The rapid growth of private equity and credit has been a persistent theme over the past two decades. Within private credit, the rise of Business Development Companies (BDCs) in number, scale, and prominence has created an entire sector’s worth of investment vehicles for public market equity and debt investors. In our view, BDCs currently offer compelling investment grade alternatives to the otherwise low-yielding U.S. dollar-denominated high-grade credit universe.
The Rise of BDCsBDC growth accelerated after the Global Financial Crisis as middle market bank lending was constrained by subsequent legislative and regulatory responses to that event. Some of the largest listed BDCs are profiled in Figure 1:
BDCs were created to provide credit to domestic middle market businesses, with specific requirements on reporting, portfolio composition, and diversification. Features of BDCs include:
BDCs earn income from their loan books and origination and early repayment fees. Income and total asset value are generally stable to growing from quarter to quarter, after paydowns and originations. Diversification, market position, and underwriting discipline are important factors when considering any BDC. Ideally, we like to see evidence that the underwriting discipline has been road-tested through a market cycle. A simplified balance sheet is shown below.
Assets are the loans included in the loan book, typically secured and with maturities of 2-6 years. BDCs earn income from their loan books, mark-to-market gains, and origination and early repayment fees. Conversely, unrealized losses from mark-to-market changes in loan values and realized loan losses detract. Liabilities are chosen for cost effectiveness and flexibility, generally comprised of a mix of CLOs, credit facilities, and unsecured debt. Many public BDC bond issuers adopt a laddered maturity structure, and for most approximately half of their debt funding is from unsecured sources.
Current Opportunities in BDCs
Within the universe of generally low-yielding U.S. dollar-denominated investment grade bonds, we view unsecured BDC debt as an attractive place for credit holdings at the front end of the curve. Advantages of unsecured BDC bonds include:
While attractive as a group, not all BDCs are created equal. As with any fixed income investment, BDCs are not immune to the traditional risks of interest rates and credit; and, as a nascent sector, illiquidity and transparency are still potential risks. Thorough credit research, a look through history, and engagement with management are essential to understanding risk and return in this space. We prefer the direct origination model; ownership by and support from a larger asset management group; a straightforward underwriting process; and candor from management. The BDC space continues to present interesting debt—and equity—investment options for those interested in digging into the details.
Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.