Why You Should Invest In Debt

A complete beginner's guide to investing in BDCs.

BDCs are principally lenders to companies of all sorts and sizes that are owned by sophisticated private equity groups. The loans are usually made to fund buyouts, or acquisitions or for organic growth. The yields charged for the loans are relatively high. As a result, after all costs are paid, BDCs can pay their shareholders relatively high returns, mostly ranging between 8%-10% per annum. Given that every BDC has a portfolio of loans spread over dozens or hundreds of borrowers,  the risk of loss is mitigated. Furthermore, the rules governing BDC limit how much debt a BDC can take on, and also requires that virtually all earnings are paid out to shareholders every year. (In this regard, BDCs are similar to Real Estate Investment Trusts).  

BDCs have been around in some form since 1980, when the format was created by Congress. Over the past twenty years - and especially since the end of the Great Recession - the number of players and assets under management have more than doubled as BDCs increasingly replace banks as lenders to companies of all sizes.

There are now some 80 BDCs, but only 45 are publicly traded and principally serve as commercial lenders. (The rest are privately-held and do not trade on an exchange or are public but principally invest in equity). The total market capitalization of publicly traded BDC lenders is approx $55bn and AUM over $110bn.  Many of these BDCs have also issued publicly traded unsecured debt to finance themselves. This debt yields between 4.5%-6.5% currently, and trades daily on one of the major exchanges, just like the common stock.

Essentially, investing in BDC common stocks or unsecured notes is investing in so-called private debt. There are reportedly somewhere between 25,000- 50,000 companies in the U.S. alone, so the pool of potential borrowers is huge. Furthermore, despite the misleading title BDCs also lend to smaller public companies and to businesses around the world.

With all that preamble, this is why we invest in BDCs, and maybe you should too:

The BDC format is designed to create portfolio diversification and limit the amount of debt taken on. A typical BDC has a tenth of the leverage on its own books that a bank would typically have.

BDCs are required to pay out essentially all their taxable earnings ensuring - in most cases - a steady flow of monthly or quarterly distributions to shareholders.

Although BDCs invest up and down companies balance sheet, including in equity and in junior debt, the bulk of investments are at the top of the capital structure in a senior position, and often with the private equity sponsor providing half or more of the capital underneath. Being a senior lender also places the BDC in a pole position to be repaid should a borrower get into financial trouble.

As a public vehicle with quarterly reporting, BDCs provide the investment community with a constant flow of information about their investments - much more so than investors in private funds. Every investment a BDC made is listed out and re-valued by independent valuation firms every quarter.

In most cases BDCs are managed by teams of highly experienced financial professionals with unrivalled access to a wide variety of quality transactions, and supported by brand name asset management organizations, often with personnel that numbers in the hundreds.

Different BDCs focus on different segments of the lending market allowing investors with a diversified portfolio access to invest in the entire range of lending opportunities out there, or focus on segments they consider the most attractive on a risk-return table.

Thanks to the a mixture of the BDC structure, the payout of distributions and the professionalism of the managers, BDC investments  have a track record of almost universally generating positive "total returns" (dividends received and change in stock price) when held for the long term. Of 24 BDCs which have been active for 10 years, 23 have posted positive returns. The median return was 207% (20.7% per annum on average) over that ten year period.

In the short and medium term BDC common stock prices - less so public debt - can be volatile, which regularly provides opportunities for active investors making the right choices to generate high returns.

That's why we invest in BDCs. Of course, there are also downsides as with any investment. We'll discuss those in a subsequent article.  

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