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The worst-portrayed asset class in financial media these days is without a doubt private credit. Among perhaps-too-stable NAVs, a very uncertain economic environment, and continued AI fears, investors (especially retail investors) are making a run for the door. Redemptions are far in excess of what the funds themselves are willing (and perhaps able?) to give back to their investors, further supporting the media’s argument that the private credit industry is about to collapse any day now.

I don’t want to talk about these concerns today - there’s many, many writers and analysts out there that have much more sophisticated views on the matter than I have. Rather, I want to take the time to talk about an ‘asset class’ adjacent to private credit. An asset class that some investors see as even worse-off than the private credit funds. One that some see as a way to capitalize on exactly those private credit fears in a way that would interestingly not be possible through closed-end or evergreen funds. And finally, one that I’ve actively traded for my own name over the years. (As always, nothing in this newsletter, especially any mention of a manager or specific stock, should be seen as investment advice. Do your own research, and remember that historical returns are no indicator for future performance.)

Today, let’s talk about the wonderful, sometimes-odd, world of business development companies (“BDCs”).

BDCs (‘business development companies’) are a bit of an odd structure, and perhaps more easily described through its similarities to other structures. (The following description is focused on US-based BDCs, especially the publicly traded ones).

They are a bit like a closed-end fund. They raise money from investors, to then invest that money primarily into loans or comparable debt instruments. They often also take on leverage through issuance of debt and/or preferred shares.

They are a bit like a REIT (real estate investment trust). Like REITs, they are obligated to pass on most of their income (in the case of a BDC, interest and fee income) to their investors as dividends. In addition, they are sometimes also required to lend especially to small and medium-sized enterprises, although that is a bit of a loose definition, as visible in the many BDCs that primarily invest in the debt of leveraged buyouts. Nevertheless, in return for fulfilling both conditions, BDCs are offered substantial tax advantages in the form of little to no income tax payable on their interest income.

They are a bit like any ‘speciality finance’ company (or even banks). They look to raise debt and equity capital, and try to invest that money in a way in which they can generate a spread, i.e. the difference between the (percentage) interest income on their loans and their cost of capital.

These three factors are also the primary return drivers of BDCs (source for the discount and dividend figures here):

The closed-end fund mechanic results in BDCs often trading at a discount to their net asset value (i.e. value of their debt and other assets minus outstanding debt). Depending on the market environment (more on that later), BDCs might trade down to larger discounts (the average BDC as of today trades at a 21% discount),  giving an investor the opportunity to see a gain on their investment if that discount lowers over time.

They distribute substantial dividends. The average BDC is offering an almost 10% annual dividend, often paid quarterly or even monthly. (Non-US investors should be mindful of withholding taxes of up to 30%).

They might grow their NAV over time. While most BDC income is distributed as dividends, they might accrue and skillfully invest some of their residual earnings to grow their asset base. Some also benefit from equity upside from warrants, options, or other ‘equity stubs’ they’ve gained as part of the debt financings they are offering to their portfolio companies.

Sounds straightforward, right? Perhaps it is. But if there is one thing that BDCs don’t lack, it’s risk factors.

BDCs typically invest in some form of higher-risk debt instruments. Most frequently, those are leveraged loans or variations of that, with a few exceptions, such as BDCs focused on venture debt (i.e. lending to fast-growing but less profitable start-ups). In terms of their fundamental ‘return drivers’, that makes them, in my view, comparable to asset classes such as high-yield debt, leveraged loans, or of course, private credit. All of that is not investment-grade debt, and thus, more exposed to losses in defaults.

But even with that in mind, BDCs are a little bit riskier than its ‘traditional’ counterparts. Asset manager Verdad Capital (very much recommend their weekly research) wrote a great piece on BDCs a while ago called High Yield, High Volatility, which summarizes it beautifully: One, BDCs tend to make riskier investments - partially because they are required by law to invest in smaller firms, which are typically in the non-IG (i.e. high yield) spectrum. Two, BDCs are levered through debt and preferred shares, further enhancing the risks of the already risky underlying loans. And three, a point that I would add, their volatility is likely also influenced by their investor base, which I would think is a bit more retail-skewed (esp. American retirees, but more on that below).

And when we’re speaking about their risks, there is one key thing that we need to highlight - which is that BDCs are a small asset class. All publicly traded BDCs are estimated to be ‘only’ 60 billion dollars in total market capitalization - a fraction of the ‘regular’ private credit industry, which is estimated to be somewhere north of three trillion dollars. (There are some large non-traded ones, which are exactly those vehicles subject to substantial scrutiny due to the aforementioned reasons, but we won’t address those in more detail today.)

As a result, these BDCs attract an eclectic mix of investors. There’s retired US investors hunting for high yields, but often end up burned because they just buy the BDCs with the highest dividend yields - which are not cheap for a reason, and sooner or later cut their dividends and/or see massive NAV declines over time. There’s a few institutional investors (such as Boaz Weinstein’s Saba Capital) looking to unlock the value hidden in deeply discounted BDCs, putting them at odds with the fund managers who want to do everything but let go of their excessive management fees (charged on NAV rather than market cap, of course). And then there’s the few semi-educated investors out there looking to use BDCs in a tactical or sometimes strategic fashion - perhaps as well, ‘Poor Man’s Private Credit’. I would count myself in this latter group.

Who you typically don’t find is large institutional investors. The market is simply too small for their billions in retirement or insurance capital, which is why they invest in regular private credit or other forms of debt. And this absence of institutional capital - and their emphasis on good governance - is very visible in BDCs. While there are some BDCs that want to do right by their investors, there is an equal number of BDCs that have their own best interest in mind. Such as those overpriced management fees, an absolute lack of any attempt at narrowing those discounts to NAVs, or even substantial dilution from options issued to management. And even in the not-so-bad-cases, there can be the typical ‘shenanigans’ that we know from private credit (or illiquid investments in general), such as sudden loan writedowns and substantial fee loads. (For continued reading on how bad it can really get, I would recommend this story in Institutional Investor magazine about how two brothers basically ran a BDC into the ground and still ended up with a payday. While they no longer control it today, the BDC is down 70% over the last ten years, and trades at an almost 50% discount to NAV.)

So to emphasize again: If you invest in BDCs, you should be careful where you tread - as with any other ‘small’ yet somewhat complex market out there, such as UK investment trusts (stay tuned for a future article on Poor Man’s Private Equity!) or Germany’s grauer Kapitalmarkt (home to investments ranging from containers to media rights). Much more so than in bigger, and thus more regulated and more institutional asset classes.

So despite all these risks, how should you think about BDCs as an investment, both in general, and in the current environment? Let me share my personal views, including how I personally have invested in BDCs over the years.

First, going back to the title of this article - BDCs as the ‘Poor Man’s Private Credit’. 

The ongoing democratization of finance has made asset classes such as private credit accessible not only to institutional investors and family offices at billion-dollar tickets, but has brought the minimum ticket size to ~200-500K€ for what I would consider solid products. (Whether it’s PE or private credit, I’d be sceptical of investing in any ‘retail’-focused vehicle. While I generally think that the investments in those products are typically similar to institutional products, the higher fee burden and other constraints such as higher cash reserves in my view make it very unlikely to outperform the relevant liquid benchmarks. Your money is better served in simple, lower-cost products, as is your time.)

BDCs, in comparison, have no minimum ticket, with the most ‘expensive’ one (purely on a price, not market cap or valuation basis) trading at just over $50 per share. Even if a $10,000 investment in a retail private credit vehicle is out of reach for you, BDCs might be in reach. And while you have to take into account the aforementioned higher risks, they actually provide more or less direct exposure to their individual asset class. Other than, for example, private equity firms, which in our view are much more ‘diluted’ access to private equity as an asset class itself (more on that in What Investors Get Wrong About Publicly Traded Private Equity Firms.) Of course, if you have the choice of investing in BDCs or private credit, be aware of the differences, including but not limited to the governance challenges, the higher volatility (as opposed to private credit with limited visible volatility), and in some cases, higher fees than i.e. an institutional ‘share class’ of a private credit fund.

Secondly, BDCs as a way to make a tactical trade on (private) credit.

Let’s say that despite all the ongoing challenges (AI, Iran, First Brands, etc.), you are bullish on private credit. How should you go about implementing this view?

You could just invest in a private credit fund - most GPs would happily take your money these days. Problem is that you wouldn’t be able to capitalize on the apparent market dislocation - you would have to buy shares at NAV, and in the current environment, you might rightfully be unsure whether those NAVs are fair or perhaps overstated.

But even if you are certain that those NAVs are fair, wouldn’t it be more attractive if you could buy into the asset class at a discount? That’s what traded BDCs essentially offer you, i.e. buying into the average BDC at what is currently a 20% discount. Not only would you make money if that discount shrinks, but you also buy into what might be a higher-than-usual dividend yield that stays the same on your cost basis even if the price recovers.

This is also how I have invested in BDCs over the years - a ‘trade’ hasn’t been the most lucrative one over the years by an absolute amount, but it has likely been one of the most consistently profitable ones. Find a few decently managed BDCs, buy into them when panicking retiree investors sell them in a crisis, and either sell them when the market normalizes, or simply hold them for the long time. Over the years, I’ve mostly preferred the latter, although there have been some instances when I did end up selling, such as BDCs that end up trading at a premium to their NAV, or BDCs that traded at massive discounts for structural reasons (think excessive defaults, bad management) but that ended up closing said discount due to structural changes (like a merger or a change in management). That is also the conclusion of the aforementioned research piece by Verdad Capital, describing them as a risky cyclical investments that can deliver tremendous returns during an eventual recovery.

Let’s end with a little piece of closing advice on how you shouldn’t pick BDCs - which is purely by their discount to NAV. 

Whether it’s BDCs, closed-end funds, or ‘sum of the parts’ plays like Volkswagen/Porsche Automobil Holding, buying something just because it is cheap is a bad idea, because chances are that those stocks are cheap for a reason. That typically includes the prior risk factors, such as bad management (overpriced fees, active shareholder value destruction) or simply bad investing acumen. Changing the latter can take a long time, as realized losses might meaningfully impair NAVs for a long time until the NAV can recover. Changing the former can be quick, but it almost never happens - managers don’t want to give away their golden goose. 

And even if management changes, there is no guarantee that they’ll actually change things meaningfully for the better. Take, for example, PhenixFIN, which is the successor to Medley Capital from the aforementioned Institutional Investor story: new management took over in 2021, with the stock trading at roughly $28. Today, they stand at roughly $41, a roughly 8% return per year. Admittedly, not a bad return, that could be much worse - but they still haven’t managed to bring back the BDC’s dividend, which ended in 2019, except one puny special dividend. But management always got paid, of course, and even found time to… launch a gem and jewelry financing subsidiary. (Full disclaimer, I also owned the stock a few years ago, exactly because of that big discount, but ended up selling at a loss a bit later.)

BDCs are a wonderfully odd and undercovered pocket of the market. They’re too small for institutional investors, but often too complex for retail investors. But just perfect for savvy private investors who might want to dabble in private credit, but might be sceptical or simply not (yet) affluent enough.

Tread carefully, but don’t overlook them - maybe you’ll find them as interesting as me.

Cape May Wealth Advisors is a Berlin-based wealth management firm focused on helping affluent entrepreneurs find financial independence. If you are interested in learning more about how we can help you, reach out to us via email, and make sure to subscribe to our newsletter.