Friday, February 11, 2011

Risks of a BDC

When I reviewed the TPG 10-12G, I was interested in all of the risks the company stated. If you review each of the BDC's filing documents, you should see most of the same risks for each firm. One big difference will be if a firm is Externally or Internally managed (future post). An externally-managed firm has an outside entity responsible for the investment decisions and/or the firm's operations. In that way, the BDC is just a shell company. There are two main categories of risk, Systematic and Unsystematic Risk. Feel free to look those terms up, but below I will discuss the unsystematic risk. An investor in a BDC is taking on unsystematic risk with the goal of higher returns.

Types of Risk Specified

Operational Risk
General risk that is inherent in running a business. This risk arises from the people and processes the firm employs in its day to day existence. Some common risks often mentioned in here are:
  • Agency Risk - The principals in the firm may not act in the best interests of Shareholders. Common cases - a manager choosing to invest in a firm because they like the business (say Facebook) when there are other more profitable investments out there.
  • Legal/Regulatory Risk - The firm's activities may expose themselves to lawsuits. The firm may invest in an affiliated company, harassment suits, etc. Regulatory Risk means a change in laws/regulations may materially impact the firm's profitabilty and even ability to survive
  • Fraud - The firm's employees may misappropriate funds, mistate financial statements to seem more profitable, an employee discloses the portfolio holdings of a company to another firm.
  • Disasters - There may be a natural disaster, terrorist attack or even corruption of a firm's computer networks (someone accidentally pulled the plug)
  • Other - fat finger data entry, missed reporting deadlines.
In terms of TPG, the risks they mention are:
  • We are a newly-formed company with no operating history
  • We will be dependent on upon management personnel of the Advisor for our future success
  • The Adviser and its management have no prior experience managing a BDC
  • Even in the event the value of your investment declines, the Management Fee and, in certain circumstances, the Incentive Fee will still be payable 
    • A number of externally managed BDCs (see ARCC, AINV, etc) charge a Management Fee. This means even if the firm is losing money, part of that loss will be from this charged Management Fee. This is pretty standard for most funds, but as we saw in the most recent down-turn, it can greatly hurt the firm to have these external fees during a recovery. In the future, I will comb through the other major BDCs and try to come up with a fee structure chart for comparison.  
  • The Adviser can resign on 60 days' notice. We may not be able to find a suitable replacement within that time, resulting in a disruption in our operations that could adversely affect our financial condition, business and results of operations. 
    • If TPG resigns, this BDC will be closing or in the process of being acquired. This is a standard risk of management (Agency risk)
  • Regulations governing our operation as a BDC affect our ability to, and the way in which we, raise additional capital.
  • Changes in laws or regulations governing our operations may adversely affect our business.
  • We will operate in a highly competitive market for investment opportunities
  • Our Board may change our investment objective, operating policies and strategies without prior notice or stockholder approval.
    • Again this is a little disconcerting, but still a standard disclosure. However, this should point out to any potential shareholders that companies can change their investment focus and that change may or may not be a good thing. On the positive side, this does allow the BDC to be more agile than other mutual funds with a set mandate and respond to market conditions. 

Financial Risk (Investment Risk+)
This is the general term for any type of risk that deals with a company's ability to meet financial obligations (pay debt, employees, etc). In addition to this definition, I am going to include the investment risks here. These risks eventually role up to the financial risk and will help determine the company's viability. Some common risks often mentioned here:
  • Inflationary Risk - The risk is not so much that there will be inflation or not, the risk is in the substitution effect. For example, if inflation is higher than expected and wages do not match inflation, consumers may substitute going out to the movies with just renting a movie and watching at home. For a BDC, they incur this type of risk depending on their portfolio investments.  
  • Capital Risk - Risk that an investor may lose all or part of their investment. An individual investor assumes this risk on two levels since the BDC may suffer capital losses
  • Timing Risk - A BDC may have to sell an investment before it matures or suffers a loss. This is usually minimized as a BDC is required to hold securities to maturity.
  • Interest Rate Risk - Interest rates are variable and depending on the BDC's financing and investment structure, the BDC may be exposed. For example, BDC ONE issues a Term Loan A to Company XYZ that matures in 5 years for $50MM at an fixed interest rate of 8%. BDC TWO issues a Term Loan A to Company 123 that also matures in 5 years for $50MM at a floating rate of LIBOR+500bps. At the time of issuance, BDC ONE is receiving a higher return. However, the economy booms over the next two years and LIBOR is now 500 bps. Since BDC ONE is only getting a 10% rate, it is now receiving a lower rate of return than BDC TWO that issued a floating rate security (the same is true in downturns, this is why a number of new issuances have floors in them).
  • Credit Risk - An issuer may miss or default on payments, be downgraded and/or break a covenant. This applies to a BDC with regards to their line of credit and to their investments.
  • Liquidity Risk - The porfolio companies are by definition non-public entities and the market for their securities is small. This means the BDC may be forced to take a loss if it needs to dispose of investments (see ACAS).

There are more categories and classifications, but this post is already getting too long. In terms of TPG, the risks they mention are:
  • We will be subject to corporate-level income tax if we are unable to qualify as a RIC under Subchapter M of the Code.
    • This risk could be on either side of the fence (operational/investment), but the main risk is that the company does not pay out the required amount in dividends to prevent their own taxation. If the company does have to pay income taxes, it would most likely hurt the ability for the company to meet other obligations.
  • There is a risk that you may not receive dividends or that our dividends may not grow over time. 
  • You may be subject to filing requirements under the 1934 Act as a result of your investment in the Company.
  • You may be subject to the short-swing profits rules under the 1934 Act as a result of your investment in the Company.
  • Potential conflicts of interest could impact our investment returns.
  • We may borrow money, which may magnify the potential for gain or loss and may increase the risk of investing in us.
  • To the extent that we do not realize income or choose not to retain after-tax realized capital gains, we will have a greater need for additional capital to fund our investments and operating expenses.

1 comment:

  1. Does the retail / end user investor have any underlying interest in the invested companies through his BCD investment --- like an investor in a Mutual Fund has a fractional underlying investment in the companies in the MF's portfolio??? Or is a BDC investment more like a ETF, with the retail investor having no underlying interest in the actual companies that constitue the 'basket of stockers' that the ETF tracks???