Watch Out for Cheap Prices on Private-Debt BDCs

(Vibiznews – Column) Borrowing a line from Winston Churchill, investing in a business-development company (BDC) can be likened to buying a loan wrapped in a fund, then being put back into shares. Some investors may be enticed to enter these publicly traded private financing vehicles, especially when markets are shadowed by concerns about borrowers’ credit risk, such as software companies. Many of these investment vehicles are currently trading at steep discounts to their net asset value, and sometimes offer high dividend yields. As the market adage goes: be greedy when others are fearful. But buying BDC shares is not the same as buying a loan or a bond and simply collecting the interest payments. And buying at a cheap price does not necessarily mean investors will obtain greater value for their money. In fact, it may make more sense nowadays to look at BDCs trading at a premium to their net asset value. To begin with, many funds do not hold only loans. Their assets often include equity stakes, and sometimes investments in other financing funds. Equity investments of this kind are among the hardest to value for investors. Moreover, BDCs often generate various types of fee income from their lending activities. These fees can be earned when borrowers prepay loans through refinancing, or when new loans are arranged. The magnitude of these fees can fluctuate with how active the loan market is. This risk is different from straightforward credit risk. For example, Sixth Street Specialty Lending recently signalled a period of lower fee income when explaining their decision to cut the quarterly base dividend. Sixth Street Specialty Lending’s Chief Executive, Bo Stanley, told analysts that activity-based fee income may take several quarters to normalise after a market dislocation. Another characteristic of the kinds of loans BDCs extend also affects their revenue swings. Some loan payments can be delayed, or known as payment-in-kind. The idea is to give borrowers time to preserve cash to weather tough periods. However, such payment-in-kind arrangements do not inject cash into the investment fund. As a result, a BDC’s ability to continue paying dividends can be pressured, even when all of its loans remain technically current. Private debt fund yields can be higher than traditional loans or other forms of corporate credit. But higher yields also reflect different risks than regular debt instruments. A researcher from Ohio State University, in a recent study, argued that the returns on private debt funds should be measured using an approach that accounts for both equity-related and debt risks. Marc Rowan, Chief Executive of Apollo Global Management, has said that debt profiles that resemble equity are indeed sought by many investors, particularly in BDCs. According to him, investors who enter leveraged loans are not those moving Treasury or investment-grade portfolios, but those selling their shares to enter the instrument. Viewing BDCs more like stocks can also lead to an odd strategy: focusing on funds trading at a premium to their net asset value. To enable healthy funds to capitalise on a nervous market by offering higher-yielding loans, they may first need to raise additional equity capital. That is much easier for funds that are not trading at steep discounts. Sixth Street Specialty Lending is one of the BDCs currently trading at a premium to NAV, at around 10%. The company’s shares had fallen after the dividend cut was announced, narrowing the premium. But the dividend sacrificed now may not be gone forever. Sixth Street’s BDC tracks what is called embedded fees that could be earned from future activity. Some of the fund’s activity fees can also shield them from prepayment by borrowers to refinance at a tighter spread. The ability to issue shares and channel loans at higher interest rates can also lift fee income going forward. To maintain the premium, investors must trust that the loan values in the fund portfolio truly match what the company claims. Thus, amid the various dynamics affecting BDCs, there is in fact nothing mysterious about their core mission: to provide good loans. The concept of a business-development company (BDC) as in the United States does not really exist in Indonesia’s capital market structure. However, there are several instruments and institutions with similar functions, particularly in mid-market financing, private credit, and alternative investments. In the US, a BDC is an investment company traded on an exchange, focused on channeling loans or capital to mid-sized companies that struggle to obtain financing from traditional banks. Investors can buy BDC shares like ordinary stocks while enjoying dividends sourced from loan interest and investment income. In Indonesia, such a model does not yet have a dedicated regulatory umbrella. The Financial Services Authority (OJK) is more familiar with schemes such as financing companies, venture capital, real estate investment funds, and limited partnership mutual funds. Therefore, the closest form to a BDC in Indonesia at present are venture capital companies, private equity, multifinance, and certain private debt fund managers. Nevertheless, there are differences that