BDC Review Redux Part VII: Alternate Vehicles For Investing In BDCs

by: Philip Mause

This article, like its predecessor, will deal with investments other than the purchase of the common equity of an individual BDC (Business Development Company) that provide exposure to the sector. These generally come in two forms. The first is some kind of aggregation vehicle which permits an investor to gain exposure to a multitude of BDCs with a single investment. As far as I am aware, this kind of investment is currently available in the form of a closed end fund or in the form of ETNs (exchange traded notes). I believe that the reason that aggregation has taken this form is that BDC stock can be illiquid and that the use of open end funds or ETFs might require the issuer to sell large quantities of BDC stock in response to redemptions which could, in turn, adversely affect the market.

The second type of investment is in the form of a security which is senior to common equity - either preferred stock or bonds. As a general matter, I believe that one of the great virtues of BDCs is stability due to low leverage and that these are relatively safe investments. One of my biggest home runs was the purchase of AFC - the debt of Allied Capital - now, Ares Capital (NASDAQ:ARCC) - in early 2009 when it was trading at less than a third of face value and yielding over 20%. I was able to achieve a high level of confidence that, even in a liquidation, it was very unlikely that AFC would produce less than the $7 a share i paid for it and that a liquidation was unlikely because the company's assets exceeded its liabilities by a comfortable margin. I think BDC debt is relatively safe and I am frankly surprised by the high interest rates that some BDCs have been paying.

1. The Closed End Fund - First Trust Specialty Finance (NYSE:FGB) is a closed end fund which concentrates on BDCs. It closed Friday at $8.17 which is a slight premium to NAV of $8.14. Eighty percent of the assets are BDCs; the other twenty percent seems to be made up predominantly of shares in agency mortgage REITs like Annaly Capital (NYSE:NLY). It uses a modest amount of leverage with total assets of $139 million and debt of $23 million. Of course, a fee is involved which reduces return. On the other hand, it provides an investor with exposure to the sector and the leverage enhances return somewhat.

2. The ETNs - There are two exchange traded notes sponsored by UBS which replicate exposure to the Wells Fargo Business Development Index. This provides a somewhat broader exposure to a larger number of BDCs than does FGB. In addition, the Index includes only BDCs and so no agency mortgage REITs are mixed in. ETNs are relatively new and there is counterparty exposure to the issuer so that, if UBS goes into receivership, you will have problems even if the BDCs in the Index are flourishing. As I understand it, the advantage of the ETN is that it reflects the Index performance without deviation or "drift" and is generally liquid and easily tradeable. The symbols for the two ETNs are - BDCS and BDCL. BDCL is simply a two for one leveraged version of the Index whereas BDCS is the unleveraged Index.

3. Preferred Stock - The Gladstone BDCs have issued preferred stock. It is generally not treated as debt for the purpose of calculating leverage and thus it can be helpful to a BDC that wants to raise funds without diluting its common stock or adding to leverage. The preferred stock of Gladstone Investment (NASDAQ:GAIN) is GAINP and the preferred stock of Gladstone Capital (NASDAQ:GLAD) is GLADP. Both of them pay a coupon of 7.125% of face value and trade near par. Preferred stock in a BDC is generally a pretty secure investment because of the limited leverage although it is not hard to imagine a BDC getting into trouble if much of its portfolio consists of common equity of small companies. Before buying preferred stock, you should examine the balance sheet of the BDC and review not only NAV, but also the composition of assets.

4. Bonds - BDC borrowing takes a number of forms including publicly issued bonds and loans from banks and other financial institutions. Of late, there seems to be a preference for going to the public issuance market and issuing bonds so there will be more and more of these available to individual investors. As I have indicated, the BDCs are relatively safe because of limited leverage. Another advantage is transparency; BDC balance sheets are relatively easy to understand - certainly in comparison with the balance sheets of other financial institutions. A BDC which holds debt instruments, a reasonable proportion of which are first lien loans, as assets and has borrowings that are comfortably South of the leverage limit is very unlikely to default on its own debt. I am familiar with the debt of Ares Capital - AFC pays a 6 7/8% coupon and ARY pays 7.75%. These are both very long term bonds paying off in the 2040s. Medley Capital (NYSE:MCC) has MCQ which pays a coupon of 7.125%. I am sure that there are some others.

BDC bonds and preferred stock have of late been trading very close ot face value and so the coupons approximate the percentage yield you will experience. In the event of a financial squall, some of these securities could trade at significant discounts and thus higher effective yields. Last summer, I revisited AFC when it took a short dip significantly below 80% of face value and made out very well. I would suggest that an investor keep a list of these symbols handy and be ready to pounce if a big discount opens up. Be sure you are familiar with the issuing BDC and are updated on any adverse developments. But it is very possible for these securities - which tend to be lightly traded - to develop "irrational" discounts to reasonable value and grabbing for the gold in such situations is one of the few advantages small investors have.

Last year - when I did this series of articles for the first time - a number of readers submitted BDCs which I was unaware of and I covered them in subsequent articles. Thus, this is not the last of the series - there will be at least two more. In addition, any comments calling my attention to additional preferred stock, bonds or aggregation vehicles in the BDC sector are welcome and will help make this series as comprehensive as possible. One of my goals is to give investors a place to come and get relatively complete lists of BDCs and other BDC oriented investments.

Disclosure: I am long ARCC, GAIN, GLAD, FGB. 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.

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