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.

A Look at Dividend Coverage

Overview
The Dividend Coverage Ratio is a way to measure how "safe" a dividend is for a firm. For a BDC with a required minimum payout (to avoid taxes), this ratio becomes a little more meaningful. As you can see below, some BDCs will pay out more in dividends than they earned in their current quarter's Net Investment Income.

There are many formulas out there, but this site will use these formulas:

DCR  = Net Investment Income / Current Quarterly Dividend.

DC = Net Investment Income - Current Quarterly Dividend

I am using Net Investment Income because a BDC is required to have at least 70% of their holdings in qualified securities / cash. These investments are the life-blood of a BDC and while many firms generate fee income from structuring deals, these are more volatile. One other note, if a firm pays out dividends on a Monthly basis, I am adding together the past three months of dividends to get the amount. The second formula is useful because it shows you how much room a firm has to pay out its dividend

In the below chart, I have pulled the NII from the BDCR Index and compared that value with their current dividend payouts. In cases where NII is negative, the DCR will also be negative, this allows us to sort the results.


Results

Discussion of Table


As you can see, a large number of the firms are operating at the razor's edge when it comes to their payout ratio. While this is nice for fixed income investors, it may mean that a company is actually paying out their dividends at the expense of the firm. If a company cannot cover the dividend with investment income, it needs to generate the proceeds from another source(s).

• The first source would be from capital gains on the sales of a firm's assets. This dividend is good for a tax-paying investor in the short-term as it will be classified as a return of capital and taxed (in the US) at the long-term capital gains tax-rate (15% for most people, for the IRS view, please click this link). Return of capital dividends do require you to adjust your cost basis for your position though and that may not be desired from a book-keeping standpoint. For a BDC, this type of dividend payment may be bad as the firm has presumably sold off an income generating asset to meet a payout requirement. 
• A second source would be from the company tapping their Revolving Credit Facility (Revolver) to get the cash to payout to their investors. Again this may be a bad sign for the firm as they are increasing their interest expense and leverage without any offsetting gain.
• The final source is when a firm actually goes "Ponzi" and will begin issuing new shares to pay-off old shares. This does not happen on a large scale for long; most firms will cut their dividend or violate a lender covenant if they are in this situation. But, a good example would be AINV for 2008, you can see that their asset values and net investment income were tumbling, but the firm maintained its dividend and partially funded this dividend with proceeds from selling shares. AINV was not the only BDC to do this, but they are an easy target as they are still one of the largest.

A firm that has a DCR over 1 or a DC > 0 is a firm that is currently covering its dividend with its investment proceeds and that may be a sign of a responsible management team. There are some firms that are close to their ideal payout (KCAP for example) that may be correcting their balance sheets, but you should take a look at their dividend and NII history to come to your own conclusions. The best firms in terms of dividend coverage are KFN (which is not a BDC) and MVC. The worst are the firms that have already cancelled their dividend.

Net Investment Income Addendum

Someone pointed out to me that I failed to mention what the below line represents:

Interest income from cash and cash equivalent investments

 

This line item for most companies will include true Cash that is sitting in an account and assets that are readily convertible into cash. This second category is more fluid than Cash. For most firms, CE will be money market holdings, short-term government bonds (DEVELOPED countries), US Treasury Bills and Notes, highly liquid securities and commercial paper with Investment Grade Ratings. For example, MSFT commercial paper may be considered Cash Equivalent while Lehman CP would not. Some firms like to get more exotic in their cash equivalent definition by including duration (bonds), time to maturity, if the issuer of the debt (bond/loan) is a GSE and the list goes on and on.

Thank you for reading and welcome to all new readers!

Net Investment Income Overview

Net Investment Income (NII) is one of the most important factors when evaluating a BDC. NII as a definition is a measure of the income received from investment assets (bonds, stocks, funds, loans and other investments) minus equivalent investment expenses. For a BDC, this number measures how well their investments are performing. As a simple way of breaking this information down, I am pulling in the balance sheet from TCAP's Q3 earnings release to illustrate.

Investment income:
Loan interest, fee and dividend income:
Non—Control / Non—Affiliate investments	6,654,541
Affiliate investments	1,044,088
Control investments	333,993
Total loan interest, fee and dividend income	8,032,622
Payment—in—kind interest income:
Non—Control / Non—Affiliate investments	1,338,018
Affiliate investments	231,525
Control investments	117,419
Total payment—in—kind interest income	1,686,962
Interest income from cash and cash equivalent investments	67,501
Total investment income	9,787,085
Expenses:
Interest expense	1,864,442
Amortization of deferred financing fees	469,394
General and administrative expenses	1,840,794
Total expenses	4,174,630
Net investment income	5,612,455

Basic line by line breakdown:

Non-Control / Non-Affiliate Investments - These represent the bread and butter investments of a BDC - extending capital (most of the time in the form of term loans) to firms to collect interest. You would expect the majority of a firm's NII to come from this line.

Affiliate Investments - This means that TCAP has some type of influence or relation to these companies. Such situations could be: a person in TCAP sits on the board of the company (or if an officer), holds either directly or indirectly 5% or more of the outstanding voting securities or if the affiliated company is an investment company, TCAP has seeded the company.

Control Investments - Will let the 1940 take it from here - "Control" means the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company. From what I have seen, a BDC likes to avoid controlling a firm as that is not the specialty of the BDC. Also, it tends to take considerable personnel power to both manage another company as well as your entire portfolio.

Payment in Kind Interest Income - Quick sub-note on this. http://en.wikipedia.org/wiki/PIK_loan

Interest Expense - This is the expense that the company pays on the leverage it issues (loans/bonds) to make investments. A BDC will take out a Loan (most likely a Revolver) because they make money off of the spread. If a BDC pays interest at LIBOR+200 and can lend that money out at LIBOR+500, it is doing OK. This is the same principal on how a traditional bank makes money. Take in deposits and pay a certain rate and lend money out at a higher rate. Remember, a BDC must be in compliance with a max 1:2 Leverage to Assets ratio (200% test).

Amortization of deferred financing fees - These are the costs incurred with issuing debt such as commissions paid to investment banks, auditors, lawyers, etc. These fees are amortized because of accounting reasons which you can easily lookup online.

General and administrative expenses - The incredible catch all which includes costs of doing business. For example, if a business professional is evaluating a potential portfolio company, they can expense (within limits) travel costs and acquisition costs.

What does this all mean?

Well, from looking at those lines, we see that TCAP has a positive NII and if you divide that by the number of outstanding shares, you get to a NII of 0.46 per share. This is important because that means TCAP is currently covering their dividend of 41 cents (now 42 cents) with their NII. This is important when you look at a BDC. There are a number of BDCs that currently have a dividend shortfall (future post). If a BDC is not covering their dividend with NII, then you have a problem with a BDC selling assets to make payments or even going Ponzi by paying out dividends from equity and leverage raises.

Capital Structure

Before continuing on the ACAS company dive, I wanted to have a quick post that discusses some of the key terms used when describing a BDC's portfolio companies. A hyper-link on the term means I am sending you to a site with a good definition that expands on the item.

Capital Structure 
This term refers to how a company finances its assets and business through various combinations of Debt and Equity. There are many different variations of Debt and Equity and each one represents a trade-off between security and agency within the company.

Debt Financing
There are two main types of financing extended to a Company - Asset-Backed and Cash Flow. Asset-backed loans for everyday people would be equivalent to a mortgage or car loan. There is some form of collateral that is backing the loan. If the borrower defaults on the loan, the lender can take possession of the physical (or in some industries - take the Intellectual Property (IP)/patents) asset. A Cash Flow loan is equivalent to a Credit Card. These loans are based on the company's earning power and ability to pay back the loan with its Earnings.

Asset-Backed Loan
In terms of corporate finance, a typical asset-backed loan is a fixed term loan of about 3-5 years (as opposed to a 30 year mortgage). The main reason a company looks for an ABL is to fund an expansion of the firm (leveraged buyouts will be discussed later). These loans have many flavors and names such as "Term Loan", "Senior", "Subordinated", "Jr.," "Mezzanine" and "Tranche". The name is very important in an ABL, it tells you the claim priority of the loan (who gets paid first in case of bankruptcy) as well as what guarantees are attached to the loan. The amount a company can receive in an ABL is tied to the company's assets.

Term Loan A, B, C
It is very common for a BDC to hold a Term Loan B or C on its Balance Sheet. Most ABLs are extended by a primary lender (bank) that will hold the most senior tranche of the loan (Term Loan A - TLA). The bank will typically hold this loan on its balance sheet until maturity. Sometimes if the desired amount of credit the company desires is more than what the primary lender wants to extend, the loan is offered by the lender to other institutions. This is known as syndicating a loan and these investors typically invest in a slightly different tranche called the Term Loan B or C. TLAs typically have a fixed amortization schedule and the lowest pricing for a loan. A Term Loan B/C is different than the TLA. These loans have the same seniority "pari passu" as the TLA, but their amortization is usually a token amount followed by a balloon payment at maturity (think ARMs). TLB/C may have a longer maturity date than the TLA and will have a higher price than a TLA (L+500 versus L+300). For a lender to extend loans to a company, they typically attach a number of covenants to the loan. These covenants help ensure that the borrowers stays in a position that will allow them to pay for the interest and amortization over the course of the loan.

Cash Flow Loan
A CFL is called a Revolver in the corporate world. A revolver is typical for many companies that have seasonal cash flows (think retailers/construction) that need to fund their need for working capital during these times. A Revolver is a special type of loan in that it is a Line of Credit extended to a company (like a credit card) but it carries a maturity date and two interest rates. The first interest rate is the funded rate - this is like your APR on your credit card. The second rate is for the unfunded/unused portion of the Revolver. This rate is typically very small (25-75 bps) but when you have a $100m Revolver, the interest expense does add up!

Basis Points (BPS) "bips"
A basis point is equal to 1% of 1% as a rate. So, 100 basis points = 1% interest.  It may take awhile to get used to this, but after reading enough documents or talking with enough people about finance, it will become second nature.

Pricing
A loan's "price" often refers to the interest rate on the loan. This is different from Bonds, since most bonds are quoted on their yield to maturity (a 5% coupon yielding 5% is priced at par, where as a 4% YTM means the bond is above par). Since most loans in corporate finance are floating rate (they have an underlying index such as LIBOR, PRIME or EURIBOR), it is very common to hear of a loan priced as "Libor plus 500".

Tenor
This is the loan's remaining years until maturity, although it will sometimes be quoted in months. For example, a 5 year loan that was originated in 2008 has a tenor in 2010 of 3.

Loan Seniority List / Hierarchy of Creditors
When you hear about a company going bankrupt / loan pricing, the order of seniority and pricing generally have an inverse relationship (more senior you are, the lower the price). Here is the order of seniority in a firm's capital structure.
Revolver - Secured, little influence on management
Term Loan A - Secured
Term Loan B - Secured
Term Loan C - Secured
Mezzanine Loan - Unsecured
Bond Holders - May be secured, mostly unsecured
Preferred Equity - No security, but have influence on management
Common Equity - No security, but have influence on management

There you go, now when you read a firm's 10-K and you see they have "Senior Secured" notes, you know they most likely have a TLA/B/C.

What is a BDC?

If you have stumbled onto this blog via Google or some other link, then most likely you have a basic idea of what a Business Development Company (BDC) is. Just in case you do not, here is a quick overview of a BDC.

A BDC is a closed-end, may or may not be diversified investment management company that has a class of its shares registered under the Securities Exchange Act of 1934. BDCs were established as a part of the Investment Company Act of 1940 Section 54 (page 105 on that link if you are curious).  They were established in part to spur investment in smaller business after the Great Depression that banks were not willing to provide. The main points of the law establish what a BDC may and may not do.

Some key examples - a BDC must maintain an asset coverage ratio of 200%. Most other publicly traded funds (mutual funds) must maintain a coverage ratio of 300%. What is an asset coverage ratio? Typically it is defined as a ratio of debt to total assets. This means if all of the firm's debt/liabilities came due at this exact time, would they be able to cover them? So, if a firm issued $10m in Equity, they could also issue $10m in Debt. This is also referred to as their debt to equity ratio.

Investment Restrictions - A BDC must have at least 70% of its portfolio invested in eligible portfolio companies. What is an eligible portfolio company? One, it must be a company that is organized and has its principal place of business in the USA, sorry foreign issuers. Two, it must be a non-investment company unless it is a SBIC (small business investment company) that is wholly-owned by the BDC. Finally, it must be a company that does not have a class of publicly traded securities. In plainer English, an eligible portfolio company is a small to medium-sized (rarely large) non-public business.

Investment Types - Most likely a BDC will extend some form of debt financing to a portfolio company. This financing comes in all shapes and colors, from a Senior Secured Loan all the way down to Common Equity. If you do not know what those are, Investopedia may be a decent help or you can wait for my next post.

Managerial Assistance - A BDC is expected to offer significant managerial assistance to a portfolio company. The reason for this is because a BDC is there to help a company thrive. The managerial assistance may take the place of balance sheet restructuring, recruiting and hiring a managerial team and exploring mergers and acquisitions (or divestitures) for the company.

Taxation - A major reason for a company to be organized as a BDC is to be classified as a “regulated investment company” (RIC). As a RIC, the company avoids having to pay corporate taxes on capital gains and investment income that is distributed to shareholders.  To be a qualified RIC, the BDC must distribute at least 90% of the above to shareholders in the form of dividends. If at any time a BDC fails to comply as an RIC for the year, they will be subject to corporate taxes as a regular "C corporation" under US Tax Code.

Dividends - Due to the Taxation treatment above, BDCs will tend to pay out most of their Net Investment Income in dividends to shareholders. The reason why NII is used is because it represents the money that a BDC is taking in from interest payments, capital gains or dividends (from a portfolio company). If a BDC overpays their dividend (shortfall - Dividend Amount > NII per Share), that means the company had to either sell assets, issue equity, take on more debt or some combination of the three. Other times a BDC will underpay their dividend. The reasons for underpaying are varied, but include times when a BDC is anticipating a dividend shortfall in the future or making a significant asset purchase.

There you have it, the quick overview of what a BDC company is. In my next posts I will expand on these topics and then begin an analysis of each BDC company. I plan on going in alphabetical order by ticker symbol so anyone hoping for a TCAP review may have to wait awhile.