Heightened Interest in the Business Development Company Model

The business development company (BDC) model has been gaining popularity. McGladrey's Colin Sanderson discusses what's driving this interest and the trends and obstacles surrounding the current BDC investment market.

In this video interview with Mergers & Acquisitions editor in chief Mary Kathleen Flynn, Colin discusses the evolving BDC market. Read on for a more in-depth Q&A with Colin.

Investors seem to be demonstrating significantly heightened interest in BDCs. What's driving this?

Colin: Some of the most sophisticated and successful investors are already involved in BDCs—such as Apollo Investment Corp.—and many others are looking seriously into this option. Most recently, Oaktree Capital, an $85 billion alternative asset manager, launched its first BDC product. Primary reasons for the increased interest:

• A significant appetite exists for retail investors for yield-orientated products. BDCs have been very effective in generating cash yields in low yield environments. For example, the median yield for all active BDCs is over 10 percent, and MCG Capital Corporation currently has 16 percent yield.
• BDCs provide a permanent capital base to fund managers that can be utilized throughout the private equity investment cycles—a significant advantage given that the best time to be investing is generally also the time when raising capital is challenging.
• During the last four years, there was a reduction in competition in middle-market lending due to banks and other traditional sources of liquidity creating a funding gap for the leveraged loan market. This has provided the opportunity for BDCs to invest at credit terms more attractive than before and obtain greater access to deal flow.

Which BDCs have been really successful and what do they have in common?

Colin: Because BDCs are required to pay their income out as dividends to maintain their favorable tax treatment as a regulated investment company, they generally grow through raising capital and aggregation of assets. Some of the largest BDCs are: Ares Capital, American Capital, Apollo Investment Corp. and Prospect Capital. Many of these BDCs are building platforms of funds or business that complement the BDC business.

What trends have you been seeing in the BDC sector?

Colin: During the last two years investors seem to have greater interest in:

• Non blind pools – Legacy portfolios or acquired portfolio of assets from successor or affiliated funds
• Small business investment companies (SBICs) that have become BDCs through successful IPOs

Some BDCs have SBIC subsidiaries as a dropdown structure—and many in the registration process appear to have a similar structure in mind—to provide access to low cost funding sources from the Small Business Administration (below a 4 percent rate). An SBIC with $75 in capital can access up to $150 million in leverage from the SBA (up to two licenses)—and with applying for exemptive relief, it does not count toward leverage at the BDC level.

More recently there has been some interest in equity-only BDCs that invest in venture capital and emerging growth companies that will likely qualify under the recently passed JOBS Act, allowing for increased liquidity event opportunities.

What are the common obstacles to starting BDCs and how can you overcome them?

Colin:

• Traded BDCs are generally only able to access the capital markets at times when they trade in the public markets above their net asset value. This essentially creates windows of opportunity to raise capital.
• The regulatory environment can be slow moving as it relates to obtaining exemptive relief and guidance from the SEC given that it is niche area within the 1940 Act. The public reporting requirements can be daunting, and this is a highly specialized area. That's why it's critical to work with service providers that have the necessary experience and expertise.
• If the fund manager does not have an extensive track record, the fund may need to consider the non-traded BDC route where the interest in the BDC is sold through a dealer manager network in order to scale up capital before the IPO. Some BDCs have been successful in offering this product to both retail and institutional managers.