When you put it all together, a BDC is generally focused on deriving consistent return on investment in the form of interest income or dividend income off of investments in portfolio or platform companies. Portfolio growth is great, but consistent quarterly earnings might be even more important so that the BDC can keep paying a consistent, or growing, dividend. If a BDC can generate a mid-teens return on their investment capital, whether in the form of a debt or equity investment, the BDC should be able to deliver the proper return to its public company shareholders.  

BDCs as a Buyer for Commercial Finance Companies

BDCs offer an interesting prospect for the independent finance company’s management team in a sale scenario. They are, in essence, publicly traded private equity firms who often incentivize their portfolio company management teams with incentive compensation such as stock options, restricted stock or long-term retention bonus pools. Unlike a private equity buyer, a BDC has access to permanent capital via its publicly traded stock, and it typically does not have the investor pressure to sell its investment in a portfolio company the way a financial sponsor typically would.

A 10% - 15% return hurdle is far lower than the typical private equity firm’s hurdle of 20% or more, which means a BDC, if it is so inclined, can be more competitive on investment price and structure than many private equity firms.   Like a private equity buyer, many BDC investors will allow a target company management team to continue to run the platform it acquired with minimal operational oversight, providing greater autonomy to the acquired company’s management team.

BDC Dependability on the Capital Markets

In addition to the aforementioned leverage limitations facing the BDC model, a greater issue facing the sector is the substantial dependence on the capital markets for growth. Given the 1-to-1 leverage cap, a BDC needs fresh equity capital to support growth in its portfolio. Thus, the strength of a BDC’s stock is critical when it sets out to raise equity capital.

Currently, the BDC peer group is not only trading about 8% off of where it was in June 2014 on average, many BDCs are trading below tangible book value (average price/tangible book value of 90%), making the prospect of raising equity capital a dilutive proposition (Source: SNL Financial LC). Without fresh equity capital coming into the BDC, a BDC generally cannot grow since it does not retain earnings with which to invest in new assets. And without growth, a BDC will be challenged to grow its earnings which impacts its ability to raise dividends and increase share price. This dynamic is playing out currently with several companies in the BDC sector.

If new capital is going to be tough to come by, a BDC may be tempted to stretch for higher debt and equity returns on new investments as a way to improve earnings, which may mean sacrificing credit quality. Alternatively, a BDC can look to reduce overhead to maintain or improve earnings. But yet another idea would be for a BDC to look at complementary asset classes that can generate solid returns.

Near-Term BDC Interest in Commercial Finance

Despite the aforementioned equity market challenges facing the BDC sector, we continue to see a significant level of interest from BDCs in our asset based lending, accounts receivable factoring, equipment lending, and SBA lending clients. To be sure, these companies are not a fit for all BDCs. But several BDCs have seen the merits in the commercial asset classes.

A BDC’s interest in the commercial finance sector can be far-ranging, including a simple desire for solid returns, or a desire to bring another ancillary debt product to the table for the BDC’s existing borrowers. Other BDCs or their affiliates are going one step further by creating discrete pools of capital to invest exclusively in the commercial finance space, seeking to exploit the uncertainty and regulatory quagmire of the banking sector.  

Given the highly competitive market for new loan originations today, more sellers are showing an interest in aligning with other partners who can help them find some competitive advantage with which to grow or expand. Banks are always interesting buyers for a commercial finance company because of the obvious cost of funds and leverage synergies, and private equity buyers tend to leave a management team alone to operate a business as long as things are going well. Many BDCs, however, will bring capital like a private equity buyer but will also bring a ready-made customer base of borrowers that private equity buyers cannot always provide.   And while a BDC’s cost of funds is not as attractive as a bank’s, their overall equity return targets often are not too different from those of a bank’s. Today, a good bank generates a 10% after-tax return on equity. A well performing BDC generates a 10% pre-tax return on equity.

Conclusion

While the BDC peer group is trading lower today than it was a year ago, we believe the broader specialty finance sector will provide an attractive debt and equity investment opportunity for the BDC lender and buyer universe due to the steady cash flows that many finance companies have generated, which provides dividend income or debt service capacity for the BDC. BDCs with stock prices trading below book value could do well to boost dividends by investing in a high risk-adjusted returning commercial finance company. And many management teams would enjoy the freedom that can come from affiliating with a BDC that doesn’t have the regulatory burden of a depository.

Note: Statements and opinions expressed herein are solely those of the author and may not coincide with those of Houlihan Lokey.