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Date: April 30, 2018
Category: Credit

BDCs Finally Win the On-going Leverage Battle with Congress

In March 2018, Congress averted a government shutdown by approving a new $1.3 trillion spending bill.1

Known as the “Omnibus” bill, its benefits are wide reaching. Thanks to the new bill, defense spending will jump, as will funding for both U.S. Customs and Border Protection. Numerous transportation programs will also get a bump, along with funding increases to tackle the opioid epidemic, and more money for the arts.2

And there was one last-minute addition to the bill that may prove interesting for investors – investment companies controlled by private-equity firms, also known as business development companies, or BDCs, now have the ability to borrow more money and increase lending.3

Understanding BDCs

To put it simply, BDCs are organizations that invest in and help small- and medium-sized companies grow in the initial stages of their development. They were created by Congress in 1980 under the Investment Company Act of 1940 to help stimulate the economy by increasing available capital for smaller companies.4

Similar to private-equity funds, they buy stakes in businesses and generate loans, but instead of soliciting capital from investors, they raise money by selling shares traded on stock exchanges. And like real estate investment trusts, or REITs, BDCs are exempt from corporate income taxes and are required to pay at least 90 percent of their taxable income to shareholders in the form of dividends.5

A big win after a long battle

Since 2012, the BDC industry has been lobbying Congress to raise their limits on leverage, which would in turn provide them with a larger pool of capital to use while potentially boosting investor returns. Previously, the cap on BDC leverage was a 1-to-1 ratio of debt to equity. The addition to the Omnibus bill would allow BDCs to borrow $2 for every $1 of assets that they own, potentially increasing a company’s earnings by as much as 20 percent.6,3

Modernizing the BDC industry

This leverage increase may be one of the biggest changes to the BDC industry since 1980. Previously, BDCs faced headwinds due to high competition in the middle-market lending environment. Some BDCs struggled to grow and meet quarterly dividends as “newbies,” and high levels of fundraising for middle-market direct lending and private credit have put increased pressures on borrowing rates and yields. But this new bill will give these BDCs the ability to pursue higher-quality deals with less credit risk, while still affording them the ability to generate returns for investors.6

But it’s not just BDCs that can benefit. When examining the bigger picture, this measure may also benefit the economy. Middle-market businesses are major drivers of economic growth, and increased leverage may help bolster investments in smaller business.6

Investing in BDCs, what’s the catch?

Overall, the new law is overwhelmingly positive for BDC companies, and with forward-looking markets, there’s likely to be an influx in investor interest and higher prices for the sector. However, you must understand that BDCs come with increased risks. For example, permitting BDCs to double their leverage will significantly raise risk and increase the likelihood that one or more of the companies will fail in a market downturn, resulting in sharp write downs of the loans held, causing leverage to rise and making cash difficult to find.4 Changes in interest rates may also reduce anticipated returns or affect the market value of a BDC’s investment portfolio. Additionally, certain BDCs stand to benefit from the new bill more than others depending on a range of factors, including the percentage of first-lien investments, track record, portfolio size/platform, investment-grade rating, and current leverage, so, BDC selection and research is crucial.6

The Lesson Here:

If you look at BDCs as part of a diversified portfolio rather than a single investment, you may be able to mitigate risk while potentially benefiting from the new law's BDC benefits.

1 Times. Congress Approves $1.3 Trillion Spending Bill, Averting a Shutdown. 3/22/18.

2 The Washington Post. Here’s What Congress is Stuffing Into Its $1.3 Trillion Spending Bill. 3/22/18.

3 Bloomberg. Private-Equity Giants Get a Surprise Win in $1.3 Trillion Spending Bill. 3/22/18.

4 Institutional Investor. $1,3 Trillion Spending Bill May Be a Boon for BDCs. 3/22/18.

5 U.S. News. What Is a Business Development Company. 6/14/17.

6 Reuters. BDCs Win Leverage Cap Increase After US $1.3trn Budget Signed. 3/23/18.

 
This information is educational in nature and does not constitute a financial promotion, investment advice, or an inducement or incitement to participate in any product, offering or investment. It is not intended to be used as a tool to determine your specific financial situation, tax status, investment objectives, investment experience, suitability for any specific investment, risk tolerance or investment profile. Resource is not adopting, making a recommendation for or endorsing any investment strategy or particular security.

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