Debunking BDC Misconceptions: Part III

Apr. 29, 2022 7:00 AM ETARCC, ARES, BXMT, CSWC, GBDC, MAIN, NEWT, NEWTL, NEWTZ, ORCC, STWD67 Comments50 Likes

Summary

  • Business Development Companies ("BDCs") are among the highest yielding asset classes available today.
  • A combination of factors, including poor performance on some non-traded BDCs, heavy utilization of external managers, and general distrust of high-yielding assets, among others, has created a mountain of problems.
  • BDCs are simple businesses at their core, but fully understanding and properly measuring their activities require expertise.
  • This piece has been in the making for a long time and is designed to succinctly address common misconceptions surrounding BDCs.
  • Welcome to Part III of our series. Please visit Parts I and Parts II published in March for the first five topics.
  • Looking for a helping hand in the market? Members of iREIT on Alpha get exclusive ideas and guidance to navigate any climate. Learn More »

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This article was coproduced with Williams Equity Research

Many of my readers and followers know that I'm a REIT Guru, having spent over 25 years in the trenches - developing commercial real estate - and over a decade on Seeking Alpha - as a REIT analyst.

From time to time I get the question: which are better investments - REIT or BDCs?

REITs are entities that generally own and manage income-producing real estate.

BDCs are entities that generally invest in small and mid-sized businesses.

In order to answer that question, we decided to provide in-depth BDC coverage, and this article is our third in a series titled "Debunking BDC Misconceptions." In case you missed it, here are the first two articles:

Debunking BDC Misconceptions: Part I

Debunking BDC Misconceptions: Part II

Time For Round 3

As mentioned in Parts I and II, Business Development Companies ("BDCs"), like Real Estate Investment Trusts ("REITs") and Master Limited Partnerships ("MLPs"), are special company structures created by legislation to solve certain problems. Revisit Part I for a quick overview of why REITs and MLPs were created by Congress.

BDCs, unlike REITs and MLPs, are not focused on the ownership of hard assets. Instead, BDCs are required to invest at least 70% of assets in the debt and or equity of U.S. businesses. These are almost always private companies that don't have many options outside of the BDC lending system for external financing. In addition to the constraint on the types of investments they can make, there are limits BDC leverage.

As noted in Parts I and II, the positive attributes of ("most") BDCs include floating rate investments less sensitive to changes in interest rates, average base yields above 7%, highly diversified portfolios, and a proven business model that precedes the Great Recession.

Some BDCs maintain significant (>25% of the portfolio by gross assets) equity holdings, such as Main Street Capital (MAIN) and Ares Capital (ARCC), while others shy away from equity exposure and invest almost exclusively in senior secured loans, such as Owl Rock Capital Corp (ORCC) and Golub Capital BDC (GBDC).

This is a good time to eliminate potential misconceptions. This is not a BDC popularity contest. There is no need to become emotional if your favorite BDC isn't mentioned.

If curious whether we think your favorite BDC is of high quality, subscribers are welcome to shoot me a note. We rank the vast majority of BDCs as Tier 1, 2, and 3, with only about a dozen earning the elite Tier 1 ranking. Rankings are thoroughly reevaluated at least quarterly in line with the release of earnings.

BDCs tend to elicit one of two responses: marked enthusiasm or "I'll never invest in BDCs." The reason is usually one of these four perceptions/situations:

  • Poor performance and corporate governance concerns of certain non-traded BDCs;
  • Poor performance and corporate governance concerns of certain publicly traded BDCs and their external managers;
  • Confusion around the return profile of BDCs in general; and/or
  • Confusion around what BDCs do and own in their portfolios.

This article is designed to do what the title says: articulate several common BDC misconceptions and provide a useful explanation of what is right and wrong about each. It is not, however, intended to comment on every BDC or touch on every possible topic. I will also inevitably leave out certain components for brevity's sake.

As a reminder, we tackled these in Part I:

1. BDCs Are Too Risky

2. Those Must Be Sucker Yields

3. High Loan Default Rates

Part II discussed these popular topics:

4. Supplemental Dividends Are Everything

5. BDC Distributions Are Unreliable

6. BDC Portfolio Companies Have Low Credit Quality

There are reasonable justifications as to why these assumptions are held. Believing one or more are true before or after reading this article is not cause for alarm or a reflection of your investing acumen. This series designed to test assumptions by telling the whole story and letting you come to your own conclusions.

Let's get started with first topic.

7. External Management Always Underperforms

Before diving into internal versus external management, let's pin down what this means. Most publicly traded companies are internally managed, which is exactly as it sounds: management of the company runs the company. External management is when a company (which can be a portfolio of assets) hires a third party to fulfill management responsibilities.

This may sound strange to individual investors, but it's the default for the long list of private funds funded by endowments, pensions, sovereign wealth funds, family offices, and very high net worth individuals.

These firms have large, sophisticated staffs of investment professionals, most of which are paid bonuses based on the performance of the investments they select. So why in the world would these firms allocate a large percentage of assets into externally managed companies if they are inherently flawed like many believe?

There are more reasons than I'll cover here, but I will point out a couple important ones. First, from an alignment of interest perspective, there isn't necessarily any difference between externally and internally managed companies. If that sounds blasphemous, read on and you might change your mind.

An external manager paid mostly on the long-term total return of the managed company (e.g., a portfolio of real estate or loans) may actually have a stronger incentive to perform and manage risk than a traditional corporate management team. I think we all know more than a few internally managed companies that have been run into the ground. How is that possible?

You know the answer to that one too: Internal management can enthusiastically award themselves massive salaries and bonuses while delivering subpar financial results. External managers, however, are generally constrained to a fixed percentage fee on assets and an incentive fee based on, you guessed it, specific performance metrics.

It is extremely important to critically evaluate the management agreement between the external manager and the company, which are admittedly difficult for those not well versed in the topic to do on their own. In our case, no BDC can be awarded a Tier 1 (the best) rating without an average or better score awarded to the terms of the management agreement (the key characteristics are included in quarterly/annual SEC filings).

Second, there are practical reasons for companies to be externally managed. In the cases of Starwood Property Trust (STWD) and Blackstone Mortgage Trust (BXMT), for example, these two externally managed heavyweight mortgage REITs couldn't come close to obtaining the same access to deal flow or skilled personnel without the breadth of their external managers.

That doesn't mean they couldn't succeed if internally managed (many mortgage REITs do), it just means there are real negatives to relying only on the company's staff (which has to be 100% paid for by the company) compared to an external manager that can apply the expertise and scale of a giant enterprise while charging the company a small fraction of their total operating expenses.

If a company has a finite life (e.g., a 7-year private equity or real estate offering for institutional investors), it's inefficient to completely staff the company only to fire them all a few years later when the portfolio liquidates.

What's behind the popular sentiment of "I'll never invest in an externally managed company" that all long-term investors in REITs and BDCs have inevitably come across? The premise is twofold: 1. external management doesn't have alignment of interest with investors and 2. their fees eat up too much of the company's profits.

As usual, there is some truth to both assertions. It is up to the investor to perform due diligence, either directly or with qualified help, to ensure the fee structure isn't lopsided in favor of the external manager. The majority of well-known BDCs have reasonable fee structures today, but that was not necessarily the case just 10 years ago. I'd list a few names, but Seeking Alpha forces me to explain each, which is reasonable but not worth the effort for this article.

We've tackled the alignment of interest topic, but what about performance? Externally managed BDCs do, on average, absorb higher average operational costs (including fees) than the best internally managed BDCs. Doesn't that mean we should avoid them entirely?

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Q4-21 MAIN Investor Presentation

Main Street Capital, arguably the most popular internally managed BDC, is proud of their peer-leading cost efficiency, as they should be. It's roughly half the BDC average and much lower than commercial bank averages. That ~1.5% improvement in annual operating efficiency gains means they can distribute those savings to investors year after year.

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Q4-21 MAIN Investor Presentation

That's contributed to Main Street Capital's massive outperformance compared to the S&P 500 index since its inception in 2007. We are talking nearly triple the return. There is another interesting data point "hidden" in this chart. Note that the "Main Street Peer Group" didn't perform as well as MAIN but still more than doubled the S&P 500 index over the same period.

The peer group is defined in the second footnote and includes nearly 30 BDCs. Only a few of those are internally managed (e.g., Newtek (NEWT) and Capital Southwest (CSWC)), yet this large group of BDCs outclassed the S&P 500 over more than a full market cycle with relative ease. It isn't only internally managed BDCs that have market-beating performance over long periods of time, and there is no need to cherry pick from the cream of the crop to prove the point.

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Q4-21 TSLX Investor Presentation

Sixth Street Specialty Lending, formerly TPG Specialty Lending, has beaten BDC peers by 16,878 basis points since inception or 168.78%. It has outperformed high yield bonds by an even greater degree (another ~13%) and most impressively in my view, beaten the S&P 500 index by 37% since its IPO. Sixth Street is externally managed.

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Q4-21 ARCC Investor Fact Sheet

Ares Capital Corp, which is managed externally by Ares Management Corp (ARES), is one of the oldest and largest BDCs around. Since its IPO in 2004, a dollar invested in ARCC was worth approximately $8.66 as of the end of 2021, compared to $5.91 for the S&P 500 over the same period.

That's a 46.5% greater return for the credit-focused BDC compared to the exclusively equities benchmark. I could go on, but I think you get the point. Externally managed BDCs do absorb greater operating costs compared to the best internally managed peers, but the top firms still demonstrate extremely compelling risk-adjusted performance versus both debt and equity indices.

8. High Interest Rates Hurt BDCs

There is a grain of truth to the idea that high interest rates can potentially hurt BDC financial performance. Like REITs, the market often rotates out of BDCs when rates first rise but come crawling back as higher rates improve their financial performance. This has been true over many market cycles (the effect is even more significant for REITs).

One way to dissect this situation is scenario analysis. In my applied probability coursework, we'd take a complex question, like what's the probability of a blowout preventer failing on an offshore oil rig or a multistage testing regime for cancer producing type I or type II errors across a large hospital network (those are actual examples), and break it down by determining a wide range of inputs and outputs before applying confidence intervals (e.g., 10-20%) that each occurs. The probability of all outcomes must equal one. With a "little" math, this helps the human mind, which is not skilled at dealing with uncertainty, find certainty.

We won't go through that exercise for BDC investing in totality for brevity's sake, but suffice to say we can boil this specific scenario down to a few possibilities.

  • If the BDC owns primarily floating rate loans, which most do, then increases in the applicable benchmark, which is almost always LIBOR, will increase net investment income, all other things equal.
  • Since all other things are rarely all equal, the increase in net investment income is influenced (but not dominated) by the structure of the BDC's leverage. If leverage is relatively long-term and fixed rate, as most investment grade BDCs have, then higher rates immediately generate greater cash flow per share.
  • Higher rates, however, must be manageable for the portfolio companies subject to them. This is where skilled underwriting by the BDC's management team comes into play. In conclusion, higher interest rates generate more cash for investors to the extent 1. The cost of their debt doesn't rise proportionately and 2. Portfolio companies can absorb the higher interest rates.

Historically, high quality BDCs mostly avoid these concerns and receive almost all the projected increase in cash flow as interest rates rise. Since debt-to-equity ratios in the industry rarely exceed 1.25x in today's environment, even BDCs with significant floating rate debt exposure on their balance sheet still generate additional net investment income when rates rise.

9. BDC Total Returns Are Weak

The article already provided enough data to refute this one, but it's a sufficiently common remark that I think it deserves its own segment. It also gives me an opportunity to touch on a couple new points, one of which I'll initiate through the chart of MAIN's long-term performance versus several benchmarks.

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Q4-21 MAIN Investor Presentation

MAIN's return is in a totally different league than the S&P 500 and Russell 2000, but this isn't the lens most investors look through. Instead, it's this:

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Yahoo Finance

MAIN's common stock (dark blue) still outperforms the S&P 500 (light blue) and Russell 2000 (purple), but it's not nearly as dramatic. That's because no major financial website, not Seeking Alpha, Yahoo! Finance, or any other, includes regular or supplemental dividends into their calculations. For BDCs that focus less on growing net asset value and more on high current dividends, the delta in perceived versus actual performance is even more extreme.

The greater the percentage of the total return composed of dividends, the more important it is to use total performance to compare return profiles. Since BDCs are currently the highest yielding manager asset class, this means you cannot responsibly evaluate performance without taking into consideration base and supplemental dividends.

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Q4-21 MAIN Investor Presentation

The next time a friend or colleague says, "this company is trash, the stock price hasn't gone anywhere" about an income investment, remember this chart and article. I have literally lost count of how many times I've heard individual investors make a statement along these lines based on the assumption the stock price of the income investment hasn't risen "enough."

They'll often sell the stock based on this "assessment." MAIN, for example, has paid $33.54 per share in total dividends since inception through February 23, 2022. Exactly zero of that shows up in the Yahoo! Finance stock chart most people use to compare the performance of two companies. MAIN's IPO price, by the way, was $15.0 per share.

Conclusion

We hope that you found this exercise educational and that it made you a slightly wiser BDC investor. In a time of elevated inflation and depressed bond yields, BDCs have the potential to serve a valuable and difficult to fill role in a portfolio. We are here to help you solve the BDC puzzle as we recognize that ongoing, firm-specific research is critical for success in this sector.

Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking.

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This article was written by

Brad Thomas profile picture
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Brad Thomas is the CEO of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 6,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.

The WMR brands include: (1) The Intelligent REIT Investor (newsletter), (2) The Intelligent Dividend Investor (newsletter), (3) iREIT on Alpha (Seeking Alpha), and (4) The Dividend Kings (Seeking Alpha). Thomas is also the editor of The Forbes Real Estate Investor and the Property Chronicle North America.

Thomas has also been featured in Forbes Magazine, Kiplinger’s, US News & World Report, Money, NPR, Institutional Investor, GlobeStreet, CNN, Newsmax, and Fox. He is the #1 contributing analyst on Seeking Alpha in 2014, 2015, 2016, 2017, 2018, and 2019 (based on page views) and has over 102,000 followers (on Seeking Alpha). Thomas is also the author of The Intelligent REIT Investor Guide (Wiley). 

Thomas received a Bachelor of Science degree in Business/Economics from Presbyterian College and he is married with 5 wonderful kids. He has over 30 years of real estate investing experience and is one of the most prolific writers on Seeking Alpha (2,800+ articles since 2010). To learn more about Brad visit HERE.
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Disclosure: I/we have a beneficial long position in the shares of MAIN, NEWT either through stock ownership, options, or other derivatives. 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.

Additional disclosure: WER has a beneficial long position in the shares of MAIN, NEWT, ARCC, TSLX, BXMT, STWD, ORCC, GBDC either through stock ownership, options, or other derivatives.

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