If Jonathan Bock put on a conference, work friends warned,
the only attendee would be Jonathan Bock.
He is the undisputed guru of an esoteric financial lending
structure business development companies and he
believed there were BDC-curious investors out there who should
know more than the vehicles reputation for outsize
returns and complexity.
As one investor puts it, BDC: that stands for
Be. Damned. Careful.
In 2013, Bock, a Wells Fargo & Co. research analyst and
managing director, and his employer put together the inaugural
forum, booked the rooftop room of New Yorks St. Regis,
and hoped for the best.
I expected 100 people to show up, and 300 came,
Bock recalls, his grin audible over the phone. Wow, was
it hot in that room. That first year, it was basically a few
BDC managers, the SECs investment management head, Norm
Champ, and Steve Schwarzman. The year after, we moved to two
days at the Plaza and had 600 people. Then 900. Last year, we
hosted over 1,215. Attendees in 2016 included Goldman
Sachs CEO Lloyd Blankfein, Wells Fargo CEO Tim Sloan, Apollo
Global Management co-founder and CEO Leon Black, Providence
Equity Partners CEO Jonathan Nelson, TPG co-founder David
Bonderman, Avenue Capital Group CEO Marc Lasry, Blackstone CEO
Schwarzman and head of credit Bennett Goodman, and former New
York Yankees manager Joe Torre.
The hottest sector, by far, for large investors is direct
lending when anyone but a bank or a brokerage firm lends
money to another company as Institutional Investor
research found in late 2016. Banks used to be the main lender
to the middle market (firms earning $10 million to $100 million
per year) but have backed away since the financial crisis. And
institutional investors have eagerly stepped in.
Theyre looking at a return closer to 10 than to
0, on a floating rate, and you dont have to sit around
for five years to realize those numbers, says Steve
Nesbitt, CEO of alternatives advisory firm Cliffwater. Says a
top-performing manager, Nesbitt is the one consultant
worth listening to on BDCs. There are two main avenues
for investors to get their money to middle-market lenders, who
do the serious legwork of sourcing deals, assessing
creditworthiness, and negotiating loans. The first is private
partnerships, which operate as they do in private equity, with
the general partner putting limited partners capital to
Then there are BDCs similar to real estate investment
trusts for direct lending. Created by Congress in 1980,
the idea was to stimulate lending to U.S. middle-market
companies. BDCs can be publicly listed or private, and they
pass income through to investors tax-free. The great
thing about BDCs is these are 40-ACT vehicles, are
SEC-registered, must report performance, and file 10-Ks,
Nesbitt says. For institutional investors concerned about
transparency, its great here.
Registering and filing reports with the Securities and
Exchange Commission hasnt convinced everyone that BDCs
are safe investments. Fraudiest Industry, a Twitter
poll by @WallStCritic asked in May, gathering more than 600
votes: Pre-revenue Biotech (32 percent), Junior Miners
(28 percent), BDCs (21 percent), Pre-revenue Tech (19
percent). Nesbitt, Bock, and all other BDC-savvy experts
interviewed dispute this aspect of the vehicles
reputation. These managers arent fraudy,
Nesbitt says. Its hard to be a fraud and be
SEC-registered. Are there practices that, while compliant with
the SEC and the BDC rules, are anti-shareholder? Yes. You just
have to know what those practices might be. And you want to
steer clear of those.
BDCs feel like opposite land for sophisticated allocators.
Retail investors discovered the middle-market lending frontier,
and institutions are trying to settle it. But many encountered
the anti-shareholder practices Nesbitt refers to
and turned on their heels back to private partnerships. Fee
loads and structures apparently tolerated by mutual funds or
individuals, for example, flabbergasted UPSs Greg Spick.
Head of private markets for the couriers $36 billion
pension fund, Spick and senior portfolio manager Robert Thomas
began following the sector closely in 2014. They saw a trove of
serious talent in BDCs. But it is incredibly
expensive, he says. A lot of people are making
a lot of money.
Two fee practices common among BDCs are unheard of elsewhere
in private markets, note Spick and Bock: charging a management
fee (typically 1.5 percent) on total assets, including those
financed through leverage (capped at 1-to-1 for BDCs). In
contrast, private equity firms charge management fees on
committed capital or the equity portion only. When an
investment vehicles fee practices make private equity
look good, it may have a problem.
The second piece of this thats critically
important is incentive compensation. A lot of BDCs do not have
a look-back provision that takes into account the capital
losses on their assets, Spick says. Pretend
Ive invested $500 in a BDC, with one turn of leverage. On
that $1,000 in total assets, say interest income should be $50,
but 10 percent arent paying. Theyve got problems,
so we are only earning $45, or 9 percent, he says.
If my hurdle rate is 7 percent, I would pay 20 percent of
the income over the 7 percent, even though I know I may take an
impairment on that 10 percent of nonperforming loans. My total
return actually falls below my hurdle rate.
In other words, many BDCs charge performance fees on capital
they end up losing. Both Spick and Bock get wound up just
explaining the model.
One of the most respected BDCs, Golub Capital, changed this
aspect of its fee model in 2014, and some others have followed.
We simply added a cap to everybody elses fee
structure, says David Golub, the firms president.
The cap says that we wont earn an incremental
dollar of incentive fees if, after doing so, we would have
taken more than 20 percent of cumulative, preincentive
fee net income. Many people told us, Oh, its too
complicated. You cant do that. Its not
complicated. Its simple. Were in the long-term
Ask anyone steeped in BDCs to name top managers, and you
will hear the same short list: Golub, Ares Capital, TPG
Specialty Lending, and Owl Rock, plus one or two personal
favorites. Goldman Sachs gets credit, as well, as other
investment giants Apollo, for example launched
BDCs that havent lived up to the quality of the core
brands. (Apollos BDC has made strides recently on fees,
Bock notes. A spokesperson for Apollo declined to comment.)
The bottom-feeders of the industry, experts say, are
zombie BDCs. These listed BDCs trade well below
their respective net asset values and do so for a long time,
Bock explains, indicating that either the market doesnt
believe their valuations or it values their assets less because
of whos managing them. Year after year, zombies rake in
large fees for poor performance, and capital dwindles but
doesnt flee. Several firms have succeeded in pushing BDCs
to advisers managing individual retirement accounts, who in
turn recommend them to individual investors. For BDCs the
good-governance mechanism of activist investors doesnt
exist. No hedge fund, mutual fund, or other investment firm can
own more than 3 percent of another, per 40-ACT rules. A
pension fund or endowment could play BDC Bill Ackman, but
it hasnt happened yet. And so the zombies lumber on.
There are grown-ups in the BDC room, those with the talent
and track records to rake in institutional capital (at
institutional fee levels). But, as one of these grown-ups
quips, Its a big room.