BDCs have fallen an average of 8.4% (compared to a 3.7% decline in the S&P 500) since S&P announced on February 24, 2014 that it would remove BDCs from its indices and was followed by Russell on March 3, 2014. This article is a follow up to "BDCs and the Russell Indices" and will cover the most recent quarter BDC expenses as a percentage of income. Russell announced that it would exclude all BDCs from its current index series as a result of the "distortive impact" caused by Acquired Fund Fees ("AFF") rules and has given the SEC until May 15 to remove these reporting requirements. Expenses are the key issue since the inclusion of BDCs can inflate the expense ratio of a fund investing in BDCs. BDC expenses are treated differently than the expenses of other companies held in the indices, because they all fall under the Investment Company Act of 1940. Their management fees and other costs become "acquired fund fees" for a fund owning BDC shares and fund managers are required to report these expenses as part of a fund's expense ratio even though these expenses are not actually being borne by the fund. This would be similar to including employee compensation expenses for banks in fund expense ratios even though it is already factored into the price of the stock and not actual cash expenses paid by the fund. These rules have been waived for banks, REITs and even CLOs and should be waived for BDCs for similar reasons.
This article will focus on BDC expenses as a percentage of 'available income' and update the information contained in "Management Fees as a % of Assets and Income" and "Fees for Externally Managed BDCs". Available income is total interest and fee income less interest expense from borrowings. Capital gains are not included and neither are the associated incentive fees. Basically this is the amount of income that is available to pay management expenses and shareholder distributions. BDCs with lower expenses can pay higher amounts to shareholders without investing in riskier investments. I believe that lower cost BDCs will outperform the others for a few reasons including being more efficient and having a better chance of less institutional turnover related to the Russell reconstitution. The table below shows the income and expenses for the 25 BDCs that I follow.
Outliers: Solar Senior Capital (NASDAQ:SUNS) and PennantPark Floating Rate Capital (NASDAQ:PFLT) are newer BDCs and did not reach the required 'hurdles' to pay out the full amount of income incentive fees and are currently operating with lower expenses. American Capital (NASDAQ:ACAS) always seems to be an outlier for many reasons and does not pay a dividend but 51% of available income is currently used to pay operational expenses which is double the amount of the other internally managed BDCs. Most likely this is due to having investments that are more focused on capital appreciation compared to income.
The other internally managed BDCs such as Main Street Capital (NYSE:MAIN), Triangle Capital (NYSE:TCAP), Hercules Technology Growth Capital (NASDAQ:HTGC), KCAP Financial (NASDAQ:KCAP) and MCG Capital (NASDAQ:MCGC) have much lower expenses than externally managed companies. I believe MAIN, TCAP and HTGC will rebound the quickest and the current multiples being paid for these companies supports this.
Larger BDCs such as Ares Capital (NASDAQ:ARCC), Apollo Investment (NASDAQ:AINV), Prospect Capital (NASDAQ:PSEC) and Fifth Street Finance (NYSE:FSC) that pay $20 million to $60 million per quarter in fees to an external manager are not able to benefit from economies of scale as well as internally managed companies. Some external managers bring value to the BDC in other ways due to having related businesses and/or funds, but when the BDC is the primary business, investors should ask what is the benefit of being managed externally. PSEC is a good example of having an external manager ("Prospect Administration") that is mostly focused only on the BDC and should be internally managed to reduce expenses and pay more to shareholders. I believe that some investors pay lower multiples for these BDCs giving them correspondingly higher yields.
Currently four of the lowest priced BDCs using NAV multiples are ACAS, Horizon Technology Finance (NASDAQ:HRZN), BlackRock Kelso Capital (NASDAQ:BKCC) and Gladstone Capital (NASDAQ:GLAD), which also have the highest expense ratios in the industry. I do not believe this is a coincidence.
The one BDC that actually has an incentive fee structure that becomes more favorable to shareholders as rates begin to rise is TICC Capital (NASDAQ:TICC) as discussed in my "TICC Report" and "TICC Capital: Lower Fees For Higher Yields In 2014?". I believe this is not reflected in the current analyst EPS projections and as rates begin to rise, this will become a large driver of expense reduction for the company.
The rest of this series will continue to focus on the potential impacts to BDCs and the current pricing anomalies that investors should be taking advantage of. I will use this research to rank which BDCs have the lowest amounts of exposure related to the Russell reconstitution. Investors should only use this information as a starting point for due diligence.
Disclosure: I am long HTGC, MAIN, TCPC, FSC, ARCC, TCRD, PSEC, NMFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.