With: Greg Mason, Managing Director, Ares Management Portfolio Manager, Litman Gregory Masters High Income Alternatives Fund
Date: November 14, 2019
Greg Mason: When we think of, “What is a business development company?” BDCs were actually created by Congress, to try to get capital flowing to private US businesses. They wanted to stimulate Main Street.
If you’re a BDC and you make a loan to a private US business and you pay that all out as a dividend, you pay no federal taxes. It’s similar to a REIT (real estate investment trust) structure.
What we have in our portfolio is essentially a portfolio of corporate loans to private US businesses.
Again, they take that interest income off the portfolio and pay it out to us.
What we have on the upper right-hand corner of the BDC portfolio statistics – we took the stocks that we own in the Litman Gregory fund, and said if you look through that portfolio, what do you actually own in our companies?
With that, we have exposure to $32 billion of loans, and almost 1400 middle-market credits. These are private credits; not liquid. Vast majority – 90% — floating rate. You can see over 50% of the portfolio is first-lien investment with a mix there of first, second, junior debt and some equity in the portfolio.
What’s nice about the BDCs is, we have significant transparency into their portfolio. Unlike a bank, when you look at their financial statement and they have commercial loans and it’s just the number, that’s all you get. With the BDCs, we actually get every single investment they make. We get information about those loans.
So we have significant detail of what’s in their portfolio, and a fair market value of all of those assets every quarter. So we get real-time information on what’s going on in their portfolio.
Our view is, if you’re able to do the work and have the expertise, you can dig in and really understand what’s going on from a credit perspective in these corporate bond portfolios.
The BDCs have very high income. Again, they pay it all out as a dividend. So we’ve got about a 9.5% dividend yield on average, with solid dividend coverage from that.
We actually see some regulatory changes that are providing some tailwinds for the BDCs that we think are going to potentially increase earnings and dividends and maybe bring some institutional investors back into the space.
BDCs are not included in any indexes … So we don’t have any passive flows making their way to the BDCs.
Down at the bottom, historically, at book-value, if you can buy them below book-value, it’s historically been a good price. Particularly when you get those periods of volatility—
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Audience: Could you give an example of where the BDCs are lending geographically, and the types of businesses they’re lending to?
Greg: Yes. From a geographic standpoint, they’re all over the United States. We have the BDC industry as a whole as 50 BDCs with almost 100 billion dollars of assets that are invested in US public companies. Geographically, it’s all over the United States.
Also from an industry-diversification, every BDC is a little bit different. But it’s broadly diversified on an industry basis. You have anything from IT software to industrials to manufacturing. It’s really a very diverse portfolio from an industry perspective, as well.
Audience: You talked a little bit about the internal costs within the BDC for making the loans; playing banker, so to speak, and their own internal leverage. Whether the BDC investor was getting an 8% or 10% payout is actually being adequately compensated relative to the gross cost-free yield that would be up in the teens, potentially.
Greg: Yes.
From a BDC perspective, because they’re investing in that private-direct-lending, it gets significant yield enhancements that you get over the liquid credit markets. The average yield inside the BDC portfolio – the yield that they’re charging to the end business – is typically a 9.5% to 10% yield.
Probably 400 bps (basis points) that you get over a liquid high-yield. Again, as you can see, there as we had in the slide, a lot of them are first-lien portfolio yields, secured by the assets versus high-yield bond completely unsecured.
What we have seen historically is that loss-rates have been superior in those private-credit markets. I think they generate higher risk-adjusted returns for that.
They do have higher expense structures than a high-yield bond portfolio would charge. But ultimately, we think that the risk-adjusted returns that they’re able to generate adequately compensate for those returns.
In addition, they have leverage that they utilize. One of the potential tailwinds for the BDC space is Congress just increased the maximum leverage ratio for BDCs. It used to be a BDC couldn’t lever its portfolio more than 1-to-1 debt-to-equity. Congress just passed a law that allowed them to go to 2-to-1.
We’re still just starting that process. In fact, if there is a market dislocation, the BDCs actually have dry powder to take advantage of that with the increased leverage limitations. But I think that can be a driver of growth over the next several years, as they can take advantage of that potential additional leverage in their portfolio.
Interestingly, when we’re talking to the BDC managers, being pretty big investors in that space, we’re telling them, “You don’t need to ramp up your leverage now. We’re fine with the yields. Have that dry powder so that if we have a recession or a dislocation in the equity markets, they can take advantage of that and go on the offense.