Looking for higher yields? Try lending money
Business development companies in US find a booming business in private loans
THE Taube twins, Seth and Brook, make money the old-school bankers’ way: They lend it. But the Taubes don’t run a bank. What they run are business development companies, firms that ply the booming trade of private loans.
BDCs have been around since the 1990s. Similar to closed-end mutual funds or real estate investment trusts, they usually trade as stocks, but each one is essentially a portfolio of investments. In the case of BDCs, the investments are loans to companies. Lately, they’ve spread like kudzu as investors’ appetite for private lending has grown. About 90 of them now sit atop a combined $97 billion. That’s more than double their assets five years ago.
The pitch for private debt is simple. Many banks have been pulling back on loans, while pension funds, endowments, hedge funds, and the like have plenty of money to play with. So why not have investors lend money to businesses directly? Private equity heavyweights such as Blackstone, Carlyle Group, and KKR have jumped in, forming BDCs and doing more direct lending.
Everyday investors are drawn to BDC stocks because they pay fat dividends as they distribute the interest they collect on their loans. The borrowers are mainly small and midsize companies that would likely be unable to borrow from banks. Over the past 12 months, the stocks on the Wells Fargo Business Development Company index paid an average dividend yield of more than 10 per cent. That compares with the yield of around 3 per cent on a typical bond fund.
But like seismographs registering faraway tremors, BDCs are particularly sensitive to rumblings in US corporate credit. Even longtime private debt practitioners warn that underwriting standards in general are weakening as money floods in and more loans are made—often a sign of trouble ahead.
Medley Capital Corporation, one of two BDCs run by the Taubes, is an example of the risks that sometimes lurk behind an enticing yield. The Taubes took their company public in January 2011; its share price has since plummeted 70 per cent. That collapse has been cushioned for investors by dividend payments. Taking those into account, and assuming they were reinvested in Medley, investors have lost about 28 per cent.
One apparent misstep for Medley: Plastics Group Inc, of Willowbrook, Ill. Medley loaned the manufacturer $22 million in 2014. Then the company lost some big customers and scaled back. By March of this year, Kroll Bond Rating Agency Inc estimated the value of Medley’s loan at $3.5 million—an 84 per cent loss. Similar stories have played out at Medley-backed companies in California and New Jersey.
People familiar with Medley say its managers were in a hurry to make loans with the money they raised in its $125 million initial offering and sub-
Investors are drawn to BDC stocks because they pay fat dividends as they distribute the interest they collect on their loans
sequent stock sales. That makes sense for BDC managers, because they’re paid a fee based on total assets—the bigger you are, the greater the fees. The setup, detractors say, encourages BDCs to take risks that traditional bankers might avoid. Since 2011 the fees stockholders have paid to Medley’s managers have added up to $171.6 million, according to data from Wells Fargo & Co. They’ve collected an additional $97.5 million in fees for their private BDC.
The Taubes declined to comment. They’ve told investors they made mistakes, with risky loans going bad as the proof. But that was the past. Now they’re merging the companies they own to create one large, $5 billion public BDC that they say will make bigger loans to higher-quality companies.
Other BDCs have done better, as you’d expect in an expanding economy that’s made it easier for companies to make loan payments. According to the Wells Fargo index, the total return on BDCs since February 2011 is close to 6 per cent annualised. But what happens from here? BDCs are only one piece of a much bigger private credit puzzle. By some estimates, the combined value of private debt is approaching $1 trillion. The worry is that people are throwing so much money at direct lending that mistakes are bound to happen. S&P Global Ratings warns that this class of lenders is taking bigger and bigger risks at precisely the wrong time. Weaker deal terms are “creeping down lower in the middle market,” says Trevor Martin, an associate director at S&P. Interest rates are rising, and corporate America is deeper in debt than ever.
“There’s a lot of not-so-great underwriting going on,” Kipp deVeer, chief executive officer of Ares Capital Corporation, the $12 billion granddaddy of BDCs, said in a conference call for investors in August. “There are a lot of mistakes being made. We’re trying not to make them, but we’ll see.”
For now, the rush is on. In the past year, KKR & Co formed a partnership with FS Investments that will create the largest BDC of all, with more than $17 billion in assets. Blackstone has said it plans to start a business development company, too, with about $10 billion. Carlyle and Goldman Sachs Group Inc. have taken BDCs public in recent years.
A decade after the financial crisis, Capitol Hill is encouraging the explosion of private debt. This spring, in a bipartisan move, lawmakers allowed BDCs to double their leverage—that is, borrow more to fund loans. Industry champions say this gives the best players more flexibility and the bad ones more rope from which to hang themselves. S&P says it may downgrade BDCs that take the opportunity. “Given the types of loans and the environment they are doing it in, we think it’s prudent to move ratings down if they go through with it,” Martin said.