An attractive yield, expenses are covered by the BDCs, but is it worth the risk?
What exactly is a BDC? Will the underlying companies and the fund income increase as planned when the economy improves and rates tick higher?
We analyzed this quite interesting (to say the least) ETF and give our recommendation.
Market Vectors BDC Income ETF, (NYSEARCA:BIZD), is a rather unique ETF. It derives income from investing in various Business Development Companies. The ETF is tied to an index (and may not be able replicate it) called the Market Vectors Business Development Company Index. Van Eck Global is the fund manager of the ETF. There are many nuances in this ETF and its underlying companies. We will analyze these details, income, expenses and risks, and provide our recommendation. We will also shed light on why some columnists informed investors a year ago and again this year to avoid the sector and its lone ETF.
To begin, a little history is in order. In 1980, Congress Authorized what is termed the Small Business Incentive Act of 1980. Based upon the Investment Company Act of 1940, the structure is designed to allow a flow of funds to small and privately held companies in the US. There are certain requirements needed in order to be classified as a business development company. In general here are five requirements:
90% of the gross income is "passed through" to the shareholders of the Business Development Company and 90% of a BDC's gross annual income must be derived from dividends, interest, and realized capital gains from its investment portfolio.
The firms must have a debt/equity ratio of under 1/1.
There must be diversification of the company. Specifically, they must have at least 70% of their assets in private debt, or in equity investments in private or thinly traded companies (below $250 million market cap). In addition, a Business Development Company is required to have more than 50% of its portfolio invested in a variety of individual investments. Each of these investments can make up no more than 5% of the BDC's total assets. They must also limit their investment size to no more than 25% of any one-portfolio company's total assets.
The BDC's are required to offer significant managerial assistance (according to the SEC) to the small and medium-sized business in which they invest.
In addition, the BDC's are not required to register as investment companies under the Investment Company Act. They are, however, required to register their securities under the Securities Exchange Act of 1934.
An investor can think of the companies as a way to invest in a version of an albeit, small private equity firm and enjoy the cash flow via an equity ownership. In terms of the overall structure of the BDC's many of them have been investing in asset based lenders. As such, they tend to loan the majority of their assets as floating rate investments. These investments can of course, be reset at higher rates, if and when, rates move higher. The overall liability structure of the BDC's are set at a fixed rate. So, as the economy improves their cost of capital is fairly constant, yet their income can increase as they lend at higher rates. In terms of the listed shares, usually on the initial move in higher rates, their share value falls back. After a period of time, they resume their stability since their income streams that pass through are attractive and of course, higher. It is extremely difficult to determine at what time and point the actual buying opportunity appears. As such, a dollar cost average approach would be the most prudent way to invest in a BDC and in this ETF, in general. We will explain further shortly.
Returning to the index and fund, the index has 28 constituents as of August 29 and is rebalanced monthly. This is considered 90% of the investable universe, which is valued at over $24Bln. Company weightings are capped at 20%. Five or 57.29% of the components would be considered mid-cap companies (companies with a market capitalization from $1.5B to $6B) and 19 or 40.95% would be considered small cap (companies with a market capitalization from $200M to $1.5B) and the balance, 4 companies, are 1.77% micro-cap (market capitalization up to 200M). The 1.5 year old fund (inception date of 02/11/2011) seeks to replicate the underlying index and also includes the same 28 companies. We state "seeks" due to an issue which is a risk of the ETF. According to VanEck:
[T]he fund and its affiliates may not own in excess of 25% of a BDC's outstanding voting securities.
This, of course, may limit the Fund's ability to fully replicate its own index. I only see this a problem during a period of rapid market turbulence and rapid interest rate moves. Once again, a prudent dollar cost averaging approach will minimize this risk factor.
Before we review the acquired fund fees and expenses, the overall return and our recommendation, let's review the underlying BDC's in the ETF.
For information purposes here are the top 15 BDC's in the ETF, their symbols, and weightings, which represents 81.77%:
- Ares Capital Corporation (NASDAQ:ARCC) 11.83%
- Prospect Capital Corporation (NASDAQ:PSEC) 8.62%
- American Capital, Ltd. (NASDAQ:ACAS) 8.20%
- FS Investment Corp (NYSE:FSIC) 6.52%
- Fifth Street Finance Corp. (NASDAQ:FSC) 5.17%
- Apollo Investment Corporation (NASDAQ:AINV) 5.04%
- Main Street Capital Corporation (NYSE:MAIN) 4.87%
- Hercules Technology Growth Capital, Inc. (NYSE:HTGC) 4.79%
- Golub Capital BDC, Inc. (NASDAQ:GBDC) 4.30%
- Triangle Capital Corporation (NYSE:TCAP) 4.13%
- PennantPark Investment Corporation (NASDAQ:PNNT) 4.13%
- New Mountain Finance Corporation (NYSE:NMFC) 3.70%
- Medley Capital Corporation (NYSE:MCC) 3.67%
- BlackRock Kelso Capital Corporation (NASDAQ:BKCC) 3.43%
- Solar Capital Ltd. (NASDAQ:SLRC) 3.37%
The remaining 13 BDC's only represent 18.23%.
While it can be quite time consuming to review each of the firms in the ETF for debt and capital structure we did analyze some of them. One of them is Ares Capital or .
Ares Capital, which as noted has 11.83% in the fund, (in terms of weighting), is one of the largest BDC's with $8.6 billion of total assets, as of June 30, 2014. During the second quarter 2014, they invested $1Bn in 29 different investments. Their investments were primarily in floating rate and senior loans of middle market companies. As an example of the debt structure of a BDC, according, to their latest 8K filing:
The weighted average stated interest rate and weighted average maturity, both on aggregate principal amount, of all the Company's outstanding debt as of June 30, 2014 were 5.1% and 7.2 years, respectively, and as of December 31, 2013 were 5.3% and 7.9 years, respectively.
For an investor these are not particularly long term debt and as such would not cause pressure on the firm in the event of an interest rate shift. It is also a good sign that the debt has become shorter from the preceding quarter. As I mentioned in the beginning of the analysis, this is the key to investing in a BDC and obtaining an attractive cash flow in a growing economy with possible or eventual, rising interest rates. One example of a "household" name investment for a BDC such as Ares, would be a First lien senior secured revolving loan due in 2018 and a First lien senior secured loan in 2019 for Benihana, Inc. Ares also has many co-investments with GE Global Sponsor Finance LLC and General Electric Capital Corporation. Most other large BDC's have similar well known co-sponsors.
As one can observe, it takes a great deal of analysis to examine an individual BDC. Diversification is the key reason of investing in an ETF and as such allows investors to participate in many different structures of BDCs. Some invest only in senior secured debt, while others invest lower down in the capital structure, others favor an under-leverage approach that lets them sit on cash or a "war chest." Should they see an opportunity they will then take advantage of it. These approaches can be combined. Hence the difficulty in examining multiple issues. As such we highly recommend an ETF approach.
Returning to BIZD, in 2006 the SEC required FOFs to report a total expense ratio in its prospectus fee table that accounts for both the expenses that a fund pays directly out of its assets (sometimes called "direct expenses"), and the expense ratios of the underlying funds (including business development companies or BDCs) in which it invests (often called "acquired fund fees" or "indirect expenses").
The new requirements were more transparent. Investors would have a more thorough understanding of actual costs when then invest in a FOF. BIZD has acquired fund fees (or AFFEs) of 7.93%. However, because these fees are not borne directly by the Fund, they are not a fee of the FOF. They are simply the internal and external management fees, incentive fees, and other expenses of the BDC which are "passed through." BIZD's management fee is similar to other Market Vectors ETF's at .40. This cap is set to expire on September 1 of this year. This is set to continue after this date until such time that the Board of Trustees of the Advisors decides to act to discontinue all or a portion of such expense limitation. My analysis is they should continue this at the same expense structure/ratio for the conceivable future.
Let's conclude our analysis on this ETF by reviewing the performance, AUM and recent negative stories in the news on BDCs. In terms of performance an investor would not generally participate in a BDC or this ETF for capital gains. As I mention, with the income passing through this is purely an income vehicle. As such, the 1 year return is 4.67% (versus 4.97% for the index), as of July 31, 2014. The 52 week price range is a rather narrow $19.23 to $21.71. The YTD return is a miniscule .22% (versus -1.09% for the index). The 30 day SEC yield is an attractive 8.12% with distributions made quarterly and AUM of only $46.3M, as of August 29, 2014. One item to note that we will address is the return on June 30, 2014. At that time the 1 year return was 12.53% and YTD was 3.85%. The question is, what happened in July? Based upon some specialists, they feel that it is attributed to profit taking in the Floating rate debt market, high yield bond liquidations and simple profit taking after a quick upswing in the sector that began in March which followed a sell-off in late Winter. In late February S&P decided to remove BDCs from the mid-cap S&P 400 and small-company S&P 600. The primary reason was the fees that are acquired and reported. One analyst stated that in general that it was tough for many fund managers to account for them in their reports. As such, the removal sparked a sell off that continued after they were removed from the Russell Indices as well. The BDC's in general lost over 3% during that short period of time following the index changes. There also tends to not be allot of liquidity in some of the BDC's and they tend to suffer when the high yield market takes profits. As such, a prudent investor must be do careful analysis to chose which or several BDC to invest in and at what time. In June 2013, one analyst suggested avoiding the sector. Items that were cited included worries over the Fed and a major investment by Fifth Street Finance Corp. and their announced acquisition of HealthCare Finance Group. The concern then was the increased debt burden and of course, higher rates hurting the BDCs similar to a REIT sell-off. The recent sell-off was attributed to distribution harvesting, exposure to high yield (again) and worries over FRN's and loans(floating rate notes).
Our feeling is there is always a concern with BDC's that is similar when we analyze the high yield debt market. When interest rates are going lower there is concern of defaults as an economy weakens and business slumps. When interest rates are rising there is concern of exposure to a higher cost of capital and in this case the BDCs. The fact is, as I mentioned, that most of the debt is not only short term and adjustable but is serving a purpose in a market for capital that has been neglected by banks and other financial firms for quite awhile. This will only continue after the recent regulatory changes. As such, I highly recommend taking advantage of the attractive yield on BIZD and acquiring shares over both a short and long period of time. Don't try to predict the next sell-off, simply take advantage of the opportunity now and into 2015.