One of the testiest exchanges at a company conference call in recent years took place during the fourth-quarter 2024 results presentation by Prospect Capital Corp., a struggling business development company trading under the ticker PSEC.
Questioning by a Wells Fargo analyst about the company's finances and share structure provoked a five-minute tirade from PSEC chairman and CEO John Barry that culminated with:
“Why don't you do the world a favor and do a little research before you come on an earnings call with absurd questions like this? You don't even know what you're talking about.”
The incident captured the sour mood dogging the BDC industry, predating the economy-wide impact of the tariff shocks set off by President Trump. The sector was already in a funk, and since “Liberation Day” in April has fared worse. The benchmark BDC index is down .4 percent year-to-date, compared with the S&P 500's gain of 7.3 percent.
Economic headwinds and a deal-making slowdown have taken a toll on BDCs, especially those operating on thin cushions. Even before tariffs became a focal point, many BDCs were grappling with yield compression and the challenges of replacing their low fixed-rate debt with higher-cost loans.
“We've had a deteriorating sector outlook for BDCs for three consecutive years now,” says Chelsea Richardson, BDC analyst at Fitch Ratings. “So we were expecting challenges even prior to the change in administration.”
BDCs are likely to face additional headwinds on net investment income, or NII, one of the industry’s key metrics. They may struggle to generate enough deal flow to mitigate shrinking spreads and a possible uptick in nonaccruals on their loan books.
“But the performance gap between the best and worst players is dramatic,” says Matt Hurwit, BDC analyst at Jefferies.
Laggards like PSEC and venture lender Horizon Technology Finance have been paying out more dividends than income and suffered sharp declines in their net asset values.
By contrast, a handful of top-BDCs — such as Main Street Capital Corp. (MAIN), Blackstone Secured Lending Fund (BXSL), and Blue Owl Capital Corp. (OBDC) — continue to provide equity-like returns and trade at a premium to their NAV while still delivering sizable dividends. Though their strategies may differ, the best-performing BDCs share a defensive approach, managing well-diversified portfolios with a strong bias toward senior, first-lien debt.
Business development companies were created by Congress in 1980 to provide small and medium-sized businesses with access to capital for growth. In essence, they serve as lenders to businesses that lack access to funding from institutions such as JPMorgan Chase or Bank of America.
On the other hand, banks provide almost as much capital to BDCs as investors do. That's because capital requirements encourage banks to lend to BDCs rather than directly to companies, especially those in the middle market that carry higher risk ratings.
BDCs earn money primarily through the interest payments they receive for the capital they lend. They also collect income from origination and prepayment fees and other lending-related charges. In some cases, they take equity stakes in their portfolio companies and can realize capital gains.
Whether publicly-listed or nontraded, BDCs share strict rules, such as investing at least 70 percent of their assets in non-public companies. Like real estate investment trusts, they are required to pay out 90 percent of their taxable earnings as dividends. Hence, they are known for high dividend yields.
Also similar to REITs, BDCs are quick to feel the impact of interest rate moves. When the Federal Reserve raised rates in 2022 to tackle inflation, many BDCs benefited because of their mainly floating-rate portfolios.
But unlike REITs, BDCs face a regulatory roadblock known as index exclusion. In 2014, major stock indexes dropped many BDCs after a change in U.S. Securities and Exchange Commission reporting rules. The culprit was a rule called AFFE, or Acquired Fund Fees and Expenses. It required mutual funds to count BDC management fees as part of their own expenses — making the funds look costlier to investors. As a result, mutual funds and ETFs largely steered clear of BDCs, triggering a roughly 25 percent drop in institutional ownership and weighing on share prices. Today, institutional investors account for only about 30 percent of BDC ownership on average.
Little wonder that overall investment in BDCs is a lot less than in REITs. As of the end of 2024, BDCs managed some $440 billion in assets, compared with about $4 trillion for REITs.
But BDCs can be appealing to income-oriented investors looking to diversify beyond REITs, master limited partnerships, and closed-end funds. BDC yields tend to be higher than those of REITs.
“So if you want higher liquidity and a more opportunistic investment option, publicly listed BDCs are an attractive way to generate income in a reasonably decent economy,” says Lawrence Glazer, co-founder and managing partner of Boston-based Mayflower Advisors, which caters to clients with around $5 million in liquid assets. “But if you want a lower-volatility vehicle, they probably aren't for you.”
Main Street Capital is widely cited as the gold standard of BDCs. It built a reputation for dependable monthly dividends regardless of market conditions. In fact, it has never cut dividends since going public in 2007 and often issues supplemental payouts. The co-founder and current CEO, Dwayne Hyzak, helped guide the firm through the global financial crisis.
MAIN’s conservative balance sheet, equity co-investments, and in-house management model deliver more secure dividends and a steadier yield than most BDCs. And because MAIN is internally managed, it spares investors the added fees that externally run peers — such as Ares Management's ARCC, the largest public BDC — typically pass along to their parent firms.
“Internal management puts shareholders and managers on the same side of the table,” Hurwit says.
MAIN invests not only in debt products, but also in direct equity holdings. It takes substantial minority stakes — 39 percent on average — in about half of its borrowers. In effect, MAIN plays a venture capitalist’s game — earning strong yields and gaining a shot at equity upside. Profits from portfolio companies then help drive even higher dividends.
“We come from more of a private equity underwriting background — as opposed to a private credit or lender investor background,” says Hyzak, who directed M&A at a construction engineering company prior to joining MAIN.
At MAIN, he prioritized taking stakes in companies founded by individual owner-operators who seek to exit their businesses as they near retirement.
MAIN has expanded beyond that niche. But unlike its peers, which are constantly aiming to lend to larger mid-cap firms, it remains focused on so-called lower-mid-cap firms with annual earnings of $3 million to $20 million. It practically owns the franchise.
“Most BDCs have a lending-only focus or invest in companies that are owned by private equity firms,” Hyzak says. “It would be difficult for them to transition to our hybrid approach.”
MAIN's lower-mid-cap investments can lead to eye-popping returns. One example is Heritage Vet Partners, a veterinary partnership network in West Point, Nebraska, operating largely in agricultural regions across the U.S.
In December 2020, MAIN made a $7 million direct equity investment and extended $69 million in debt financing to HVP, enabling it to grow via 18 acquisitions. In May, MAIN exited its equity investment, resulting in a realized gain of $55.5 million plus $7.4 million in dividends.
Such returns have helped MAIN dramatically outperform the BDC industry average. Over the past 17 years, the S&P 500 rose more than fivefold, while the S&P's BDC index lost 47 percent, including dividends. Yet MAIN soared more than 16-fold, thanks to compounding dividends from its direct equity holdings.
MAIN commands the highest price-to-NAV ratio among publicly traded BDCs. According to research platform BDC Investor, MAIN's P/NAV at the end of May reached 1.99x, indicating its stock traded at a 99 percent premium to its NAV per share.
So what's not to like about MAIN?
A major concern with the smaller companies that are MAIN's clients is whether having a more “monoline” business can make them vulnerable to an overnight price surge in crucial imports, or the cancellation of a contract with a government client — just the sort of risks that are rising under Trump.
CEO Hyzak told analysts in May that a high-single-digit percentage of MAIN's portfolio companies had “meaningful exposure to tariffs” — a level of risk he called “very manageable.”
But, “Obviously, if the situation becomes more significant or more negative than it is today, or if the time period gets drawn out, that risk could change in the future.”
Blackstone Secured Lending Fund is seen as the paragon of an elite externally managed BDC. More than any of its peers, BXSL is defensively positioned for periods of uncertainty as well as high-growth conditions.
Parent Blackstone provides BXSL with numerous advantages.
Blackstone Credit has hundreds of experienced investment professionals in corporate lending, giving the BDC access to proprietary research, risk analysis, and insights into just about any sector.
Blackstone’s size and reputation attract private credit opportunities from large sponsors, banks, and company relationships that might not be available to other BDCs. As a result, BXSL – in contrast to MAIN – focuses on larger middle-market clients with average annual earnings of $200 million.
“We think they have a better risk profile,” BXSL co-CEO Brad Marshall says. “Generally, they have gotten bigger because they are higher-quality businesses with better management teams and with access to larger private equity firms that have excellent resources.”
To reduce the risk further, 99 percent of BXSL's portfolio is in floating-rate first liens, meaning the lender gets paid first if a client stops paying interest or goes bankrupt. In any case, BXSL has a minuscule 0.1 percent nonaccrual rate, compared with the BDC industrywide average of 1.34 percent.
When a company fails to perform as expected, even if it isn't facing nonaccrual status, BXSL can rely on its parent for assistance. For example, Medallia, which tracks and measures customer experiences for large enterprises, hasn't been growing at the rate BXSL was expecting. So BXSL is asking its more than 200 portfolio companies to consider using Medallia’s services.
Founded in 2018, publicly traded BXSL manages $12.8 billion in assets – mainly loans – on behalf of mostly individual investors.
But because of growing demand from individuals for access to private credit, Blackstone in 2021 also launched BCRED, its privately managed, nontraded BDC that has surged to $70 billion in assets. Apparently, more investors are willing to forgo BXSL's liquidity in favor of potentially higher returns from the perpetual-capital investments offered by BCRED.
Of course, this all comes at a price. Unlike at internally managed BDCs, investors pay substantial fees. BXSL charges a 1 percent management fee on gross assets and a 17.5 percent performance fee once the investment return exceeds 6 percent a year. BCRED levies a 1.25 percent management fee on net assets and a 12.5 percent incentive fee after the annual return tops 5 percent.
Founded only four years ago, Blue Owl Capital is on its way to becoming one of the five largest alternative managers.
More surprising is the fact that Blue Owl's business model has essentially been its BDCs, led by listed OBDC. This contravenes the more usual formula of BDCs growing out of well-established alternative managers.
Blue Owl was created primarily to take advantage of the expansion of direct lending as an asset class, according to Craig Packer, chief executive of the firm's BDCs. The BDC business model was especially attractive because of its use of perpetual capital to match long-term, illiquid loans to companies.
“Also, there were a lot of smaller BDCs, and we thought there was an opportunity for a scale player,” Packer says.
That scale increased this year when OBDC completed its merger with a nontraded Blue Owl entity to create the second-largest public BDC, with $18.4 billion in assets.
OBDC is likely to experience even greater organic growth in the future because Blue Owl owns four other nontraded BDCs with some $51 billion in assets that are potential candidates for public listing.
“The bigger our scale, the bigger the companies we can lend to and the more diversified our portfolio can be,” Packer says.
But the industry is experiencing a decline in deals. OBDC dropped from $1.94 billion of new investments in the first quarter of 2024 to $1.16 billion in the first three months of this year. A prolonged slowdown in M&A activity for BDCs can reduce their NII growth, which is crucial for covering dividends.
Stronger BDCs such as OBDC, which saw NII dip in the first quarter from the prior three months, can use spillover income if needed to help cover dividends. Spillover is income that a BDC earns but doesn't distribute to shareholders during the current fiscal year. Instead, it retains this income and can use it to support future dividend payments.
“In the short term, it can give investors comfort that BDC dividends should be sustainable,” Packer says.
Lately, Prospect Capital (PSEC) has provided little such comfort to investors. In November, it slashed its dividend by 25 percent. But that hasn't stanched the decline of its valuation, which has fallen by close to half over the past three years. PSEC's NAV discount — a whopping 46 percent — is the highest among its peers and far above the industry's 8 percent average.
PSEC's troubles belie an impressive pedigree. Founded in 1988 by former senior managers of Merrill Lynch, it became a public BDC in 2004 and ranks sixth by net assets.
Real estate, which accounts for 20 percent of PSEC's portfolio, has been one of the hardest-hit sectors since COVID-19 emptied commercial properties and drove up interest rates for landlords.
In theory, with most of its loans on a floating basis, PSEC should have benefited from higher rates. But rising rates squeezed real estate profits and impaired the sector's ability to cover its debts.
Unable to pay interest in cash, real estate borrowers turned increasingly to payment-in-kind — issuing more debt to cover interest payments. PIK income for the BDC industry doubled from 2019 to 2024. But PIK is controversial because it can mask credit problems at companies or cause cash shortfalls for lenders.
One of the reasons PSEC cut its dividend was a sharp plunge in PIK-related interest income that suggested some of its borrowers weren't meeting their obligations.
To reverse these dreary trends, PSEC has shifted its overall strategy. Reducing real estate's share of the portfolio below 15 percent is a priority, but in an orderly fashion, says Grier Eliasek, PSEC's president and COO. “We've exited dozens of real estate deals profitably and look for us to do the same,” he says.
To partially replace its real estate investments, PSEC is focusing on closely-held, lower middle-market companies rather than competing against stronger BDCs that partner with private equity firms to target the upper middle market.
“We believe small is beautiful in the current environment,” Eliasek says, noting that competition is less fierce and there are hundreds of thousands of founder-owned, closely held lower-mid-cap companies to choose from.
On the downside, finding appropriate candidates requires a lot of work. PSEC evaluates more than 3,000 possible deals annually and closes on less than 1 percent.
The new strategy resembles MAIN's successful formula, combining loans with equity in portfolio companies. Take the recapitalization deal for Taos Footwear, a women's shoe company, which closed in March. PSEC invested $65 million in first-lien loans and preferred equity in Taos, which is shifting much of its production away from China.
Elsewhere, PSEC is trimming its collateralized loan obligations. And its first-lien debt — at 65 percent still lower than at other leading BDCs — is increasing with an ultimate target of 85 percent. In addition, the 0.6 percent nonaccrual rate compares favorably to that of PSEC's peers.
Another encouragement to investors is the unusually high insider ownership. The 28.8 percent of outstanding shares held by senior executives and other staff — versus the 1.8 percent average for public BDCs — provides a strong incentive for management to persevere with the turnaround strategy.
“We eat our own cooking, and investors like that,” Eliasek says.
But PSEC and other BDCs that stumbled in recent years could struggle to regain their footing. The more limited M&A activity, combined with a swelling stockpile of dry powder in capital, might tempt some BDCs to chase deals that have been turned down by stronger performers as too risky.
And Trump's tariff policies and the prospect of an economic slowdown may well accelerate a flight to safety by investors.
“Nobody knows where we are headed,” says Brian Snerson, co-founder and managing director at Essex Wealth Management, a New Jersey-based financial adviser that manages an average $2 million for some 200 clients. “So for BDCs, we'll stick with the cream of the crop.”
