June 27, 2024 - As a source of permanent capital for alternative asset managers, Business Development Companies (BDCs) have proved to be very popular structures and BDC AUM represents a significant share of the private credit landscape. According to LSEG LPC, BDC AUM reached a new high of $343 billion at the end of 1Q2024 – representing an 8% increase from 4Q23 and a 23% gain year over year. Despite the popularity of BDCs – and the transparency BDCs afford – these vehicles are not well understood.
We have prepared a primer series on BDCs that unpacks the lessons in the “Nuts and Bolts of BDCs” webcast. Part 1 introduced the three types: publicly-traded BDCs, non-traded BDCs and private BDCs. Part 2 surveyed the applicable reporting requirements under the ’34 Exchange Act. Part 3 looks at the key restrictions and limitations on BDCs pursuant to the ’40 Act as well as tax considerations for BDCs that elect to be treated as Registered Investment Companies. This Part 4 will look at operational, management and governance considerations for BDCs.
Trends in BDC structuring have changed over time. In 2004 – when we saw the start of real growth – there were five publicly-traded BDCs, all of which were internally managed, meaning the BDC is internally managed by its executive officers. Today there are more than 50 publicly traded BDCs, 10% of which are externally managed, meaning a registered investment adviser is hired by the BDC to manage its portfolio subject to an external management agreement. External managers to a BDC are permitted to take a base management fee and an incentive fee on realized capital gains and investment income unlike other registered closed-end funds. The base management fee is calculated at typically 1-2% on gross assets less cash. The incentive fee is permitted to be up to 20% of a BDC’s realized capital gains net of all realized capital losses and unrealized capital depreciation. While 20% is permitted under the Advisers Act, fee compression has been observed amid the rapid BDC growth and incentive fees are now routinely 12.5-17.5%. The advisory agreement will specify the fee structure as well as the NAV hurdle, which needs to be cleared before the fee accrues. About 50% of BDCs also have a lookback which serves to reduce the incentive fee when there are realized or unrealized losses, i.e., the portfolio is not performing. The advisory agreement must be approved by the BDC shareholders as well as the board of directors, a majority of which must be independent.
Aside from management of the BDC’s portfolio, its adviser assists in preparing its SEC reporting subject to the oversight of the BDC’s board of directors. Perhaps most significant is the valuation of the BDC’s assets. Investments are reported at fair value, as determined in good faith by the board. There has been increased focus on valuation as non-performing loan holdings have increased, but the valuation process followed by a BDC is highly prescriptive and subject to controls. These include the documented approval of trades, segregation between preparation and review of valuations, identification and monitoring of problem loans as well as the use of third-party valuation consultants. A BDC’s assets must be classified into three levels. Level 1 means the valuation inputs are unadjusted, quoted prices at the measurement date. Level 2 means the inputs include quoted prices and inputs that are observable for the financial instruments, either directly or indirectly, for substantially the full term of the asset’s life. Loans with broker quotes, like broadly syndicated loans, may fall in this category. However, the majority of a BDC’s equity and debt assets will be Level 3. Here the inputs include significant unobservable inputs and include situations where there is little, if any, market activity for the asset. This means that the fair value determination may require significant management judgement or estimation.
Recently, third party valuation providers have sought to facilitate broader understanding about the valuation process. Those interested in further detail can look to reports by Houlihan Lokey and KBRA on the subject.
This concludes the ABCs of BDCs series. The series attempts to create a window into the complex and important world of BDCs with the recognition that the series is neither exhaustive nor as nuanced as the realities of BDCs. As noted in the Dechert webcast there are not enough BDC resources available. We hope that readers find the information useful with that objective in mind.
