Look­ing for higher yields? Try lend­ing money

Financial Chronicle - - MONEY GAME - HEATHER PERLBERG

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.

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