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On to this week’s Net Interest…

Most American investors have at least a passing familiarity with the Investment Company Act of 1940. Known as the ‘40 Act in industry circles, it is the primary source of regulation for mutual funds and closed-end funds, and impacts how hedge funds, private equity funds and even holding companies operate.

Less well known is the Small Business Investment Incentive Act of 1980. And yet this piece of legislation has played a pivotal role in the boom in private credit that we’ve discussed many times here before. Signed into law by President Jimmy Carter during a period of economic malaise, the Act was designed to channel much-needed capital to America’s small and medium-sized businesses by creating a new type of investment vehicle: the Business Development Company (BDC).

A BDC is a special category of investment company with unique privileges and obligations. BDCs are granted more generous leverage limits and greater flexibility in distributing capital to investors than typical closed-end funds. In exchange, they have to commit to a specific mission: at least 70% of their investments need to go into eligible assets, primarily securities of private companies or public companies with market capitalizations below $250 million.

Today, there are 52 BDCs publicly traded on the stock market. Between them, they manage $71 billion of capital and sit on $156 billion of assets, the majority of which comprise private credit. Some have performed very well. On his earnings call last month, the outgoing CEO of the largest, Ares Capital Corporation, boasted that during his roughly ten years in charge, “the company has paid over 40 quarters of steady or increasing dividends, increased book value per share by over 20% and generated $500 million of realized gains in excess of realized losses. This investing success has led to a stock-based total return for our investors of nearly 14% per annum.”

Others have performed less well. Bloomberg ran a story this week about Prospect Capital, whose CEO harangued the only analyst to ask a question on last summer’s call. “Why are you relying on me? You’re a research guy,” he snapped. “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?” The CEO was clearly sensitive. His stock was down 40% over three years as portfolio losses mounted and Prospect was forced to accept “payment-in-kind” from borrowers rather than straight cash.

As a means of allowing retail investors to invest in private credit, BDCs offer many advantages. They offer high dividend yields because they are required to pay out 90% of annual income and are not taxed at the entity level. Yields on underlying assets can be high especially once leverage is added and so even after expenses, there can be a lot of cash to distribute. Ares Capital Corporation currently pays a dividend yield of 8.3% and Prospect (for now) runs at 12.5%. Liquidity is also good: Regardless of the underlying assets held in the structure, investors can buy and sell stock in the market on a daily basis.

But as closed-end funds, they are constrained. Like most closed-end funds, they often trade at a discount to their net asset value. It’s a feature we’ve discussed before in the context of Bill Ackman’s fund, Pershing Square Holdings Limited. Although the structure provides its sponsor with permanent capital not subject to redemption by flighty investors, a discount can put a cap on growth by making it expensive for the sponsor to raise more capital. Ares Capital Corporation currently trades at a premium but Prospect trades at a 47% discount. Oaktree Capital recently took a hit by pumping $100 million of additional capital into its BDC, Oaktree Specialty Lending, at net asset value rather than market value which was 10% lower. Third-party investors benefited but it’s not something any of them would have done.

This cumbersome feature of closed-end funds explains why they are running out of favor, especially with daily liquidity increasingly being seen as overrated (at least in the days of a bull market). Apollo Global Management recently launched an exchange-traded fund in partnership with State Street to operate alongside its BDC, MidCap Financial Investment Corporation. And other firms have launched non-traded “interval” funds that offer quarterly withdrawals rather than intraday liquidity. Blackstone has $40 billion of net assets in its non-traded private credit fund, BCRED, compared with $6 billion in its listed vehicle, BXSL.

But given their greater transparency, BDCs offer a unique window on the private credit industry and are worth keeping an eye on. As recession fears resurface, this is where stress will appear first. To explore the competitive struggle between banks and private credit through the lens of BDCs, read on...