The big idea and why it matters: Business development companies (BDCs) are legal investment structures created to help smaller companies grow. Perpetual BDCs are an important evolution in the ongoing democratization of Alts and an improvement upon the prior generations of BDC structures. They allow private, long-term investments (particularly private credit) to be managed in a private, long-term, investor-friendly structure – which is good news for the investment community.
“I’ve got to admit it’s getting better, a little better all the time.” -The Beatles (“Getting Better”)
In my financial services career, I’ve found “business development” to be a synonym for “growth,” but I assume this applies across many other fields, too. Those involved in “biz dev” are there to help identify and implement growth drivers to (hopefully) manifest better outcomes (i.e., more clients/sales/revenue, improved cost structures, and a more valuable enterprise).
Similarly, business development companies (BDCs) are legal investment structures created to help smaller companies grow. Per Investopedia, “The BDC must invest at least 70% of its assets in private or public U.S. firms with market values of less than US$250 million. These companies are often young businesses seeking financing or firms suffering or emerging from financial difficulties. Also, the BDC must provide managerial assistance to the companies in its portfolio.”
Partially inspired by this short whitepaper on the new Cliffwater Perpetual BDC Index, today we’ll revisit BDCs and gain some insights regarding the importance of the latest BDC iteration: the perpetual BDC. Here we go!
What makes a BDC a BDC?
This list of BDC attributes from Nexcapital isn’t anything I need to try and improve upon, so here you go, verbatim. Private BDCs:
- Do not pay corporate taxes on their earnings, but are required to distribute 90 percent of their taxable income to shareholders.
- Invest at least 70 percent of their assets in privately held or thinly traded companies.
- Provide managerial assistance to their client companies.
- Governed by an independent board of directors.
- Make regular public filings with the Securities & Exchange Commission (10-Ks, 10-Qs, 8-Ks, etc.)
- Leverage is limited to 50 percent loan to value.
- Little to no correlation to publicly traded stocks and bonds.
- Can provide a potential hedge against inflation.
- Quarterly portfolio valuations.
Better, better, better
As the saying goes, “If you’re not growing, you’re slowing.” Business development is an ongoing effort, and I like that the latest BDC structure has caught up with that notion. Based on the above Investopedia quote, it’s not intuitive, but – as Cliffwater points out (above link) – BDCs invest principally in private debt. In my experience, BDCs have provided a palatable avenue for non-institutional investors to enter private debt markets. Still, they have been but one piece of the puzzle in The Inexorable Rise of Private Credit we’ve seen since the 2008 financial crisis.
The first version of the BDC was a publicly traded vehicle. The second version, however, was a private BDC slated to eventually be acquired by that same manager’s public BDC vehicle. I liked the private structure enough to use it on behalf of some clients in the past – but with the intention of exiting the private BDC fund before the public acquisition; i.e., the private part was good, but the public part was not attractive.
Why does staying private matter?
As we covered back in Feb of 2021 in Marky (to) Market & the Unfree Lunch, the returns and volatility of public vs. private vehicles can be drastically different (if you revisit that link, scroll to the table at the bottom). I won’t repost the data here, but the punchline is that this private credit strategy experienced a max drawdown of less than -5% in the private BDC vs. more than -50% in the public version! Again, these are the same underlying holdings! The private structure is certainly less liquid than the public BDC, but I’ll take that trade all day.
Tommy Likey
[It never hurts to throw in a Tommy Boy reference whenever possible (am I right?)]
While Gen 2 BDCs were so/so in their structure, Gen 3 – the perpetual BDC – is a welcome improvement. For advisors and clients alike, if we can identify a fund/strategy we genuinely believe in and would ideally hold forever – privately – why would we want something that is essentially a ticking timebomb, as it eventually goes public and undermines many characteristics of why it was a good investment in the first place?
The industry has caught on
The perpetual BDC is not breaking news. Per Cliffwater, this structure began in 2021, but – with $74 billion of net new assets in the past three years – already makes up about half of all BDC assets. You may already own a perpetual BDC investment but not know it, as some of the most prominent players in Alts, like Blackstone, Blue Owl, and Apollo, have significant offerings in these structures. And, even If you don’t own a perpetual BDC outright, it still may be an underlying holding within another Alts fund (e.g., an interval mutual fund with multiple underlying managers/strategies).
Not VC (sort of)!
I don’t expect anyone to follow links, but I like Investopedia’s point in its BDC overview, so it’s worth touching on here: The idea of BDCs providing capital to smaller, young companies surely sounds similar to venture capital. I did find some venture debt funds in BDC format, and there is even a Canadian company called “BDC Venture Capital,” which is totally confusing, as it has nothing to do with the BDCs we’re talking “aboot” (😊 BDCs are inherently American tax/regulatory structures)…but I digress.
I suppose Venture Debt could play well within a BDC, but it probably wouldn’t fit the risk/return profile we’re seeking for clients. Aligned with that notion, the companies we see within BDC managers’ portfolios are well past the venture stage, which is vital for risk mitigation. A lot of underwriting and downside protection in private loans is based upon the lendee companies’ cashflows and/or assets, and early-stage VCs don’t have those things to offer.
Even if it appears in BDC format, VC Equity would still be generally difficult for the non-institutional crowd to stomach. For the most part, it lacks cashflow, is highly illiquid (10+ years for many investments), is very hit or miss (a lot of zeros coupled with a few home runs, if all goes well), and doesn’t make sense for most portfolios.
I’ll venture to say that’s a great segue
For investors in the more comfortable position of having assets beyond what they need to cover their most aspirational lifestyle needs, I think VC investing can be an exciting way of giving back – a topic we’ll soon cover.
Wrapping up today’s discussion, the perpetual BDC is yet another example of the ongoing democratization of Alts. I’ve got to admit it’s getting better all the time.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
