with lower cost structures can pay higher dividends without taking on more risk. In this series I will try to identify the BDCs with the most efficient cost structures and take into account factors such as use of leverage, length of operation history, and adjusting for one time incentive fees related to capital gains.
There are two types of BDCs
Internally Managed: all operating expenses, including compensation, are paid directly by the BDC, and shareholders have the ability to vote on compensation issues. As assets grow, a greater percentage of each incremental dollar of revenue can be paid as dividends to shareholders. Generally total operating expense ratios are lower than externally managed BDCs.
Externally Managed: pay expenses and fees to a management company that is not required to provide shareholders with compensation information. A base management fee is calculated based on a fixed percentage of assets under management (generally ranging from 1.75% to 2.0% of gross assets). Compensation information is not disclosed, and shareholders do not have the ability to vote on compensation issues. Other annual operating expenses are calculated in addition to the base management fee. Incentive fees of 20% of net investment income ("NII") and realized capital gains are paid to management after a "hurdle rate" is achieved.
I looked at measuring expenses as a percentage of total assets and available income to shareholders. When looking at expenses compared to total assets I used the average amount of assets during the period but this has a negative impact on BDCs growing much faster because the expenses are spread over a skewed amounts of investments. I will revisit this issue after they report results this month using the most recent period. The table below shows management expenses for both internally and externally managed BDCs as a percentage of average total assets for fiscal year 2012 and 2013 year-to-date annualized. I have adjusted the incentive fees for the portion that is related to capital gains that are one-time in nature compared to the recurring portion that is part of ongoing expenses. These fees are indicators that the company is performing well and growing net asset value ("NAV") per share and affected TCP Capital (TCPC), New Mountain Finance (NMFC), Ares Capital (ARCC), Fidus Investment (FDUS), and THL Credit (TCRD), the most because of substantial recent gains as discussed in "BDCs With The Highest Gains". It is important to note that Prospect Capital (PSEC) and Medley Capital (MCC) have both grown their portfolios (assets) much more than the other BDCs skewing the results as discussed earlier while MCG Capital (MCGC) and American Capital (ACAS) benefit due to lower or declining growth in investments.
Obviously internally managed BDCs operate with lower expenses on average but there were a few externally managed companies that have lower cost as a percentage of assets including Solar Senior Capital (SUNS) and PennantPark Floating Rate Capital (PFLT). I believe a more accurate way to look at expenses is comparing them to the amount of income available to investors for dividends. Basically this would be the total amount of income less interest expense and debt service fees that can be used to pay management expenses or dividends to shareholders. The table below shows management expenses as percentage of total income (less interest expense) and again the internally managed companies operate at a lower cost other than ACAS (always the outlier).
However this does not take into account the amount of leverage each BDC uses. Typically BDCs with higher amounts of leverage pay higher amounts of incentive fees due to increased income from investments and higher base management fees due to larger amounts of assets but the other operational expenses decline as percentage. The table below shows expenses year-to-date for 2013 as percentage of available income along with the debt-to-equity ratio for each BDC.
It is important to notice the companies with higher amounts of leverage but lower than average expense ratios. Most of them are the internally managed BDCs but NMFC, PSEC and Apollo Investment (AINV) all have lower operating expenses with higher amounts of leverage than the average BDC.
In the remainder of this series I will dig deeper into the fixed vs. variable expenses of each BDC to find the ones that will outperform with higher amounts of leverage as well as the ones that are the most inefficient. The goal is to provide investors with the maximum amount of return for the amount of risk associated with each.
Investors should only use this information as a starting point for due diligence. See the following for more information: